In a nutshell, Nomura expects the global impact of the Brexit to be more through the financial, confidence and psychology channels than simply through trade. Their warning is to not underestimate the depth and reach of global financial market contagion, which seems to have increased since 2008...
To assess the global impact of this surprise result, it is important to look beyond the trade channel. Once the financial, confidence and psychology channels are taken into account our warning is to not underestimate the depth and reach of financial market contagion to Asia.
A globally coordinated central bank response to a global financial market meltdown is quite likely, such as liquidity support through FX swap arrangements and possible FX intervention, but with policy credibility at such a low it is unclear how successful these emergency measures would ultimately be when there is extreme market risk aversion.
Do not underestimate the global contagion
At first glance, it would seem that the financial and economic impact of this result should be largely confined to the UK, given that its economic size is quite small at less than 4% of world GDP and world imports in 2015. However, we believe that this is too simplistic of a view and that the impact of the Brexit will be far reaching and long lasting, for two main reasons.
First, we expect non-trivial spillover to the euro area economy and financial markets. While the value of merchandise exports from the rest of the EU to the UK is only 3% of the rest of the EU’s GDP1, the UK’s position as a global financial hub – UK financial sector assets account for more than 8x its GDP – leaves the rest of the EU much more exposed to the UK in terms of financial and investment linkages, in part reflecting the UK’s relatively liberalised domestic market and its strong legal framework and institutions.
- One-third of the UK’s financial and insurance services exports are to the EU
- More than half of the UK banking sector’s cross-border lending is directed to the EU
- Almost half of the foreign direct investment received by the UK comes from the EU2
In addition, Brexit could further inflame anti-EU sentiment in other EU member states, heightening fears of more countries opting to leave the union. It is largely due to these non-trade-related channels that we expect a reduction in euro area GDP growth by 0.5 percentage points (pp) and a weaker EUR/USD.3 While UK share of global GDP is less than 4%, the rest of EU’s share is 18%, so once second-round effects on Europe are taken into account, the global impact is no longer trivial.
Extreme uncertainty is an anathema to financial markets
This extreme uncertainty in the City of London, one of the world’s largest financial centres, is anathema to global financial markets, especially when the global economy is as fragile as it is and as there are limited monetary and fiscal policy easing buffers available to most of the world’s major economies.
At this early stage, great uncertainty exists over just what the Brexit will ultimately mean for the UK economy. For example, how soon and how successful will the UK be able to negotiate with the EU the terms of its withdrawal, and renegotiate trade relationships with 60 non-EU economies where trade is currently governed by EU relationships? Will there be constitutional havoc in amending legislation from EU law to UK law? Will Scotland push for another referendum on independence? Heighted uncertainty and risk aversion is likely to discourage new investment in the UK and weigh on consumer sentiment. The danger is that all these factors – rising inflation, falling asset prices, high uncertainty and weakening private domestic demand – reinforce each other in a downward spiral, dwarfing any positive impetus from a more competitive exchange rate or monetary and fiscal policy easing.
The psychological impact – a link to the US elections
Moreover, one should not underestimate the psychological impact and how quickly markets could link the outcome to a rising risk of Donald Trump winning the US presidential election. As Anatole Kaletsky warned in an article on Project Syndicate (see Brexit’s impact on the world economy, 17 June 2016), the UK referendum is part of a global phenomenon – the rise of nationalist sentiment and populist revolts against established political parties. The demographic profile of Brexit supporters is found to be strikingly similar to that of American Trump supporters. The opinion polls are also strikingly similar: The UK polls showed the Brexit and Bremain camps to be close to neck and neck going into the referendum, as are the US polls on the two main US presidential candidates, Trump and Hilary Clinton. In contrast, investors, judging from recent price action, did not anticipate a Brexit, and option pricing suggests markets are also discounting a Trump victory. The UK betting markets too have downplayed the results of opinion polls: the odds of Brexit were generally about 1-in-3, similar to what US betting markets assign to a Trump victory.
The surprise Brexit result should now increase the credibility of opinion polls – they had indicated a much closer race than the odds published by bookmakers – in gauging how people actually vote. Statistical theory even allows us to quantify how expectations about the US presidential election should shift following the Brexit wins in Britain. To quote Kaletsky, imagine “for the sake of simplicity, that we start by giving equal credibility to opinion polls showing Brexit and Trump with almost 50% support and expert opinions, which gave them only a 25% chance. Now suppose that Brexit wins. A statistical formula called Bayes’ theorem then shows that belief in opinion polls would increase from 50% to 67%, while the credibility of expert opinion would fall from 50% to 33%.” The upshot is that investors are likely to take the results of opinion polls more seriously now and, as such, financial markets could start pricing in a greater risk of a Trump victory in the 8 November election and, possibly, a greater chance of populist insurgencies in the rest of Europe.
The financial tail wagging the real economy dog
In a nutshell, we expect the global impact of the Brexit to be more through the financial, confidence and psychology channels than simply through trade. Our warning is to not underestimate the depth and reach of global financial market contagion, which seems to have increased since 2008. For instance, during the European crisis of 2011, when there were significant fears of EU breakup, Asia’s stock and bond markets became much more highly correlated to the Euro Stoxx 50 and the German government bond yield than over 2000-07 (Figures 1 and 2). And as Hyun Song Shin, economic advisor and head of research at the BIS, recently described it (see Global liquidity and procyclicality, 8 June 2016), “the real economy appears to dance to the tune of global financial developments rather than the other way around”, through wealth, confidence, loan collateral and liquidity effects.
Granted, one potential cushion to a global financial market selloff is expectations of a further delay in the next Fed rate hike, but markets have already significantly priced out Fed hikes for this year (following the Brexit outcome, the market is now pricing a mere 6% likelihood of a Fed rate hike in 2016, down from 58% prior to the EU referendum).
Our US team now believes that the most likely timing of the next Fed rate hike is December (see Policy Watch: Brexit vote will likely delay FOMC rate hike, 24 June 2016). Instead, we believe that the more dominating factor will be renewed concerns over global growth and a likely stronger USD – together they are likely to cause oil prices to continue falling, adding more fuel to the fire of a major risk-off event in emerging markets. A globally coordinated central bank response to a global financial market meltdown is quite likely, such as liquidity support through FX swap arrangements and possible FX intervention, but with policy credibility at such a low it is unclear how successful these emergency measures will ultimately be when there is extreme market risk aversion.