Friday 06/24, world markets opened to shock and chaos in the wake of news that the United Kingdom had decided in a vote of 51.9% to 48.1% to leave the European Union, a move seen only once previously when in 1982 Greenland decided to leave the EU. The result thus far can only be described as pandemonium with the Dow Jones down over 600 points on Friday, the British pound plunging 10% to a 30 year low against the dollar, and mortgage rates plummeting an eighth of a point in a single day, something that has only happened nine times in the past decade.
While the chaos still ensued this morning at market open, cooler heads are beginning to look to the future in the hope of stabilizing markets and quelling uncertainty with many still asking, why did this happen, and what do we do next? Understanding the why is just as complex as understanding what will happen next and what this means for the larger global economy. To understand the future however, we must first look to the past.
The European Union (EU) was formed in 1951 as the European Coal and Steel Community, in an effort toward reconstruction and healing the devastation caused by World War II. The thought behind the effort being the idea that countries who trade together are less likely to declare war on one another. Today, the EU has become an economic and political partnership between 28 countries that acts as a ‘single market’. This partnership allows both goods and people to move around as if they were in a single country, which in itself constitutes one of the contributing factors in the UK’s departure from the EU.
Many voters in the United Kingdom feel as though the European Union has changed in size and bureaucratic authority thereby infringing upon the United Kingdom’s Sovereignty. In addition to this sentiment, other factors contributing to Brexit include:
–Democratic deficit in Brussels: many feel as though the EU’s governing body in Brussels is out of touch with the ordinary population in its member countries which has given rise to many angry populist movements. (Note: populism is the belief in the power of the ordinary citizen and their right to have control over government, rather than for government control in the hands of a small group of the political or wealthy elite.)
–Weakness in Eurozone economies: much of the ordinary population has become disenchanted with bearing most of the burden of public spending cuts while not sharing in economic prosperity.
–Immigration: Immigration has been cited as the biggest political issue surrounding the Brexit vote. Much of the British population is disgruntled with the influx of immigrants, something the leave side used to its advantage, promising a thriving economy and curb on immigration if the UK voted to leave the EU, a promise that will likely prove difficult to keep as the UK regroups and takes the next steps towards separating themselves from the EU.
Keeping to his pre-referendum promise, in a speech to British parliament this morning, Prime Minister David Cameron indicated that most major decisions in separating from the EU would have to wait for a new Prime Minister and his primary focus would be to help calm the markets. Cameron indicated that he would not be invoking Article 50 of the Lisbon treaty, leaving that task for his successor. With a great deal dependent on the type of trade deal and the time frame in which Britain can negotiate with the EU, the EU is urging Britain to invoke Article 50 sooner rather than later.
Article 50 serves to set a two year frame to agree to terms of departure set out by the 27 other countries comprising the European Union. Britain would not have a vote in the decision, and it is likely that many Brexiters will support informal negotiations over formally invoking Article 50.
Should Article 50 be invoked however the two likely offers would be:
- Like Norway become a member of the European Economic Area (EEA) and in return for the trade advantages offered Britain would have to contribute to the EU budget and allow free movement of people from other EU countries into and out of the country.
- Britain could be allowed to opt out entirely and trade with the European Union under rules laid out by the World Trade Organization in the same way that countries like the United States, China, and India trade with countries in the EU.
It is speculated that the primary focus of the EU in these negotiations will be working to ensure other countries do not follow suit and attempt to leave the EU by setting an example with Britain through strict negotiations. Regardless of whichever trade agreement is decided upon, most analysts agree that Britain is likely to slip into a recession.
The Bank of England has been insistent upon the fact that they are a strong economy equipped for the impact of Brexit and prepared to cut their central interest rate or revive their quantitative easing program if necessary. Despite this assurance, Britain is likely to see a slump in spending on big ticket items, an increase in inflation, and pressure on real incomes.
Although Britain’s economy only accounts for 3.9% of the world’s output, and isn’t big enough to have the impact on global markets that China or the U.S. would, Europe and possibly the rest of the global economy could feel the effects of any British recession. For instance, generally speaking a reduction in Britain’s GDP is felt by a drop in GDP in Europe by about half as much as the drop in Britain. In Asia, the result of a weaker European economy would then have a negative impact on Chinese exports and dollar strength could further depress the Yuan.
In the U.S we have already seen investors flock to the safety of U.S. treasuries, and while this has been a boon for borrowers looking to lock in their mortgage rates, as stated previously, the stock market has gone haywire with most analysts agreeing that Brexit will be more harmful than helpful to the U.S. and global economies. Publications such as The Economist even went so far as to state, “The Economist is not neutral: we are convinced that a decision to leave (a so-called Brexit) would be bad for Britain, Europe, and the world.”
For now though, while we wait to assess the full impact of the Brexit fallout the one thing we can say for certain is that we will see continued volatility in the markets with many analysts, traders, and brokers encouraging clients to get used to the volatility and prepare for the unexpected.