Update on “Brexit”

Victor Levinson Comments

On Thursday, June 23, British voters, by a majority of 52% to 48%, voted to have their country leave the European Union (EU), an event dubbed “Brexit” by the media. Since the financial markets reacted sharply to this event (stock prices down, then quickly recovering; bond prices sharply higher, meaning continuing lower yields to investors), and the media proclaimed the event historic, this month’s Comments are devoted to this topic.

The print media’s immediate treatment of Brexit can be seen in the following headlines:

  • June 25, NY Times front page: “Global Shocks After Upheaval in Britain.”
    • Sub Headline: “Investors Gripped by a Panic Last Seen in ‘08”
  • June 28, NY Times, page B1: “Brexit Spreads Fear Far From Britain’s Shores.”
  • June 25-26, Wall Street Journal: “UK Vote Sets Off Shockwaves”
  • June 25-July 1, Economist Magazine cover:  “A Tragic Split”
  • July 2- July 8, Economist Magazine cover: “Anarchy in the UK”

The media discussion of Brexit covered many consequences: political (resignation of British Prime Minister and other political leaders), societal (vote partly against immigration), economic, and financial.  Our focus will be on the economy and financial markets, using the July 2nd-8th issue of The Economist (a magazine based in London, with a decidedly liberal, global, and upscale point of view) as the basic source of information.

In describing the outcome, the first of many Economist articles (page 9) states: “Anger stirred up a winning turnout in the depressed, down-at-heel cities of England. Anger at immigration, globalization, social liberalism and even feminism, polling shows, translated into a vote to reject the EU…. Unless these voters believe that the global order works to their benefit, Brexit risks becoming just the start of an unravelling of globalization and the prosperity it has created…. Proponents of globalization, including this newspaper, must acknowledge that technocrats have made mistakes and ordinary people paid the price. The move to a flawed European currency led to stagnation and unemployment and is driving Europe apart.”

Elaborate financial instruments bamboozled regulators, crashed the world economy and ended up with taxpayer funded bailouts of banks, and later on, budget cuts…. Trade with China, which lifted hundreds of millions of people out of poverty and brought immense gains for Western consumers, also left many factory workers with lost jobs, and they have been unable to find a decently paid replacement…. While American GDP per person grew by 14% in 2001-15, median wages grew by only 2%…. As Brexit shows, when people feel they do not control their lives or share in the fruits of globalization, they strike out, and the distant, baffling, overbearing EU makes an irresistible target.”

The next article (page 10), rather than seeking causes, focuses on the future. “The country needs a new leader, a coherent approach to negotiating with the EU, and a fair settlement with those nations within its own union that voted Remain (in the EU)…. Brexit comes in many varieties, from an arrangement, like Norway’s, involving continuing access to Europe’s single market, in return for allowing free movement of people from EU countries and a contribution to the EU budget, and at the opposite extreme, cuts its ties entirely, meaning no more payments to EU and no more unlimited migration, but no special access to the market which buys nearly half of Britain’s exports…. Britain’s next leader must explain to 17 million voters that the illusion they were promised – all of the EU benefits with none of its obligations – does not exist.” [Our note: negotiations on the terms of the British exit from the EU have a two year deadline from a still-to-be determined start time).

The next article (pages 17-20) focuses on the EU, and what Britain has chosen to leave (terms of departure currently unknown). Recent EU issues range from the “debt crisis in the euro zone (our note: mostly Greece; Britain is not a member of the euro zone), and the mass influx of refugees and other migrants. But Brexit is qualitatively different, since it strikes at the very idea of a union…. The EU is the world’s biggest single market, counting some 500 million rich-world consumers. It stabilized new democracies in southern and eastern Europe…. Two big questions… will anyone else follow Britain out of the union, and what reforms are needed if the institution is to cohere and survive?  Eurosceptics across Europe have similar dissatisfactions as Britain’s ‘Leave’ voters: resentment of globalization, estrangement from elites, a sense the EU is distant and undemocratic, and above all, the EU has let in too many foreigners who take away jobs, benefits and national identity.”

