Brexit presents risks, opportunities for middle market

On June 23 the U.K. voted to end its 43-year membership in the European Union. The vote to exit means concerns about sovereignty, the perceived overreach of EU bureaucrats and immigration triumphed over the near-term risks an exit poses to the U.K.’s economic outlook. While there are nascent signs of stress, we don’t believe the exit vote will result in a systemic crisis in the near-term.

Global financial markets, especially currency markets, responded to the vote with significant volatility and turmoil. The British pound declined to its lowest level since 1985 before modestly rebounding. Meanwhile, yields on the U.S. 10-year Treasury, viewed as a safe haven by global investors, declined to 1.49 percent, setting up a test of the cyclical low of 1.38 percent.

The Bank of England immediately announced £250 billion in liquidity is on standby to support financial markets, and we now anticipate the central bank will cut rates at their July 14 meeting. The U.S. Federal Reserve responded by saying it would deploy its trillion-dollar swap arrangements with the Bank of England, Bank of Canada, European Central Bank, Bank of Japan and Switzerland National Bank to address dollar funding pressures and help calm markets.

The FRA-OIS spread, which is a measure of financial stress and credit risk, has widened to levels not seen since 2012 during one of the more intense periods of the EU sovereign debt crisis associated with Greece. Given concerns about financial stability, global central banks may choose to implement a coordinated policy to overwhelm these challenges.

The mechanics of an exit will likely take up to two years to complete, but there are a number of near-term challenges and long-term opportunities for the middle market that should be discussed. In the medium-term, the potential for reallocation of foreign direct investment (FDI) in the U.K. will likely flow into Ireland and the Netherlands as firms seek to avoid rising costs of business associated with post-exit Britain.

From an economics perspective, with 1.5 trillion U.S. dollars in FDI at stake, general living standards in the U.K. are at risk if that capital goes elsewhere given the 7 percent current account deficit of the economy. This will force an economic adjustment to an increase in trade friction, rising cost of capital, foodstuffs and raw and finished materials, which will almost certainly manifest in higher inflation. That may prove difficult for the central bank to address given a weaker economic growth path.

What Brexit means for the U.K.

The U.K. now faces a very different economy. Arguably, the vote to exit the EU will raise questions about the city of London’s preeminence as the financial capital of Europe. The competiveness issues that were already a challenge to London will likely intensify as the EU puts in place a series of policies designed to unseat London as the center of pan-European finance and insurance. At stake post-exit is whether the EU would tolerate a financial capital that doesn’t fall under its regulatory umbrellas. This represents a challenge to a U.K. economy with a heavy concentration of finance in London. The city alone is responsible for about 25 percent of the U.K. economy. There are 336,000 employees that directly work in finance, with 22 percent of those workers being of foreign nationality.

Optimism?

For the U.K. this is not a one-sided slide into doom and gloom. Once the divorce is final, the depreciation of the currency should boost exports via the trade channel for manufactured goods and financial and insurance services, which should partially offset the loss of economic activity elsewhere. This will, however, require a large number of free-trade agreements with the other 27 members of the EU, the U.K.’s largest trading partner, in a relatively short period of time.

There are times when crisis presents opportunity. It is plausible that, after a modest period of contraction, and as the economy shifts to a lower growth path, forward-looking policymakers may choose the opportunity to put in place reforms in entitlement spending, regulation and taxes that will result in a more efficient allocation of capital, thus spurring growth.

Economic, financial and political risks

Below is an outline of various economic, financial and political risks for the U.K., Europe and the U.S.

United Kingdom

• Economic/Financial Risks
  • Sterling has already seen a more than 10 percent depreciation, in line with our pre-referendum forecast. If that holds, or if there is a sustained depreciation, it will result in a general increase in inflation over the next six to twelve months, accompanied by a slower rate of growth. The Bank of England has stated it believes the U.K. economy will fall into a recession, which would likely commence later this year or early in 2017. We agree and expect the U.K. economy to decline into a shallow recession in the final quarter of the year due to the near-term financial shock. Under such conditions, the Bank of England would face a difficult choice: either risk hard-fought price stability and do nothing, or increase rates into a recession, which would be politically unpopular.
  • The U.K. takes in $1.5 trillion U.S. dollars in foreign direct investment; $400 million from the U.S and emerging markets and $700 million from the EU. Much of that would be at risk, and a reallocation of capital would cause a sharp increase in domestic financing costs, thus causing capital expenditures to drop. Ireland, Scotland and the Netherlands are the likely target for much of that capital.
  • Fifty percent of U.K. exports, worth £229 billion, are purchased by members of the EU.
• Political Risk
  • Two-year exit: We think a two-year time horizon is optimistic and anticipate a multi-year period of investment uncertainty caused by political negotiations.
    • Key is to avoid a trade war with Brussels via the construction of tariffs and non-tariff barriers to trade.
  • Article 50 to withdraw from the EU: this is the formal mechanism through which a member state can withdraw from EU. An immediate declaration of article 50 by the prime minister at the June 28 European Council meeting may initiate a round of political tensions. The article would set in motion a bilateral round of negotiation that does not guarantee an exit that favors the U.K.
  • Second Scottish referendum to exit the U.K.: According to Bloomberg, the Scottish National Party has said the U.K. decision to leave the EU justified another vote on Scots independence.

Europe

• Economic/Financial Risks
  • Viability of the euro may be called into question by global investors. Possible medium-term loss of access to the depth and breadth of London’s capital markets is possible. It would take years to develop capital markets in Europe to rival that of London. This is the greatest risk to global financial stability.
• Political Risks
  • Avoid trade war with Brussels via the construction of tariffs and non-tariff barriers to trade.
  • June 26 Spanish election: A U.K. exit may embolden the Socialist and Podemos parties in Spain that favors de-linking from the euro and separation from EU.
  • 2017 elections in France and Germany turn into de-facto referendums on the EU and the euro.
  • Unleashing of other referendums on remaining in the EU among other member states.

United States

• Economic/Financial Risks
  • Indirect economic risks through the financial channel and direct risks through the trade channel.
  • Sharp appreciation of the U.S. dollar creates competiveness pressures for firms with large global exposure.
  • U.S. middle market firms generally have little exposure to the external sector so what risks remain are largely indirect through the financial channel. For firms that derive more than 50 percent of their revenues from the external sector, dollar appreciation represents a risk should it be sustained or accelerate back to 2015 levels.
  • Lower yields. In the aftermath of Brexit, the cyclical low of 1.38 percent posted in July 2012 will be tested and markets may set up for a test of 1.25 percent.
  • Some large U.S. banks, particularly those with significant income from U.K.-based operation, face some risk.
    • Given the prominent role that some large banks play in middle market lending, this bears watching.
  • Insurance firms that derive a significant portion of earnings from the U.K. also may face some near-term risks.