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Monday, June 27, 2016

Leaving the EU

What's the problem?

The UK’s decision to leave the European Union shocked financial markets, which had been taking a 'Remain' majority for granted.

The surprise result led to an immediate very sharp mark down in the value of the Pound, a smaller but still large decline in global equity indices, and a flight to 'safe harbours' bidding up the prices (and driving down the yields) on government bonds.

The immediate impact of this turmoil on the value of globally-diversified investment portfolios for UK investors may be surprisingly modest or even positive, as Sterling weakness offsets the impact of stock market volatility.  The longer-term impact of the referendum result for Sterling investors may not be so modest and unconsidered unintended consequences will only be clear with the passage of time.  However, UK inflation risk has probably increased and the time when interest rates rise and conservative assets will again provide for a decent secure income has probably been pushed even further into the distant future.

Why did economists mostly agree with each other, and why were they ignored?

During the referendum campaign, economists were overwhelmingly reported to favour the UK staying in the EU, even though there was a small group of economists who campaigned for the UK to leave the EU.  In January, the FT reported that: "there are few issues that unite UK economists but Brexit is one of them: they overwhelmingly believe leaving the EU is bad for the country’s economic prospects."

One survey of leading American economists (who presumably have no vested interest in the answer) early this year found a clear bias toward expecting that a decision by the UK to leave the EU would result in lower real income per person in the UK after ten years (than if the UK had remained in the EU).  Though full disclosure would also add that a number reasonably said they had no view on this European issue and around one third said that their view was that the impact after ten years was uncertain.

There are three reasons for this majority opinion among economists against the UK leaving the EU.  One is that the UK’s decision to leave the EU adds uncertainty, which has most immediately been reflected in financial market turbulence.  It also introduces major uncertainty to the business environment and this will be harmful as it is leads to delayed (at best) investment decisions.  This lowers business activity, tax revenues, business profits and wage incomes.

Another reason for the level of agreement among economists is the risk (even if unintended) that Brexit poses of introducing impediments to trade in goods and services. 

The productivity gains that have flowed from trade liberalization and deregulation of labour markets around the world (together with the impact of innovation) are important parts of economists’ explanations of the rapid growth in recent decades in global wealth and reductions in extreme poverty.  The EU’s single market (and its expansion into central and eastern Europe) is a part of this narrative.

However, economists often fail to mention the important footnote that the losers from trade market liberalisation may be many, even though the gains from trade should easily be sufficient to smooth the transition (for example through funding retraining). 

The West's political problem may be that laissez-faire economic policies over the past quarter of a century have had localised ill-effects, from Detroit to Port Talbot and endless places in between, that governments have not taken sufficiently seriously.  The UK’s referendum result may be one reaction to that lack of attention.

'A canary in a coal mine'?

Global investors may wonder whether the UK’s decision to leave the EU is any more than an ephemeral piece of political drama of little importance to them.  After a few weeks, this is how most investors outside Europe may treat it.  An alternative interpretation is that the UK referendum result is much more than this and, in the words of one US financial analyst, “a canary in a coal mine”, alerting those who pay attention to more worrying threats than a localised UK political argument.

The UK is not the only democracy where established political norms are being disrupted by new challenges.  Across the developed world, stagnation of real wages over many years is  being attributed by politicians to immigration, globalisation and to the outsourcing of production by multinationals who seek, with little loyalty to existing employees, the lowest cost business locations around the world.

The response to this in the years ahead may involve crowd-pleasing trade restrictions and employment protections both of which undermine long term productivity growth.  It is productivity growth which is the key to an enduring higher standard of living.

After its referendum,  the UK faces a risk (and perhaps the opportunity) of leaving the world's largest single market to try to replace it with better.  Experienced trade negotiators might say, 'good luck with that in a world where many social ills are being blamed on the adverse effects of free trade'.

The UK referendum result may be a warning signal of more inward-looking policy trends that may establish themselves around the world.  If so, all global investors should take heed, because it would suggest that the rewards from owning equities could be less in the future.

Peter Stanyer, independent economic consultant to The Financial Planning Corporation LLP
June 27, 2016

Peter is the author of The Economist Guide to Investment Strategy, 3rd edition, Profile Books, 2014.  The views expressed are his own personal views, and do not constitute advice to buy, sell or hold any investment.

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