Peter Rawson-Harris, Research Analyst, Macquarie
Wednesday 06 July 2016
Monthly economic commentary: June 2016
Peter Rawson-Harris, Research Analyst, Macquarie
Economic and market highlights
The focus this month was overwhelmingly the United Kingdom (UK) referendum on European Union (EU) membership, or “Brexit” as it came to be known. The United States (US) Federal Reserve prudently left interest rates on hold as it awaited the outcome of the vote.
Bond yields collapsed across developed markets as the referendum results prompted a flight to safe-haven assets. The uncertain outlook for global growth and the unexpected Brexit vote has markets pricing in a 75 per cent chance that interest rates in the US will not change by the end of 2016.
Volatility was elevated as equity indices sold off in the immediate aftermath of the referendum. Prices slumped over five per cent in some markets as investors took the approach “sell first, ask questions later”.
The US dollar and Japanese yen rallied strongly on the news of the UK’s referendum outcome. Given the increasing likelihood that the US Federal Reserve will hold further interest rate rises until 2017, and the comments from the Governor of the Bank of England on the possibility of monetary policy easing in the UK, the recent buoyancy of the Australian dollar is likely to persist.
Brexit becoming a catch-22
The long term economic implications of the recent referendum on the UK’s membership to the EU are unclear. Much planning and negotiation is required to revise trade agreements and common market access arrangements should the British Prime Minister invoke Article 50 of the Lisbon Treaty. Remarks made by British Prime Minister David Cameron in his resignation speech suggest he will leave this particular duty to the incoming Prime Minister. Until then, there is a sort of limbo.
The all-important discussions between the UK and EU will centre on trade deals and access to the common market. However, before those discussions can even begin, Article 50 must be triggered and the UK (or perhaps only Britain) must withdraw as a member of the EU over a maximum of two years. Under EU law, the trade bloc is not permitted to form a separate trade deal with one of its members, which the UK will be for at least the next two years, and EU regulations also prevent an existing member from entering its own trade deals with countries outside the EU. Only once the UK and EU have separated can the renegotiation of trade deals and market access necessary to reconstitute any relationship take place.
The mechanics of a Brexit are quite tricky. To leave the EU, British Parliament must now vote to pass a bill to repeal the 1972 European Communities Act. However, to vote on the bill, Parliament needs to understand the likely form of the new relationship. The new relationship can only take shape after leaving the EU, thereby allowing negotiations to commence, but negotiations can not commence until the UK leave. It is a catch-22 of enormous dimensions. Negotiation is also unlikely to proceed in the UK’s favour, with European bureaucrats adamant that without the free movement of goods, services, capital and labour (which is a central tenet of EU membership), there will be no special deal for the UK.
Trade after Brexit
The disruption will vary depending on export sector. Independent policy think-tank Open Europe have published research suggesting market access for UK goods exporters is likely to be far easier than for sectors like financial services- an important export sector for the UK, producing significant trade surpluses.
Source: Open Europe, MWM Research, July 2016
Traders wrong-footed over Brexit
Financial market volatility increased dramatically in the wake of the Brexit vote, with investors clearly of the view that an exit vote was unlikely, the reaction of asset prices evidence that few had anticipated the outcome. The immediate aftermath saw a rush to developed market safe-haven assets like government bonds, the US dollar and the Japanese yen. Gold futures rallied five per cent on the news. Even George Soros, who famously bet on the withdrawal of the pound sterling from the European Exchange Rate Mechanism in 1992, failed to predict the public mood, being caught with a large currency position as it plummeted in value. Betting agencies also got it drastically wrong, attaching a 24 per cent probability to a “leave” outcome only days before the vote.
Source: BCA Research, MWM Research, July 2016
While this volatility will dissipate, it will likely be years before the true nature of UK’s relationship with Europe begins to crystallise. In the meantime, fundamental macroeconomic forces will continue to exert themselves, for better or worse. The distribution of potential outcomes in this scenario is enormous and markets will take time to digest these and incorporate probabilities (which may or may not be accurate) into asset prices. The sell-off in the pound illustrates how wrong investors and traders en masse can be.
Brexit from an Australian perspective
The impact on Australia’s economy is unlikely to be serious, but there remains the potential for the adverse effects of financial market volatility spillover and shifts in consumer and business sentiment due to the heightened level of uncertainty. While investment flows from the UK remain significant, as a trading partner, it is of declining relevance as a market for Australian exports of goods and services, representing under three per cent of total exports. Its share of total foreign investment is more significant, but waning, falling from 25 per cent in 2009 to 17 per cent in 2015.
Source: ABS, DFAT, MWM Research, July 2016. * Core Europe includes Germany, France, Netherlands, Italy, Belgium and Luxembourg
In the past, weathering global economic and financial storms has been possible in no small part due to the positive effect these events have had on Australia’s population growth. The global financial crisis (GFC) and European sovereign debt crisis are examples of times during which Australia benefited from an increase in net overseas migration.
Source: ABS, MWM Research, July 2016
If a similar outcome is produced by the uncertainty of a Brexit, Australia’s economy may be insulated to a certain extent from major economic spillovers due to the support to domestic demand and housing lent by greater population growth.