In the months before the British referendum of June 23rd, a large number of economists (including our own) tried to predict the impact of Brexit on the economy and the financial markets. While many anticipated that economic activity would contract and that markets would fall, it is now clear that the British economy and financial assets have finally been quite resilient since the end of June.
Indeed, British retail sales remained robust during the summer and industrial output increased in July. By end of September the MSCI British stock market index was 8.9% higher than on June 23rd, while the yield on 10-year gilts decreased from 1.37% to 0.74%. What happened this summer?
Firstly, central banks managed to convince the markets that abundant liquidity would last. The Bank of England (BoE) clearly indicated that its policy would become more accommodating during the summer, and then exceeded expectations when it announced a wide range of measures during its August 4th meeting.
Secondly, the global economic environment was favourable. On average over the past three months, US labour market figures were well above expectations, making a recession far less likely in the United States. Chinese growth stabilised, oil prices recovered significantly from their lowest point in January, and the Eurozone continued to register regular growth and a progressive decrease in unemployment. In addition, the confidence of British business leaders proved to be quite resilient: the Purchasing Managers’ composite index for August reached 53.6, above its June level of 52.4 and well above its July level of 47.6.
Furthermore, the fears of a prolonged battle to replace David Cameron were quickly dispelled as Theresa May won the party leadership contest slightly more that two weeks after her predecessor’s resignation.
Finally, investors understood that the changes decided by the British electorate might take time to materialise. According to Theresa May, the official withdrawal process will start next March at the latest. Brexit will thus come into effect in the first half of 2019, well beyond the investment horizon of many investors.
Concerning British financial markets two clear trends have emerged:
The Bank of England’s change of course triggered a plunge in interest rates on the whole yield curve. Yields have thus reached historically low levels (purchases carried out by the central bank and the asset-liability management of certain institutions like pensions funds also had an impact).
The fall in the pound improved the competitiveness of exports and increased the country’s attractiveness for tourists.
Finally, British equities took advantage of the rebound in global markets and of the full access to the single market that exporters still enjoy for now.
Does this mean economists’ worries were groundless? We do not think so. First of all one should remember that the impact of this institutional change will be felt over time, not immediately. There is a risk that many business leaders’ investment and hiring decisions will be postponed until details of the agreement negotiated with the European Union are known. Foreign direct investments are already slowing, because international companies are trying to determine whether the United Kingdom can still serve as a bridgehead to extend their activities in the European Union. Also the inflation of imported goods created by the pound’s devaluation will necessarily have an impact on consumers’ purchasing power.
To conclude, while the immediate consequences of the decision to leave the EU seem insignificant, one should keep in mind the longer-term outlook.