11th July 2016

Great Britain and EU, Brexit referendum concept

For many, the unthinkable has happened. What is clear in the initial aftermath of the Brexit vote, is that many questions have emerged that are likely to remain unanswered for some time. What will Brexit mean for the wider Eurozone project? What are the global implications? Perhaps the most fundamental question is what it actually means for the UK. A question it appears not even the most ardent of Leave campaigners could adequately answer. What we do know, is that the country will remain in limbo until a new government leader is elected before October. After that we will next wait to see what the UK can ‘negotiate’ with their one time European partners. The referendum gave us the verdict, next we will arrive at the trial, and finally the sentencing.

Market/Central Bank Reaction

The short term reaction has been instructive. As we would have expected, the pound has borne the brunt of the initial shock with GBP/USD hitting levels last seen in 1984. Global bond markets have also been quick on the uptake, pricing in lower growth for longer with government bonds in Europe moving further into negative territory (it now costs 50 basis points to lend the Swiss government money for 50 years).  Equity markets have been remarkably resilient, as has credit, as central banks have been quick to show their support. Renewed (increased) liquidity injections will be provided as and when needed. Since 2008, central banks have had plenty of practice at unconventional intervention. As a result of all of this, we see short term concerns as reasonably contained.

In the longer run, more difficult questions may be asked of central banks. With the pound some 20% weaker against the dollar compared to 12 months ago, will inflation kick in to the UK? Moreover, should the currency continue to weaken, will the Bank of England need to take a more hawkish stance to provide protection? In Europe, as rates move deeper into negative territory, the banking system is coming under further pressure with the focus now firmly on the Italian banks. Another resolution of some kind may be required to stave off disaster. Lastly to the Fed, where the market now has priced rate hikes out of the equation for the foreseeable future. The big ‘what if’ of course is that of improved data in the form of jobs/wages numbers. This may put the Fed in something of a dilemma. More on this to come no doubt.

Longer Term Implications

The fallout from this may even be more pronounced than the Lehman Brother’s default given the more difficult position the global economy finds itself in today. We have moved from an economic crisis to a political crisis; a far more serious state of affairs. The structural problems exposed by the 2008 crash have only, in many cases, been made worse by government and central banks’ inability to deal with the root causes of our debt and demographic problems. How did they think we could deal with a debt crisis by creating more debt? By the Federal Reserve’s own research many of the monetary tools used since 2008 often have serious unintended consequences which further complicate an already difficult situation (I will bet that they did not foresee one of these being the election of Donald Trump and the abolition of the Fed!). In terms of policy, the banking sector in Japan and Europe provide all of the necessary evidence of the damage a drive to negative rates can do. Financial equity valuations are screaming out that real problems exist. Falling living standards for the middle classes and a dearth of opportunities for the young have been evident for some time now – for anyone that is willing to look beyond the level of the S&P 500.

The votes for the extra £350m per week to fund the NHS are very similar to the votes Donald Trump received for his border wall against Mexico during his Republican race (neither are ever going to happen). Today’s democracies are finding it difficult to move from reality TV and Twitter feeds to real leadership and meaningful politics. It speaks volumes that the number one rated Google search in the UK the day after the referendum was “what is the EU”! Across the board economic growth predictions have been slashed; with good reason. The cost of this type of politics is clearly becoming significant.

What next for the UK

The UK has taken a significant leap into the dark with neither a torch nor water wings. The current state of the economy is that of an already sick patient. Record trade and current account deficits point to a country badly in need of foreign direct investment, whilst there exists a need internationally for its world class and open service industries. They can of course attempt to debase the currency similar to 2008. Unfortunately for the many who voted to leave, this will bring little more than higher inflation and flat wages. At the same time, the City will look for reduced taxation and potentially a ‘regulation free’ environment to play their dangerous games. Much needed infrastructure projects will be put on the back burner and construction in general will be postponed given the upcoming housing crisis. The UK had many concealed issues before this vote, today many of these have risen to the surface and need addressing.

I could of course be wrong, and this could be the catalyst for real positive change, which I recognise is what many of the ‘leave’ voters actually voted for. A lot of those that we have spoken to strongly believed that the system needed a shake-up. Not for some of the uglier nationalistic reasons we have seen rising to the surface, but due to the belief that a change of direction is needed. In fact, encouragingly, the noises coming out of Europe have been positive in this regard – German Finance Minister Wolfgang Schaeuble is amongst those who have stated that the EU “will not be able to go on like this”. Ultimately however, our belief is that the UK, along with other countries in the developed world, suffer from the same issues (globalisation, debt overhang, demographics) that are not attributable to EU membership. Issues that we believe are unlikely to be resolved by exiting the EU. Nevertheless over 17 million people voted for a referendum result, many with no idea of what their vote would ultimately mean. The unelected central bankers have already failed us, maybe the time is right for our elected officials to stand front and centre and attempt to steer the ship in the right direction.

By Steven O’Hanlon