Europe’s Brexit

2016-06-29

The opening skirmishes are behind us. Markets were shocked out of their Brexit complacency, selling risk heavily and buying safe haven, but now coming up for their first breath of air. The political leadership in England imploded, showing up deep divisions which also were felt regionally, Scotland especially. Political parties are now searching for new blood, something that may take a few months being finalised.
Europe showed up its many layered complexity, implacable principles at the top, possibly technocratic flexibility just below that, while deep in democratic bowels there are growing populist forces at work, potentially like in Britain capable of fireworks if not addressed.

Britain shows evidence of a remarkable range of wishful thinking, some hoping they can turn the clock back, others hoping to make the best of a bad case. And yet others claiming leaving will be fine, indeed make Britain stronger. Indicative there is hardly any national consensus, half a million votes in a 60 million nation decided the majority Brexit outcome, these probably simply not liking foreigners.

There is much speculation on British sides that it can pick the future relationship with Europe that suits it best, yet Europeans quick to suggest that the UK can’t cherry-pick its future relationship. 

And this is only day 6 post-Brexit. There is clearly a lot more to come before the full fallout of this development has been truly absorbed and digested.

Markets sold off so heavily for two reasons. Firstly, there had been complaisant positioning for a stay outcome that needed to be undone. Secondly, the leave option contains risks that only subsequently have fully come into view.

Why were so many caught offside? It points towards a deep social divide, not only afflicting Britain, but apparently all rich Western nations. Elites living increasingly in cocoons (or bubbles, as we call them affectionately in SA), those populating markets, media, the political and business top ranks only talking to one another and never to lower ranks, and having forgotten which is the greater democratic majority, and not fully appreciating the many angers brewing right below their feet.

The selloff when it came was heavily focused on Sterling, with Britain having a very large current account deficit (4.7% of GDP, spiking to 7% in 4Q15) that needs to be funded, against a prospect of lowered growth (increased business & consumer uncertainty), sectoral damage (financial industry shrinking) and increased stand-alone risk (rating agencies abruptly downgrading), with future trade losses yet to be decided and discounted.

It took Sterling from 1.50:$ down to near 1.30:$, with further weakness expected nearer 1.20:$. In contrast, top-tier government bond prices rose, British yields falling to below 1%.

The global market fallout was widespread, if contained, equity prices falling, most currencies weakening against a rising Dollar, with top-tier government yields heavily lower on safe haven buying (US 10yr Treasury testing 1.5%) while gold rose smartly above $1300.

Ultimately, however, the global blowout was contained, with risk recovery commencing quite quickly. No deeper selloffs will necessarily follow, unlike 2008, as this is primarily a regional development. There doesn't seem to be a much deeper institutional rot globally. Even so, that doesn't mean either that the safe haven plays will quickly unwind. See it as additional insurance taken out as the world awaits the next stage of the unfolding European Brexit, and the greater global picture marked by much uncertainty.
Which puts the focus back on Britain and her Continental suitors.

It is not certain that Scotland can constitutionally block a Brexit. More likely, the Tories need to elect a new leader, who will appoint a new cabinet, them together facing the music.

Whereas anger at the Brexit vote (and decades of UK sniping) has made some Continentals inclined to get this UK parting over with it as quickly as possible, not least because the uncertainties created will also erode European growth, the more so the longer it lasts, cooler heads also prevail.

This isn't necessarily an invitation for Britain to start & keep talking until Europe gives it what it has demanded all along (in its case less free movement of people, but with full access to trade). German Chancellor Merkel’s view of Europe is clear. The total package is one of free movement and full access. If you don't want the one, don't expect the other. Cameron got that message loud and clear. It isn't obvious everyone has (yet).

Also, there seems to be an European inclination that there is no going back. The UK has voted. This may partly reflect implacableness about immigration issues on all sides, but also reflects that there are big populist blocks everywhere. Giving the UK a sweetheart deal might only encourage these many groups.
And yet when examining the views of the six foreign ministers who came together on Monday ahead of wider meetings, one is left to wonder. More focus on common interests (defence, border security, immigration), while suggesting that a lot of other things can be handled better at local level, if necessary at varying speeds.

This suggests to some a multi-speed Europe moving away from fuller integration (and thus suggesting the beginning of the end for European integration).

Alternatively, Europe proposes coming together ever closer on bigger issues (outside threats especially) while allowing greater national sway over local issues that should not concern Brussels so much – in other words, less central standardization where it doesn't matter so much in favour of more localised democracy which does, outflanking the populist extremists.

And this places the focus back on the electoral cycle. Some in Britain want another referendum, others want an election, but the next Tory leader may prefer to stay put. Meanwhile, in Europe, Spain had its say this past weekend (firming the centre), there are key elections next year in Holland (March), France (Presidential) and Germany. Italy looks most at risk to another referendum attempt, while France may be most at risk to a presidential upset.

Whether the events these next 12 months will be enough to arrest the populist advance (or accelerate it) will depend on a number of outcomes. The clear pain to be experienced by Britain as the unset of shock and greater future uncertainty may invite economic defensiveness triggering recession that not even BoE liquidity support may effectively counter, could be a loud message to other Europeans not to go there. Also, more reform efforts, devolving locally what should be democratically left to locals (reining in Brussels) while accelerate the bigger issues with a geopolitical reach (stand together or sink).

Thus there may be many forces on a tear that will shape 2017, besides populist anger still rising.
Central banks will likely be supportive and take the edge off any downside, most forecasts only shaving a few decimals off European growth (and a fraction thereof globally). Global markets may well accept that this will remain a localised issue only, not worthy of global panic, in which case global risk recovery can proceed to unwind some of the safe haven plays.

As to the penalties to be dealt to Britain and to Continental Europe in all its diversity, that may depend on how the cards fall. I wouldn't assume an easy ride for Britain, with many of the belatedly repenting leavers sensing realistically what is being lost. Hard negotiations lie ahead, lingering uncertainty exacting its own price. Europe may also not go unscathed as markets sense deeper populist revolt still coming to the boil, longer periods of uncertainty, it all taking its toll.

The greater world isn't served by slower European growth, as it diminishes export growth. The safe haven plays favouring a stronger Dollar may see new rounds of global currency realignments (“war”), with China a key player, in turn capable of putting pressure on exposed EM and commodity plays.
Then again, central banks aren't played out. The Fed’s dovishness may yet get extended more, the BoE, ECB and BoJ are likely to undertake more liquidity support (and rate action, the latter into deeper negative territory), and China may offer some more fiscal support for the duration.

SA is affected on many levels, with trade impacts only a distant reality. Far more important are risk recoveries (favouring it), central bank support actions (also extending our safety net), key commodity price movements, and reduced EU growth on defensive pullbacks eroding our growth, but probably only minimally.

On balance, this is a punch that we should be able to handle in the short term, with Rand volatility in a 14.50-15.50:$ range in any case build into our cake for 2016. More important is global central bank support, market risk recovery and China not going critical shortly.

If so, our real exposures are domestic, and there we hardly have any reason for complacency. Too many things not right as we move deeper into robust local electioneering, setting us up for some very serious choices in the closing months of 2016.

Cees Bruggemans
Bruggemans & Associates, Consulting Economists
Website www.bruggemans.co.za
Email  economics@bruggemans.co.za
Twitter  @ceesbruggemans
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