UK opens a can of worms

Posted on June 27th, 2016

Preparations for Brexit were minimal by government, business or even financial markets.  The outcome has been a significant shock.  The event has left UK politics reeling and investors from mum and pops up will be figuring out what to do with their not so Great British Pounds. Euros will also have a question-mark over them with people wondering over the short-comings of the EU that lead one country to leave.  The USD may benefit, but the Fed will be even more reticent to raise rates, and the USD has tended to fall more easily this year as the Fed has pushed out its time-table to hike.  The JPY has been the strongest currency, but now near 100, about a quarter stronger than its lows near 125 last year, the pressure will be on the BoJ to ease policy again and its government may have already stepped in to stabilize to surging currency on Friday.  Emerging market currencies are not the natural go to havens in times of stress and uncertainty.  Gold should continue to find support in this environment

The first problem to contend with is UK political uncertainty. The Tories need to choose a new leader who will be under enormous scrutiny from a divided public.  It will be very difficult for that leadership to state a clear position on matters such as whether the UK should stay in the European Economic Area.  Since a major segment of the leave voters were most concerned over unfettered immigration from the EU, it seems impossible that a British leader will be able to commit to the EEA membership as a fall-back position to leaving the EU.

There is a high expectation that a new election will be required in the UK to set a mandate for how to proceed with economic relations with Europe.  As such the debate is likely to proceed for months, perhaps into next year, tensions in politics and the public may remain high with immigration policy a major impediment for maintaining free trade with the EU.

Even though it may be years before any actual changes to rules on commerce and people movement are implemented, businesses will feel hamstrung on making long term investment decisions in the UK. Many companies outside and inside the UK will think it safer to shift some operation towards Europe, away from the UK. Multinationals may opt to invest less in both UK and Europe until political direction is clearer.

Political uncertainty in the UK is made worse by the nature of the split in the vote across countries and socioeconomic groups.  It opens up risk of another Scottish referendum on independence, it forces the UK government to be highly sensitive to the different aspirations of the younger and more educated higher income earners in London that sided with Staying in the EU with the older and working classes outside of the financial services sector that feel left behind by globalization.  Few Britons will accept the notion that they should continue business as usual, the battle over political, economic and social policies may have only just begun.

As the USA and other countries, facing their own elections, watch on at the evolving debate and political fallout in the UK and Europe, the trend may be to implement barriers to free trade and tighten immigration policies dampening to some degree global business confidence.

Cohesion in Western developed countries appears to have taken a step back. This may be seen as part of a shift towards increasing power in developed nations, but confidence in the economic stability and political leadership in many large developing countries has taken a hit in recent years.

On one level it can seem we are reading too much into this vote, but it may represent a tilt towards less global cooperation, more inward looking government policies that heighten risks related to international disputes and dampen commerce.

One glimmer of hope in Europe is that after the UK vote, the election in Spain on Sunday delivered a stronger than expected result for the conservative Popular Party led by the existing Prime Minister Mariano Rajoy.  Ahead of the vote, polls were showing a shift towards the leftist parties.

The PP party received 33% of the vote and second was the centre-left Socialists with 24% of the vote.  The far-left Unidos Podemos gained 21% of the vote, worse than it expected.  The outcome still represents a fractured parliament, but the result is better than expected for the establishment parties that have been prepared to work more clearly with EU partners.  It suggests that the results in the UK referendum have seen voters in Spain play safe and support the case for a combined Europe.

The case for a US rate rise was placed further on the now cold back-burner by another weak US durable goods orders report on Friday.  A key point of concern in the Fed’s outlook has been disappointment in US business investment. This weaker trend has continued in this latest report; core capital goods orders fell 0.7%m/m in May, down 5.8%y/y.