Politicians on both sides of the debate over the U.K.’s secession from the European Union are fond of pointing out that nothing would change the day after the vote. And that is true.
Every law and regulation in place the day before the vote would remain in place until the terms of a Brexit were agreed upon, a process projected to take at least two years. But we can be fairly confident in the short run that U.K. equity prices would not stay the same, nor would the value of the pound. U.K. equities could see a further 2 to 3 percent sell-off, and there could be perhaps an additional 10 percent fall in the trade-weighted value of the pound sterling. If the polls had begun to point to a clear majority favoring the “Leave” camp, much of this would have occurred already.
How would a yes-Brexit directly affect the economy? Research by my colleagues at J.P. Morgan Chase & Co. suggests that a negative result could take about 1 percentage point from the growth rate in the 12 months following the vote — a significant hit, given the baseline growth forecast of some 2 percent in 2016. At the same time, the further decline in the exchange rate would tend to push inflation up.
In his inflation report press conference on May 12, Bank of England governor Mark Carney suggested the central bank would face a “challenging trade-off” in this scenario, between stabilizing gross domestic product growth on the one hand and bringing inflation back to target on the other. The monetary policy implications would “not be automatic,” he warned. In the mid-term, Brexit could in fact see higher official interest rates and lower growth for a given rate of inflation, if leaving the EU lowered the country’s supply-side potential by reducing its openness to trade and hurting investment. In the short term, however, we at J.P. Morgan Asset Management believe the negative hit on the economy would dominate the monetary policy response. The first rate rise would likely be deferred even further into the future, and the chance of a rate cut or other stimulus measures in the U.K. would go up.
Growth and investment in the rest of the EU would also be negatively affected. Given its heavy reliance on trade with the U.K., Ireland stands to see a major impact. The U.K. is the euro zone’s single largest trading partner, with exports to the U.K. accounting for 2.5 percent of GDP on average. That figure is more than twice as high for Belgium, the Netherlands and Ireland. The same J.P. Morgan analysts see a hit to euro zone GDP on the order of 0.2 to 0.3 percentage points over 18 months following a Brexit vote. Because of the greater strength of the euro against the pound, euro zone inflation might well be slightly lower in this scenario. The reverse would be true in the U.K.
Along with this macroeconomic reaction, we can expect a microeconomic response on the part of businesses inside and outside the U.K., as finance directors and other managers take stock of their supply relationships and consider how their costs, trading relationships, customer base and — in some cases — even their legal status might be affected by the decision. On such a microeconomic level is where the transition costs of moving to a post-EU regime would be felt most keenly. It could take several years for the nature of that regime to be clear. That means businesses will be living with uncertainty that much longer.
With more than 40 percent of the U.K.’s trade going to other EU countries, a new relationship with the EU would be crucial to the impact on individual sectors, and that is where the political economy gets tricky. In practice, there is a trade-off between sovereignty and market access — even if the supporters of Brexit suggest that the U.K. can have access to the single market without all the rules and regulations that go with it.
The closest analogy to what the U.K. would face with a Brexit is the Norway option: membership in the European Economic Area, making a contribution to the EU and abiding by all single-market rules, including free movement of people. This is unlikely to appeal to those who want to see the U.K. break free of Brussels, however, since it involves all of the regulation that the U.K. has today but none of the influence. Nonetheless, for the financial sector, EEA-only membership would guarantee the continuation of passporting rights for U.K. financial services firms to do business in the EU.
The less onerous option — but also the least favorable from a business standpoint — would be to fall back on the mutual market access available to all members of the World Trade Organization. Given the significant constraints that would impose on trade relative to the status quo, this outcome would also likely not be satisfactory. Outside the EU, the U.K. would also have to try to at least replicate the 50-odd trade agreements that the EU has negotiated with other parts of the world.
Most likely, the U.K. would end up with its own arrangement somewhere between these two extremes. The U.K. has an enormous traded goods deficit with the rest of the EU that has been widening recently, with imports from other parts of the EU growing much faster than imports from the rest of the world.
Supporters of Brexit say this guarantees a generous settlement for the U.K., on the ground that the rest of the EU would not want to put that trade at risk. Yet most of the deficit is with Germany and Spain, so it’s not guaranteed that the rest of the EU would see it that way. Political rancor over the decision to leave could also infect the negotiations. But the U.K. also runs a significant surplus in services trade, including a £19 billion ($27.9 billion) surplus in trade of financial services in 2014. Whether the U.K. would also get a generous deal on services seems more doubtful.
Much depends on whether EU leaders believe it is in their long-term interest to keep London as Europe’s preeminent financial center. Switzerland is often cited as a model for a U.K. relationship with Europe as a non-EU member. Switzerland has negotiated some 20 bilateral agreements with the EU and dozens of sectoral deals. But in return, it has implicitly had to accept free movement of labor from the EU, and it has no deals on financial or any other kind of services.
Recently, the Bank of England summarized four decades of research on the net economic benefit of EU membership. The answer was that it was in a wide range, of –5 percent to 20 percent of GDP. The net benefit of a Brexit would be just as difficult to measure, even long after the fact. In the meantime, however, investors already have some key takeaways:
•Expect growth and investment to be modestly lower in the first half of 2016, because of the uncertainty created by the vote. At the same time, don’t expect this lingering trepidation to outweigh more important factors such as growth in Europe and the U.S. and broader sentiment in global markets.
•Expect most of these effects to reverse themselves in the event of a vote to remain in the EU. Nonetheless, do not be surprised if the pound ends the year materially weaker on a trade-weighted basis than at the end of 2015. And do not be surprised if there is talk of another referendum on EU membership if this week’s vote is reasonably close.
•In the event of a vote for Brexit, expect these macroeconomic factors to intensify, and U.K. growth to be materially slower than in the no-change scenario. The euro zone would also see a short-term hit. For the U.K., though, the broader global outlook will be more important to mid-term growth and the broad direction of U.K. asset markets.
•In the long term, the microeconomic impact of Brexit will be much more important than the macro. Investors should be especially alert to the outcome for U.K. financial services firms, many of which could be negatively affected. Manufacturers should benefit, at the margin, from the weaker currency. Uncertainty about the post-Brexit trading relationship will loom large for them too, and skill shortages could be a negative for some companies if inward migration from the EU is curtailed.
Stephanie Flanders is chief market strategist for the U.K. and Europe at J.P. Morgan Asset Management in London.
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This piece is the second of a two-part series by Flanders on the potential repercussions of a Brexit. The first, “What Investors Should Consider About Brexit,” ran yesterday.