Markets steeled for Brexit fallout

As a political rather than an economic shock, the effect of the result on the economy is more indirect in the short term, delivered through the financial markets and the knock-on effects on business and consumer confidence, says Ian Stewart, Deloitte’s chief economist in the UK.

He explains: “[June 24] saw a flight from riskier assets, such as sterling and equities, to safer assets such as gold, government bonds, the yen and the dollar. If sustained, declining financial market risk appetite tends to feed through to weaker risk appetite in the corporate sector. Companies react by battening down hatches, paring investment and sharpening their focus on cost control.

“Foreign investors may also take fright and hold back on investing in the UK. Since the UK needs overseas capital to cover its current account deficit, the result of such a buyers’ strike would be a further weakening of the pound.” He points out that to generate a full-blown recession “consumers, who account for two-thirds of GDP, would need to stop consuming, as they did in 2009-10”.

It is unavoidable we will experience a recession Dominic Rossi, Fidelity International

Dominic Rossi, global chief investment officer for equities at Fidelity International, noted on June 24 that the decision “will fundamentally change the way we administer our laws, our regulation and trade agreements. It leaves business leaders and investors in a period of unprecedented uncertainty for the UK. I think we have to realise there will be a negative economic effect in the immediate future.”

While Mr Rossi points out the UK economy has performed well in the past couple of years, he adds: “I think it’s unavoidable we will experience a recession. It will be mild compared with 2008-09, with rising levels of unemployment and falling demand and some relief from exports from a weaker currency. I see us coming out of this recession in 2017.

“I think this is a shock and shocks tend to hit economies relatively quickly, so I think we’ll probably start seeing signs of deceleration over the summer.”

A key element in stabilising the economy will be actions taken by the government and the Bank of England (BoE), with Mr Stewart noting the most useful response “would be for the government to signal the direction of travel for the UK in its negotiations with the EU. In markets and business as in life, intent matters”.

Meanwhile, in the days following the referendum result, chancellor George Osborne ruled out the immediate introduction of a so-called “austerity Budget” that had been mooted in the run-up to the vote.

Tom Selby, senior analyst at AJ Bell, says: “While exceptional circumstances may require radical solutions, instant austerity through a knee-jerk ‘punishment Budget’ could have further destabilised an already febrile economy. However, this is likely a stay of execution rather than a full-on reprieve. If the economic warnings of the Treasury, the BoE, the Organisation for Economic Co-operation and Development and others are proved correct, the next prime minister and his or her chancellor will eventually need to wield the axe or raise taxes to balance the books.”

On the central bank side, Mr Stewart notes: “The BoE could undertake more quantitative easing, stepping up the volume and the range of assets purchased to boost liquidity and asset prices and drive down long-term interest rates. Inflation may head higher as a weaker pound pushes up import prices, but as a one-off phenomenon in an economy facing great uncertainties, such a temporary inflation would not justify interest rate rises.”

But until there is more confidence in the UK’s position, business investment and employment are likely to slow, which in turn will weigh on UK growth, warns Nikko Asset Management senior portfolio manager Simon Down.

“The BoE could react to this by reducing interest rates from 0.5 per cent to zero per cent, but it is likely to need some evidence that the economy is actually being negatively impacted before acting,” he says.

Meanwhile, one widely expected effect of Brexit is to make the US more likely to keep interest rates on hold. Jim Leaviss, head of retail fixed income at M&G Investments, suggests: “With the global growth outlook also now likely weaker, we expect the US Federal Reserve to be on hold. No rate hikes for the foreseeable future.”

Azad Zangana, senior European economist at Schroders, adds that having already put off a rate hike in June, the Fed “will almost certainly keep interest rates on hold for the rest of the year”.

Outside of monetary policy and interest rates, additional concerns include the potential for Scotland to hold a second independence referendum, with Scottish National Party leader and first minister for Scotland Nicola Sturgeon announcing a second vote is “on the table”, as well as plans to enter into discussions with the EU on “protecting Scotland’s place”.

But while there are some concerns the UK’s vote could lead to similar calls for referendums in other European countries and a knock-on effect on European growth, the likelihood of a global recession appears slim.

Joachim Fels, global economic advisor at Pimco, says: “The impact on global growth and inflation on the cyclical horizon is likely to be relatively small – and almost certainly not large enough to push the global economy into recession. Even if the UK fell into a recession, the direct knock-on effect on global GDP through lower UK import demand would be minimal as the UK accounts for only 3.6 per cent of global imports of merchandise goods and 4.1 per cent of global imports of commercial services.”

Valentijn van Nieuwenhuijzen, head of multi-asset at NN Investment Partners, adds: “What we do know is that this is a political crisis that will not automatically trigger a worldwide recession or a liquidity crisis in the financial system. There is huge uncertainty politically and economically, especially for the UK. Recession there seems likely, but policy action will be key in determining how deep it will be.”

Eric Chaney and Laurence Boone, from the research and investment strategy team at Axa Investment Managers, add: “We expect a slowdown in the UK, starting to materialise in the third or fourth quarters – a recession being a possibility. Neither the US or Asia are likely to be significantly hit by the UK vote. Markets will unavoidably ask the question: ‘is this exogenous shock going to trigger a global recession?’ Our answer is probably not, but it is fair to say that uncertainties have increased.”

Nyree Stewart is features editor at Investment Adviser