While Brexit has dominated headlines, Stephanie Flanders of J. P. Morgan believes its true impact will be local, not global.
Investors were seriously wrongfooted by the result of the UK referendum. But the shock of City traders was nothing compared with the stunned response of the people who thought they ran the country. The economic and political questions raised by the vote will not be answered for years. But the immediate questions for investors are over how long the markets will continue to seek the safety of low-risk assets, and how much damage that flight to safety will do in the process.
Our initial assessment is that this is a large shock but, ultimately, a local one. The UK economy will slow sharply. Our best estimate is that growth will drop from an annualised pace of 1.6% to around 0.6% in the second half of 2016, with a similar growth rate achieved in 2017. But the decline in the value of sterling, particularly relative to the dollar but also to the euro and other currencies, will put pressure on prices as our imports become more expensive. We can expect inflation to jump to 3% or 4% by the second half of 2017, as a direct result of the decline in sterling. That compares with a previous forecast of around 1.7%.
However, we think the Bank of England (BoE) is likely to consider the rise in inflation temporary – and it will need to consider this alongside the weakening of the economy when setting its monetary policy. Inflation is likely to rise above the government’s target of 2%, which in normal circumstances could trigger a reaction from the BoE’s Monetary Policy Committee. But the extraordinary circumstances of Brexit mean that policy will surely be looser than it would have been in the event of a Remain vote.
The BoE has made clear its willingness to offer emergency liquidity to the market, but it is also likely to gauge its response to the slowdown in economic activity. Moreover, we expect it will think hard before intervening to defend the pound. The initial fall was dramatic, by any standard, with the pound at one point falling to its lowest level against the dollar in 31 years. But the scale of the fall had been exaggerated by the rally preceding the vote. Arguably, a double-digit decline in the currency is not an overreaction to a policy change of this magnitude.
Good for credit?
The interplay between domestic and global factors was highlighted by the reaction of the UK gilt market. Immediately after the vote, long-term government bond yields barely moved, but they then moved sharply lower after David Cameron, the prime minister, announced his resignation. We would expect gilt yields to be lower, over time, than if voters had opted to remain in the EU, given our expectation that short-term rates will be ‘lower for longer’. To put this another way, we do not think questions about sterling will turn into questions about the creditworthiness of the UK government.
Further afield, growth in the eurozone will be dented, possibly strengthening the case for the European Central Bank to expand its quantitative easing programme of bond purchases in the autumn. If there is a prolonged decline in global market confidence, the US central bank could find it more difficult to move forward with higher interest rates in the second half of 2017. Central banks in countries with ‘safe haven’ currencies, notably Japan and Switzerland, may also come under pressure to ease policy to prevent these currencies rising further.
Get a grip
As things stand, we do not think the referendum shock poses an immediate threat to the global recovery. Over time, we would expect this reality to be reflected in asset markets outside the UK, particularly in the US, where the stock market initially reacted sharply to the result, even though it would be expected to have only modest direct consequences for the US economy.
However, it could take some time before the dust settles. Investors should expect plenty of volatility as UK policymakers and the wider world come to grips with the consequences of this historic vote.
This immense shock for the UK will have an economic and financial impact on the rest of the world, but we believe that the fallout should be manageable, if policymakers respond appropriately and investors keep their heads. Whether the political implications will also be containable, particularly in Continental Europe, is another matter.
The opinions expressed are those of Stephanie Flanders of J.P. Morgan Asset Management and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. Full advice should be taken to evaluate the risks, consequences and suitability of any prospective fund or investment. The views are not necessarily shared by St. James’s Place Wealth Management.
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