So there we have it - the British people have spoken, voting by a small majority to leave the EU. Initial reaction to the results has been largely one sided, with Remainers calling for a 2nd referendum, some Leavers “not realising their vote actually counted” (*sigh*), David Cameron resigning, and negative comments from the most esteemed policy makers across the world.
Global financial markets have whipsawed since then, likely compounding the effects of the poor performance at the turn of the year on business and consumer confidence. Though the long-term impact of Brexit will largely depend on the details of the forthcoming UK-EU agreement, a lot of the short-term impact can be attributable to recent lurches in financial markets. In this post, I step away from the much debated residual socio-economic issues and discuss the repercussions of these large financial market (equity and FX in particular) moves on the UK economy.
Equity markets
The FTSE 100 has fallen 4% since April (local highs), with the Brexit result catalysing an abrupt fall in the index. The reality is, though, that a lot of FTSE 100 companies are global companies, with the majority of their revenues coming from outside the UK (e.g metals and mining companies such as Rio Tinto, whose largest market is China). The FTSE 250, a more broad measure of actual UK companies, has taken a more severe hit with the index falling 13% in the aftermath of the referendum results.
Though they may seem very abstract, these numbers are important representations of reality. Indeed, markets move and company market values change daily, but large falls like this can and do have an enormous impact on the UK economy in two ways. First, the effect on consumer wealth. According to the ONS, UK individuals owned 12% of the FTSE 100 in 2014 (the most recent figure). Assuming this hasn’t changed much, the FTSE 100’s fall in results day wiped out £4.7 billion off the net worth of individuals just like you and me. This is probably a lower bound as ownership would have also involved foreign stocks, and companies in the FTSE 250 which lost value too. As consumers tighten their belts following this fall in personal wealth, this tends to have an effect on consumer confidence and spending, which is no doubt negative for growth. This is a classic (and well-documented) channel by which equity markets affect consumer spending.
A more interesting channel is that of net worth. Given the asymmetric nature of information in the world we live, large loans (such as mortgages) tend to require some form of collateral for security. As equity markets fall, other assets values (such as housing) tend to fall in value too - the housebuilder stocks, such as Barratt Development, fell around 35% since the result, show how negative investors think Brexit is for house prices. With the net worth of small companies and entrepreneurs now diminished, they may not be able to put down enough collateral to obtain funding. Consequently, many of the planned expansions or investment projects will likely fall by the wayside, thus hurting (actual and potential) UK growth.
FX markets
The cleanest way of looking at investors’ view of Brexit on the UK economy is by looking at how the GBP fared against its trading partners. It is fair to say that their view wasn’t unambiguous - sterling fell 6% against the Euro and 8% against the US on results day.
Economically (ignoring effect on the cost of my holiday this year!), a weaker Pound is more-or-less a good thing. First, the value of the UK’s exports to its markets will fall. This should fuel higher demand for UK goods as they become more competitive on the international market, via the expenditure switching effect . Importantly, this comes about absent of a manufacturer price adjustment. Moreover, the UK’s imports are now more expensive, which should urge domestic consumers to buy the same products from domestic companies. These should provide an added boost to growth. As I wrote in a previous blog post, this is by no means the end of the story - there is a whole body of work on exchange rate pass through, and it is unlikely (due to firms’ pricing-to-market and currency pricing decisions) that we will enjoy the full benefits of the weaker currency.
Second, the effect on large global UK companies cuts two ways. On the one hand, their foreign revenues and profits (if priced in local currency), will automatically rise when converted back to sterling, which could act as a counterweight to falling profits from emanating from its other markets (such as the UK). On the other hand, the financing costs of these corporates who have debts in currencies other than sterling could rise substantially. Moreover, issuance of GBP denominated debt by UK companies has more than halved since 2012. Indeed, Chart 3 in the link above shows that only around 5% of issuance by private non-financial corporations is denominated in sterling, with the majority in denominated in euros. The argument of higher funding costs for global companies, I think, carries more weight now than previously.
A lower Pound could also be positive for the current account. The current account is made up of two factors : 1) balance of trade and 2) factor income (corporate net profits repatriated from overseas subsidiaries/investments). Higher exports and smaller imports from a weaker Pound as explained above should be positive for the current account. In addition, repatriated profits that are now much higher due to currency translation should also improve the current account.
Many city economists have revised their UK inflation forecasts up as a result from the fall in sterling. I am not so sure. As I explained with regard to the ECB and the euro, exchange rate pass through is only partial, even under long time horizons. Consequently, a fall in sterling will not lead to a commensurate rise in domestic inflation. Indeed, I would argue that though inflation will rise slightly, it will likely continue to be below the BoE’s target of 2% due to all the factors explained here.
The bottom line
The initial economic repercussions of the referendum results will be negative as a result of increased uncertainty, lower equity markets, and a lower currency due to some of the mechanisms presented in this post. While I am sympathetic to this view, it’s important to note that the outcome could be MUCH worse if the UK did not have a flexible exchange rate policy. In this instance, it acts as a counterweight to changes in a world where prices are relatively rigid, meaning that real variables like output and unemployment (which is what we ultimately care about) do not adjust as much. In a time where the UK system is, in a sense, falling apart, it’s probably good, for our sanity at least, to bear in mind that it could be a lot worse!
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