The article focusing on the “economic fallout” begins on page 21. “Business and financial markets hate uncertainty. The vote for Brexit gives rise to a surfeit of it…. Forecasts for economic growth are being revised down – markedly for Britain, materially for Europe, and modestly for the world.  A lot depends on the kind of trade deal Britain can negotiate with the EU and how quickly its outline will emerge…. Three broad scenarios cover most of the possibilities; … the Norway arrangement, reached quickly, in which case the spillovers to Europe and the global economy would be small and transitory. In the second case, discussions are considerably longer drawn out, key issues of disagreement remain, and businesses in Britain, and to a lesser degree other countries with which it has close ties, defer whatever spending they can… The pound remain weak, pushing up the costs of imported goods. Hours and wage growth fall…. In this middling scenario, the combined effects of business uncertainty and a weaker pound would be likely to cut the economy’s growth rate by 1-2 percentage points in the next 12-18 months….”

“A decent rule of thumb is the reduction in GDP growth in Europe will be between a third and a half as big as the loss to Britain’s rate of growth…. The worse outcome (third scenario) would occur if trade talks stall, the politics of Europe sour, and agitation for referendums in other parts of the EU grow…. Broader anti-EU or anti-euro sentiment would likely cause worried business leaders across Europe to cut back on investment. Europe’s banks might be spooked by tumbling stock prices into choking credit for firms and households.”

The article continues that “many forecasters are treating Brexit as a regional economic event, rather than a global one. Britain accounts for a bit less than 4% of world GDP; it is not big enough to make the global economic weather as America or China can.  Even so, there are worries that Brexit might disturb some existing fault lines in the world economy in a way that amplifies its impact.”

The financial market reaction is discussed in the Buttonwood column (page 62). “Shock, followed by frantic recalculation, was how astonished financial markets reacted to the British vote to leave the EU. The initial phase saw a worldwide sell-off in riskier assets, such as equities, and a flight to safe ones, prompting further declines in government bond yields. After the sell-off, equities started to bounce again on June 28th, in part because central banks may respond with easier monetary policy (or in the case of the Federal Reserve, slower tightening); in part because Brexit may not have much impact on the Chinese economy.”

The article continued that “the biggest casualty was the pound sterling, which went from $1.50 before the vote to $1.32, a 31-year low. A big drop in the pound, to make British assets more appealing to foreign investors and imports less appealing to Britons, is a necessary adjustment…. Now the initial shock has passed, investors need to work out what the economic impact will be…. One question is whether consumption will suffer because of the vote…. The bigger worry is investment, …many companies are waiting to see whether Britain decides to join the European Economic Area, alongside Norway, which would keep it in the single market…. In the meantime, uncertainty means few businesses will be inclined to invest in new projects…. For the rest of Europe the question is whether Brexit will encourage other anti EU movements.”

Given the extensive and fear-provoking media coverage of Brexit, we think it important to spotlight the actual price (and percentage) changes of some key stock indexes, starting with the day before the vote (June 23), and then over the next six business days (ending July 1)

               Dow Indus.      S&P 500      NASDAQ       FTSE 100

6/23      18,011                  2,113                4,910                6,338

6/27      17,140 (4.8%)    2,000 (5.3%)  4,594 (6.4%)   5,982 (5.6%)

7/1         17,949 (0.3%)    2,103 (0.5%)  4,863 (0.9%)   6,578 +3.8%

7/15       18,516 +2.8%     2,162 +2.3%   5,030 +2.4%   6,669 +5.2%

It is worth noting that this totally unexpected recovery of stock market prices in a few short days received much less prominent coverage than the initial declines. This again illustrates the point that much of the media coverage of financial events appears designed to frighten people, emphasizing the bad news, while addressing improving news in a far more muted tone. This suggests that the best course of action, far from hanging on the media’s breathless pronouncements, is to ignore the media’s play-by-play account of what’s happening, and instead focus on your longer term goals.

The fact is, had you missed all the news, you would have returned to stock prices that were almost unchanged, except for the Financial Times-London index (FTSE), which actually was 5.2% higher! As usual, after the fact, commentators fashion reasons for this totally unexpected price recovery. The focus now is on the idea that central banks are likely to continue to keep interest rates very low. (The low interest rates can be seen in the very high prices for high credit quality bonds in the US and certain other developed countries like Germany and Japan.) But since it will take two years from a still uncertain future date for Britain to negotiate its new status with the EU, it now appears that Brexit is likely to be a footnote in the history of stock price fluctuations.