Schroders Quickview: Stagflation looms after UK's EU referendum
The UK choosing to leave the EU comes as a major shock for investors and uncertainty will remain high for some time. In the near-term, the UK is likely to experience a stagflationary period of lower growth but higher inflation.
After months of uncertainty and market volatility, the UK is projected to have voted to leave the EU by 52% against 48% to remain (78% turnout). The Prime Minister David Cameron who campaigned vigorously for the UK to remain in the EU has announced that he will step down in October after a contest to elect a new Conservative party leader.
The formal request from the UK to leave the EU, Article 50, will not be triggered until a new prime minister is in place. The focus for investors will now turn to the reaction of markets, and the short and long-term macro implications.
At the time of writing, sterling has fallen sharply against its major trading currencies, down 7.5% against the US dollar, and 5.2% against the euro. In equity markets, Asian markets have reacted negatively to the news, with the Japanese Nikkei 225 down 7.9%.
The FTSE 100 has opened down 7%. US 10-year Treasuries have seen huge safe haven flows, pushing the yield on the 10-year Treasury by 25 basis points to just 1.45%. We expect volatility to remain high.
UK macro implications
In the near-term, the shock of the result and the uncertainty that will follow during the negotiation period are likely to prompt corporates to postpone or even cancel investment and hiring plans. Multinational companies that have chosen to locate in the UK to access the single market could start to make plans to re-locate, although ultimately, these decisions will not be taken until after the UK’s exit terms are settled on.
In the meantime, the fall in investment and hiring is likely to be felt by households as employment growth slows and possibly falls. Meanwhile, sterling is expected to depreciate significantly, which could boost the competitiveness of UK exporters, but uncertainty over trade arrangements, especially with Europe, would dampen the otherwise positive impact on overseas demand.
For households, the depreciation in sterling is likely to raise imported prices and therefore overall inflation, causing demand for goods and services to fall as the purchasing power of households is eroded. Moreover, the worsening outlook for the labour market is likely to lead to an increase in precautionary savings, exacerbating the fall in demand in the economy.
Overall, we expect GDP growth to be considerably lower in the near-term, and inflation to rise sharply. Our Brexit scenario estimated a fall of 0.9% in GDP by the end of 2017 compared to our baseline forecast, and a rise in the level of CPI (consumer price index) inflation by 0.6%.
Our next forecast update is due at the end of August, which will give us enough time to consider more accurately the extent of the changes to the forecast. Some of the key inputs will be the performance of financial markets, along with sterling, and so it makes sense to wait until the near-term volatility settles. However, we have recently published forecast scenarios of this very situation in our large study UK referendum on EU membership: The risks of Brexit.
Bank of England may loosen monetary policy
Policy makers will surely respond to try to calm fears over the economy. Beyond the provision of market liquidity by central banks, the Bank of England will probably cut interest rates, and the option of more quantitative easing is available. Given HM Treasury’s forecast of a recession in a Brexit scenario, the Chancellor (current or new) will be able to abandon the current fiscal targets and run a larger fiscal deficit. Part of the increased deficit will be caused by lower growth, but there could be some tax cuts to support confidence.
The medium to long-term impact of Brexit is currently highly uncertain due to the many aspects of the upcoming exit negotiations. Modelling a ‘most likely’ single scenario would be impossible, but as more details emerge over the negotiations, the closer we will be to a view on long-term developments.
In our view, the long-term impact on the UK economy will be determined by how much access to the single market the UK manages to retain, how migration flows are impacted by government policy, and how much the UK government manages to save in subscription costs. Most studies offer a range of scenarios concluding that the most likely outcome would be lower long-term potential growth compared to remaining in the EU.
Restrictions on EU migration could cause the UK labour market to become less flexible to demand, raising the likelihood of more pronounced wage, inflation and interest rate cycles. A more cyclical economy would not only make recessions more frequent, but international investors could demand a discount on UK assets given the higher volatility of expected returns.
UK political implications
Despite vowing to stay on and carry out the will of the people and lead the UK out of the EU, Prime Minister David Cameron has announced he will step down in October. His strong avocation for remaining in the EU meant his position was untenable and the Conservative party is expected to elect a new pro-Brexit Prime Minister. Chancellor George Osborne is in a similar situation, and may also be forced to resign.
During the leadership campaign there is a risk that the Conservative party fragments along pro and anti-EU lines. The new Prime Minister would be expected to trigger article 50 to begin exit negotiations. However given the small working majority of the government they may well be forced to call a general election. This may further delay the UK’s exit process.
Beyond the UK, the biggest concern amongst investors is the potential spread of contagion to mainland Europe. The UK’s exit could galvanise anti-EU support across Europe, starting with Spanish elections this weekend, but also French and German elections next year. Geert Wilders (leader of the Dutch Party for Freedom), Marine Le Pen (leader of the French Front National) and Beppe Grillo (leader of the Italian Five Star Movement) are all currently calling for referendums in their own countries. In an effort to head-off losses in upcoming elections, mainstream parties could yield to pressure and offer EU membership referendums of their own, risking the future of the EU and eurozone. This is a risk scenario rather than a central view, as we feel there is still strong support for the European project.
Elsewhere, the question over Scotland’s membership of the UK is likely to return. The Scottish National Party has said that Brexit would be a sufficient condition to call for another referendum. This could indeed happen in time, but given the collapse in global oil prices, Scottish public finances would struggle without help from Westminster. Moreover, a requirement to join the euro for new entrants raises serious risks for a Scotland in transition. It would need to establish a new currency, and then peg it to the euro for at least two years successfully (along with meet fiscal conditions). We suspect that Scotland would vote to remain in the UK once again were a referendum held in the near-future.
Finally and further afield, the shock to financial markets is likely to keep interest rates lower for longer across the world, and may prompt further stimulus. The US Federal Reserve, which has already postponed a hike from June partly due to Brexit fears, could now keep interest rates on hold for the rest of this year.
The UK choosing to leave the EU comes as a major shock for investors, and risk assets have sold-off in reaction. Uncertainty will remain high for some time, and the full extent of the damage done to the economy will not be visible for many years. In the near-term, the UK is likely to experience a stagflationary period of lower growth but higher inflation. As mentioned earlier, we will update our forecasts once markets settle down, allowing us to get a more accurate reading of developments.