Brexit — Now What?

Executive Summary

British voters have surprised most market participants by their decision to exit the European Union, and there has been a violent reaction in financial markets to the unexpected development. New terms regarding trade in goods and services and movement of individuals between the UK and other members of the EU will now need to be renegotiated, and uncertainty over those terms likely will depress British investment spending. The UK could be facing a mild recession in coming quarters.

In theory, Brexit should have few direct effects on the global economy because the UK economy accounts for only 4 percent of global GDP. However, there are also the indirect effects to consider. The tightening in financial markets that has occurred today, if maintained, could exert a slowing effect on economic activity in many economies. An eventual unraveling of the EU, although not very likely in the near term, cannot be completely discounted in a medium- to long-term framework. Geopolitical uncertainty could have a depressing effect on economic activity via weaker investment spending. We are not at the point where we would forecast a global recession based on Brexit, but we are prepared to adjust our views in coming weeks as events dictate.

Surprising Result Leads to Significant Market Fallout

Voters in the United Kingdom went to polling stations yesterday and decided, by a margin of 52 percent to 48 percent, to seek exit (a.k.a., Brexit) from the European Union (EU). Although polls had been neck and neck leading into the voting yesterday, most market participants had assumed that most undecided individuals would ultimately vote to remain in the EU. Because financial markets were not priced for Brexit, the resulting fallout has been intense. The Japanese Nikkei index fell 8 percent last night and stock markets in Europe are generally off 5 percent to 10 percent as of this writing. The British pound has been hammered, plunging in overnight trading to a 31-year low against the dollar.

So does yesterday’s result mean that the UK will soon be leaving the EU? Not exactly. For starters, the referendum is actually not legally binding. Only Parliament can pass the requisite legislation to leave the EU, and three-quarters of the Members of Parliament (MP) are on record as being personally opposed to Brexit.1 That said, a MP likely would be committing political suicide if he or she went against the wishes of their constituents on such an important issue as Brexit.

Assuming that Parliament eventually approves legislation to leave the EU, the UK would then begin negotiations with the EU over the terms that would govern most of their bilateral economic interactions going forward. Under the terms of the Single Market, there currently is free movement of goods, services and people between the UK and the 27 other members of the EU (EU-27). The UK and the EU would have a minimum of two years after Parliament approves Brexit to renegotiate new terms regarding trade in goods and services and movement of individuals. In reality, the negotiations could stretch on for longer than two years. In the meantime, a period of uncertainty will set in as the negotiations take place.

Will Brexit Lead to a U.K. Recession?

2 Our most recent forecast, which was completed two weeks ago, looks for continued modest economic growth in the UK through the end of 2017 (Figure 1). However, that forecast was predicated on the assumption that Brexit would not occur. Clearly, we need to rethink our forecast in light of yesterday’s vote. In short, there seems to be significant downside risks now to our most recent forecast.

The UK will not lose access to the Single Market immediately, so British goods and services will continue to enter EU-27 countries duty free, at least until a new trading relationship can be negotiated.3 Therefore, there likely will not be any immediate Brexit hit to UK exports. Arguably, the depreciation of sterling, if maintained, could actually strengthen British export growth in the near term. However, uncertainty about the eventual trading relationship between the UK and the EU-27 could cause British businesses to curtail investment until the picture becomes clearer. Growth in gross fixed capital formation has weakened in recent quarters, and there is anecdotal evidence suggesting that Brexit uncertainty has played a role in slowing investment growth (Figure 2). Growth in capital spending could clearly turn negative in coming quarters.

There is also the uncertainty of the legal status of the 2 million or so workers of EU-27 origin who currently reside in the UK. Will they be able to continue to work in the UK? The answer to that question will need to await the outcome of pending UK-EU negotiations. Although workers from EU-27 economies will not be immediately kicked out of the UK, will those individuals want to buy homes in the UK if their legal ability to remain in country is in doubt? Uncertainty could negatively impact home sales as well as residential construction.

There is also the future status of the City of London as Europe’s financial capital to consider. Although the UK is not a member of the Eurozone, London is unquestionably the financial capital of Europe. As a member of the EU, the British financial system falls under the EU regulatory umbrella. Can London remain the financial capital of Europe if the UK is no longer under that regulatory umbrella? Non-residential construction in the City of London likely will be negatively impacted as financial services firms weigh their options on the continent. In sum, the likely nearterm hit to investment spending occasioned by uncertainly could be enough to push the UK economy into a modest recession later this year.

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