The biggest fall has been in sterling but the biggest worry is the impact on long-term investment
By Buttonwood
FRIDAY was the day when international markets absorbed the shock of the British vote to leave the European Union; a vote that few investors had anticipated. But today, market focus shifted back to the places where the vote is likely to have the biggest impact; on Britain and its European neighbours.
The biggest impact was on the pound, which continued Friday's big decline, especially against the US dollar, falling by another five cents to less than $1.32, its lowest level since the mid-1980s. The weaker pound reflects the expectation that Britain will be a less attractive destination for foreign investment; with a 7% current account deficit in the last quarter of 2015, Britain needs to attract foreign capital. A weak pound helps a bit by making British assets cheaper and thus more attractive.
But it may not help a lot. First, there is the J-curve effect; imports become instantly more expensive and this widens the deficit. It takes time to crank up exports. And Britain's manufacturing sector is quite small; the last big decline in the pound in 2008-09 did not eliminate the current account deficit. What a lower pound does mean is higher inflation (wait for the first "Brexit tax" in the form of higher petrol prices) and thus a squeeze in living standards.
Turning to equities, statements by Mark Carney, the governor of the Bank of England and George Osborne, the finance minister (for the moment) about the stability of the financial system fell on deaf ears. Shares in two of Britain's biggest banks, Barclays and Royal Bank of Scotland, were briefly suspended today when their prices fell sharply after the opening. Investors seem concerned that a weaker British economy will mean both more debts and reduced demand for mortgages. The same factor explains why housebuilders like Persimmon, Taylor Woodrow and Wimpey have all seen their shares take a battering. The domestically-focused FTSE 250 index was down 7% in late afternoon trading, or around 14% from Thursday's close.
There is not the same kind of stress in the FTSE 100 index which is above the lows recorded earlier in the month (a little below 6,000). But many FTSE 100 companies are multinationals whose fortunes bear little relation to the British economy, or whose overseas earnings will be boosted (in sterling terms) by recent foreign exchange market movements.
Most remarkably of all, 10-year gilt yields have dropped below 1% for the first time in history. Some may see this as a vote of confidence in the British economy but, talking to investors, that's not the real driver. Investors pile into government bonds when they are worried about the economic outlook, and when they expect short-term interest rates to fall; Royal Bank of Canada is expecting interest rates to be cut in two stages to 0.1% by August and another £50 billion worth of quantitative easing.
Some argue that there is little to worry about here. Lower gilt yields mean reduced borrowing costs for the government; the pound was almost as low earlier in the year.
And they are certainly right; it's not the moves in the markets, by themselves, that is important but what they signify for the economic outlook.
The reasons to expect lower national income when the UK leaves the EU are well-established: prolonged uncertainty, reduced access to the single market, and reduced investment from overseas. Each of these would be highly likely, and the overwhelming weight of evidence is that each would be damaging for the living standards of UK households. As a result of the decision to leave, we should expect to see:
Lower real wages; a lower value of the pound — and hence higher prices for goods and services; higher borrowing, lower public spending, or higher taxes; in the short run, higher unemployment
Some will dismiss all this as "project fear" but the vote is done and dusted; there is no need to persuade voters any more. This is "project reality". So when Natixis, the French fund management group, forecasts a British recession in the fourth quarter of this year and the first of 2017, that is the view that is going to guide its investment decisions. The same goes for Julius Baer, the Swiss bank, which cuts its 2017 growth forecast from 1.7% to 0.7%. These forecasts may turn out to be wrong, of course, but they have their own momentum; companies will hesitate before committing to build new factories in Britain on the back of such predictions.
Evidence of the impact on business investment is inevitably anecdotal, after just three days. But here is Erik Nielsen of Unicredit
Meanwhile, recession is looming as investments are put on hold, leading to a widening of the already sizable budget deficit. My neighbour here in Chiswick, who runs a small IT company catering predominantly to the financial and legal industries, told me this morning that virtually his entire order book was cancelled on Friday by clients who are putting their projects on hold. For every one of these “micro disasters”, there needs to be an SME in north England who expands his book because of the supposedly good news of Brexit. I’ll venture a guess: It won’t happen!
The sheer political chaos in Britain means that there is even more reason to put investment plans on hold; Britain looks rudderless.
Analysts are also working out how the vote will affect specific sectors of the British economy. The real estate team of Jefferies, for example, has forecast that London office rents will fall 18% and some 10m square feet of demand for office space moves to Paris or Frankfurt (that is because banks will need to shift business to the EU to operate in euro transaction clearing or to have passporting rights in the EU). Russell Investments has said that pension funding levels will fall by 10% (lower asset prices and higher liabilities, as the bond yield falls); companies will need to divert cash from investment into their pension schemes.
The best hope for markets and investment is that Britain opts for a Norway-style deal; membership of the European Economic Area. This means continued membership of the single market but at the "cost" (in terms of political risk) of free movement of labour and a budget contribution. Commentators are suggesting variants of this deal; perhaps with an "emergency brake" on free movement. It is not clear how politically feasible this is, on either side of the negotiations. The EU has fudged solutions before. But if we start heading that way, markets may rally.
