Brexit is in train. If journalism is the rough draft of history, instant blog responses are even cruder responses to events. Nonetheless, here are some thoughts prior to market opening in the United States.
Markets
So far given the shock value of what has happened the market response has been on the calm side. The British pound is only a bit weaker than it was 10 days ago when the outcome looked highly uncertain. I would not have been surprised to see the pound below 1.30, the yen below 100 and more dramatic moves in credit spreads in the European periphery. Notably the pound which is a kind of bellwether and many other asset prices have rallied considerably from their lows during the night.
Relatively resilient markets so far probably reflect a combination of confidence that central banks will do whatever is necessary to maintain order as well as some opportunistic buying in response to opportunities created by the falling asset prices. Notably cool heads seem to be in control for now in London and Brussels. Fortunately authorities do not seem overly fussed with moral hazard at a time when the preoccupation needs to be maintaining liquidity and orderly markets. Critically, the market has expressed confidence that the Fed understands the gravity of the situation by taking the probability of a Fed hike by the end of the year down to the 10 percent range.
All of this could easily change when U.S. markets open, when investors ponder the new and more volatile environment they live in, when traders decide they do not want to bear risk over the weekend, or when a weekend of pondering leads to a wave of liquidations on Monday morning. In 1987 volatile markets with international uncertainties at the end of the preceding week presaged the Monday crash. It is far too early for any kind of complacency.
The situation of European banks should and will receive extensive policy attention. Even before the last 24 hours, several were selling at price-book value ratios suggesting alarm about their prospects. And some, not only British banks are now down more than 20 percent. Large flight to quality flows into the dollar and yen also risk bringing on alarm about emerging markets and a return to concern about currency wars.
Economics
For Britain, the economic effects are two sided. On the one hand, a major jolt has been delivered to confidence, to future unity and down the road to trade. On the other, the currency has become more competitive, and liquidity will be in very ample supply. I would expect that a significant deterioration in growth and a recession beginning in the next 12 months has to be a substantial risk though short of an odds on bet.
As suggested by the fact that stock markets in Italy and Spain are down almost twice as much as in the UK, the prospects for Europe may in some ways be worse than for the UK. There is the real risk of “populist exit contagion” in a number of countries. A credit crunch is a serious risk. Unlike in Britain, the trade weighted exchange rate is unlikely to decline very much. The central bank has less room for incremental policy measures.
The effects on the rest of the world will depend heavily on psychology. I continue to be alarmed as I wrote in this space a few days ago that this unexpected outcome in the UK will raise the spectre of “Trump risk”. If the UK can vote for Brexit perhaps the U.S. can vote for Donald Trump. I fear this possibility will lead to a freezing up of spending decisions particularly on the part of internationally oriented businesses. The odds of U.S. recession beginning within the next 12 months are I think now in the 30 percent range. Also noteworthy is that an environment of increased risk aversion and flight to quality will complicate Japan’s problem of generating inflation, and China’s challenge of attaining currency stability.
To an extent that is underestimated in some quarters and understated in others, the world economy is far more brittle than usual because of the inability almost everywhere to lower interest rates substantially. Normally in response to incipient downturns central banks lower rates by 400 basis points or more. Nowhere do they have that kind of room. Nor is there large scope for reducing term and credit spreads given their very low levels. This is no time for austerity. Greater use of fiscal policy should be on the agenda almost everywhere and certainly with the change of government in the UK.
Brexit will rightly be taken as a signal that the political support for global integration is at best waning and at worst collapsing. Dramatic exchange rate fluctuations tend to portend upswings in protectionist pressure. And problems in European banks could as in 2009 lead to a drying up of trade finance. Already global trade has lagged global growth in recent years. A clear sense of commitment to avoid backsliding towards protection from the G20 will be essential going forward. Specific efforts with respect to trade finance may be appropriate.
Broader Observations
After Brexit, Trump, Sanders and the misforecast British and Canadian general elections, it should be clear that the term political science is an oxymoron. Political events cannot be reliably predicted by pollsters, pundits or punters. All three groups should have humility going forward. In particular no one should be confident about the outcome of the U.S. presidential election.
The political challenge in many countries going forward is to develop a “responsible nationalism”. It is clear that there is a hunger on the part of electorates, if not the Davos set within countries, for approaches to policy that privilege local interests and local people over more cosmopolitan concerns. Channeling this hunger constructively rather than destructively is the challenge for the next decade. We now know that neither denying the hunger, or explaining that it is based on fallacy is a viable strategy.