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Macro View: Brexit may damage the eurozone economy even more than it may hurt the UK

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THE British people’s shock decision to opt for Brexit in the EU referendum has unleashed huge turmoil in the financial markets, with big falls in sterling and in equity prices. Other European stock markets fell even more sharply than the FTSE 100, and US shares were also badly affected. In the forex markets the downward pressures was mostly focused on the pound.

The scale of the turmoil was particularly violent because the opinion polls and the betting markets proved very wrong in their predictions before the vote. In the final days of the campaign there were signs that that the tide was turning strongly towards the Remain camp, and this inevitably amplified the adverse reaction of the markets once the true result became known on the morning of 24 June. The most dramatic immediate impact of the Brexit decision was to trigger major political tremors in the UK.

David Cameron’s decided to resign as prime minister as soon as the Conservative Party chooses a new leader in the next three months. The referendum result has also generated huge tensions in the opposition Labour Party, as many MPs mounted a coup aimed at trying to force Jeremy Corbyn to resign as leader. The longer term economic and political consequences of the Brexit decision will be unclear for a long time. The initial impact appears mostly negative, mainly because it creates huge uncertainty. But the markets’ violent reaction has almost certainly been too pessimistic. Both sides of the acrimonious campaign exaggerated the costs and benefits of either leaving or staying in. It is obvious that the Remain camp failed to frighten voters with the alleged awful consequences of leaving the EU, and it is much too early to conclude that the pessimists have been right.

Global fundamentals

Sharp falls in sterling are dangerous if they get out of hand. But a weaker pound can be very helpful for the British economy, at a time when our external deficit is too big and the UK needs effective policies to boost our exports. As for share prices, the post-referendum falls have been less severe than may have been feared and equities are still well above their 2016 lows, particularly in the US and the UK.

While the results of the referendum have accentuated many uncertainties, the Brexit vote is unlikely to alter the fundamentals of the world economy. The basic unease of markets is driven by concerns that the global economy is continuing to slow, but the major central banks are running out of ammunition counter tendencies towards stagnation, and are unable to take effective corrective measures. Very low interest rates and huge injection of quantitative easing are still necessary to stabilise the markets and avoid a new slump; but these policies are now yielding diminishing returns. Indeed, extreme measures such as negative interest rates are too risky, and they risk becoming a potential source of instability.

Market turmoil and US dollar strength following Britain’s decision to leave the EU make it increasingly likely that the Federal Reserve will delay plans to raise short-term interest rates in the near future. While Fed officials were hinting recently that an increase may be a realistic option at their July 26-27 policy meeting, this now looks unlikely. It is also more questionable that there will be a move at the September meeting.

The disappointing US labour market figures will make it easier to postpone any tightening. The US added 38,000 jobs in May, well below the 160,000 that the markets had expected. This was the weakest increase in jobs since September 2010 and comes after an increase of only 123,000 jobs in April, also a disappointingly low figure which was revised down by almost 40,000. The unemployment rate fell from 5.0% in April to 4.7% in May, more than expected, but this was mainly due to a drop in the labour force participation rate from 62.8% to 62.6%, as discouraged potential workers stopped seeking employment. US inflation rose slightly in May, as higher gasoline prices and rising rents more than offset a decline in grocery prices.

However, wage pressures are still mute, and inflation remains well below the Fed’s 2% target. With the US dollar strengthening after the Brexit vote, and with growth remaining disappointing (our full-year GDP forecast for 2016 is only 1.7%), the Fed will not face serious pressures to tighten early. Although Janet Yellen and her colleagues are in principle keen to move more rapidly towards “normalizing” interest rates, they will be reluctant to do anything in the near future that may risk worsening further the upheavals in the financial markets. At the present time, December 2016 appears the most likely date for the Fed’s next move.

Eurozone damage

In the eurozone, economic prospects improved slightly in recent months. Our current full-year GDP growth forecasts are 1.6% for both 2016 and 2017. At its meeting earlier in June, the ECB’s governing council kept its policy unchanged, by holding its main interest rate at 0.0% and its deposit facility rate at -0.40%. While the ECB upgraded slightly its previous growth and inflation forecasts, president Mario Draghi stressed that eurozone inflation is likely to remain very low, or negative, for some time; he also warned that risks to the global economy are to the downside.

Even before the British referendum, Draghi and other senior officials signalled that the ECB may consider cutting rates further and adding to QE. The post referendum turmoil will intensify the pressure for additional stimulus, although the ECB is aware of the risks that such steps may entail, particularly if they worsen the squeeze on the profitability of the eurozone’s banks. What must be particularly worrying for the ECB is that Brexit may damage the eurozone economy even more than it may hurt the UK.

Trigger timing

David Cameron announced that only his successor as PM will decide on the precise timing of triggering article 50, which gives formal notice of the UK’s intention to leave the EU. While other EU members objected to this delay, which adds to uncertainty, and would have preferred a faster timetable, the decision to wait a few months strengthens the UK’s hand. Legally, nothing can happen until the UK triggers article 50 and, until that time, Britain retains all the rights and privileges of a full EU member.

It is too early to know whether the negotiations on new trade arrangements between the UK and the EU would be friendly or acrimonious. While some EU officials are keen to “punish” the UK, so as to deter others from considering leaving, it is clear that other countries may be damaged even more by a spat. An amicable divorce is still more likely than a rancorous one.  Some people are even considering the unthinkable, i.e. the possibility that the UK will have a second referendum that will make it possible for it to stay in the EU. In the near term this is wishful thinking. Once a new PM is elected negotiations for Brexit will start in earnest. But if the EU decides for its own reasons that its current policies on free movement of people are unsustainable and potentially damaging, one of the main reasons diving the pro-Brexit vote would disappear. A lot can happen in the next two years.

David Kern is chief economist at the British Chambers of Commerce 

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