On Thursday, June 23rd, the people of the United Kingdom made the most important decision in their economic history. In one gust of wind, nationalist sentiment swept what according to polls seemed to be a deadlocked nation toward a 52-48 victory favoring to leave the EU.
The young, liberal, and educated tended to vote “remain”; 75% of citizens between ages 18-24 and 71% of citizens with a college degree chose to listen to the Bank of England’s recommendation that leaving the European Union would result in economic destabilization and bleak outlooks for the country in the near-term.
The UK banks were right - partially, at least. The aftermath hit neither the UK nor the world economy as hard as some predicted. The Economist was correct in expecting significant volatility and a sharp depreciation in the British pound if the nation chose to leave. Growth was projected to slow from declining domestic demand, largely due to the depreciation of the sterling. Analysts at Goldman Sachs expect a possible technical recession (two consecutive periods of negative GDP growth) by the beginning of 2017. Bloomberg analysts believe that there will only be significant near-term economic disruption, but no technical recession as long as financial institutions continue to function properly.
On the day of the verdict, the pound fell 7.9%, crude oil fell 5%, gold rose 5%, US markets fell 3%, and S&P pledged to downgrade UK credit rating from AAA. These are all telltale economic indications of pandemonium. Theresa May recently stepped up as the new prime minister succeeding David Cameron, and chances of a second referendum (a revote) seem bleak under her leadership.
The Bank of England does not plan to cut rates from 0.5% this month, which has been unchanged for the past seven years; however, Mark Carney, the governor of the Bank of England, clearly states that they plan to cut rates in August. To stimulate the economy, the Bank of England is currently focused on quantitative easing (injecting the economy with more money to lower interest rates and stimulate spending) and rebuilding the value of the pound. The depreciation of the pound’s value makes imports much more expensive to Britain, while making exports cheaper for other countries. Unfortunately, if Britain is unable to retain access to the single market from negotiations with the EU, their exports will also be limited.
With quantitative easing always comes the fear of inflation, and the Bank of England is currently debating over how to provide an antidote to their paralyzed economy. If inflation does take off, analysts estimate that inflation will peak in 2017, yet they still expect positive growth in the economy as a whole since Britain will be a full year into its efforts to salvage or rebuild its economy.
Rumors are circulating that rates could rise in the latter quarter of the year, around October or November. As a result, spreads will tighten and bond prices will be driven back up after experiencing a credit shock of 100 basis points. Analysts also expect Brexit to lower GDP by 1.5% in 2017 or 2018, with the brunt of the damage taken in 2017. Brexit’s temporary stalling effect on the British economy and its subsequent rate fluctuations alongside weakened growth prospects make it hard for the UK to hit its two-year 2% inflation target.
For the US, analysts only expect a 0.1-0.2% impact on GDP growth in the next 2 years, with minimal trade effects on the US economy at large.
Major SIFIs (Systemically Important Financial Institutions) like JP Morgan have stated on their recent earnings calls that it is still too early to determine the impact that Brexit will have on their operations. They answer any and all Brexit-related inquiries with a one-size-fits-all response; ”we will continue to serve those in Europe and every country to the best of our ability.”
In reality, Brexit’s most widespread result - the breakup of the European single market - is projected to hurt financial institutions the most, because fewer companies will seek these institutions to underwrite acquisitions or perform transactions for them in a time of uncertainty. Instead, most are hoarding their money, cutting down their investments in volatile securities, and slowing their expansion strategies as gold prices soar from general market uncertainty.
To cope with Brexit’s consequences, the BOE holds more than $250 billion of potentially stimulating funds that could be injected into the market in order to support struggling companies. Britain banks have also raised 130 billion British Pounds [BP] worth of capital and retain 600 billion BP in liquid assets (10x as much money held than before Brexit). This reserve will provide banks with flexibility and enable them to take moderate financial risks and continue their operations as normal, providing corporate and commercial loans.
The impact of the Brexit on the world economy is certainly nowhere near that of the 2008 financial crisis; nonetheless, analysts, media outlets, and investors are speculating the numerous potential economic scenarios of the Brexit. The important thing for the EU to take away from Brexit is to avoid punishing the UK. The two bodies may be divorcing, but their economic fates are still intertwined, and what will hurt the UK will also hurt the EU. The EU must remain open to negotiations and help the UK stay in the single market in order to restore economic stability and enhance the UK’s recovery.