Not surprisingly, the initial market reaction has been universally negative, with Asian and European markets opening sharply lower before recovering some lost ground. Initial reaction in the US stock market was also negative, but markets seem to be stabilizing in later trading.
The markets will remain volatile for some time since, despite the vote, there are huge uncertainties about how the situation will evolve going forward. There are many possible scenarios for how an actual UK departure from the EU will be implemented and when, IHS Global Insight Senior Director Farid Abolfathi and Senior Research Director Sara Johnson said in a report.
To be sure, an imprudently managed (or mismanaged) transition would be greatly disruptive and damaging for all sides in Europe and could have significant negative impact beyond Europe as well. In contrast, a prudently managed, smooth transition could minimize the disruptions. A great deal depends on policymakers’ response to events and political leaders’ management of the situation.
As discussed in our previous notes, our view is that the exit will have the most significant negative impacts on growth in the UK and the rest of Europe, especially once the implementation of the exit starts to go into full effect. This will, in turn, mute global growth elsewhere for at least a few years.
Beyond Europe, though, the negative impact on growth will be less pronounced. Financial markets, including currencies, will likely remain volatile for an extended period until the situation becomes clearer regarding the actual implementation.
The negative impact of the decision through the trade channel will likely be more significant for emerging markets and Japan than the United States, given their stronger trade linkages with Europe relative to their economic size.
The US and Japan will likely see significant unwelcome appreciation of their currencies, given their roles as global safe havens. This will likely lead to policy responses by the Federal Reserve and the Bank of Japan. The Fed will likely delay its monetary tightening till at least 2017, and the BOJ will likely further increase its monetary stimulus.
Commodity prices will remain under downward pressure as world demand for raw materials remains weak due to lackluster investment growth throughout the world. This will likely keep inflationary pressures muted for longer and keep central banks on an accommodative path longer. In line with these developments, bond yields will likely remain low much longer than had been anticipated.
The negative impact on the US economy will be mainly via a stronger US dollar and the resulting weaker US exports to the rest of the world. However, there will be an offset from lower commodity prices and lower interest rates. The flight to safety has already pushed down Treasury yields and the Fed is likely to remain on hold for an extended period of time.
The US export exposure to Europe is fairly small, so the negative impact on US growth will only be a few tenths of a percentage point. US exports of goods and services to the UK and European Union represent less than 1% and 3% of GDP, respectively. Also, after an initial hit, US stock prices are likely to rebound as investors feel relatively more confident about US prospects.
Further analysis:
Rajiv Biswas, Asia-Pacific Chief Economist of IHS provided further analysis as follow:
Financial Markets Impact: The UK vote to leave the EU is creating significant turmoil in global financial markets. GBP plunged against the USD as election results showed that the UK electorate voted to leave the EU in the referendum. With a considerable period of political uncertainty ahead for the UK and for the Eurozone, global investors are reacting by relocating their asset allocation towards safe haven assets, notably the USD, US Treasuries, the Japanese Yen and JGBs. The risk-off trades have resulted in declines for emerging market equities and currencies with political uncertainty in the UK and EU expected to continue in coming weeks.
GDP Growth: Based on the UK’s decision to leave the EU, IHS Global Insight has lowered its forecast for UK GDP in 2017 from 2.4% to 0.2% as well as for EU GDP for 2017 from 1.8% to 1.5%. This will weaken the outlook for Asian exports to European markets in 2017 at a time when export growth in many Asian countries is already contracting due to China’s economic slowdown and weakening growth in many emerging markets.
Trade in Goods: As part of the EU, the UK has benefited from being a member of the EU free trade area as well as EU free trade agreements with non-EU countries. The immediate impact of the UK Referendum is that the UK will enter a two year period of negotiations with the EU about the terms of its exit. Therefore, the existing arrangements regarding the free trade agreement within the EU will need to be negotiated through a new bilateral FTA between the UK and the EU.
After its EU exit deal is agreed, the UK will also no longer be under the umbrella of EU FTAs with non-EU countries. Therefore the UK will need to negotiate new FTAs with individual Asian countries.
However, given strong UK trade, economic and political ties with most Asian nations, this process of establishing new bilateral FTAs that mirror the EU FTAs should be relatively smooth with countries that already have an EU FTA in place, such as South Korea and Singapore. Since the EU does not yet have FTAs in place with many Asian countries, this also offers the UK greater flexibility to negotiate a bilateral FTA with other Asian countries that may have faced more cumbersome negotiations with the EU for an FTA deal.
Trade in Services: The service sector economy is a key part of overall UK GDP, and some sectors, such as tourism, or technology, media, and communications, may be slightly affected. Tourism accounts for an estimated 10% of UK GDP and 11% of UK employment. Similarly, the technology, media and communications industry, accounts for 8% of UK GDP. The immediate impact of the UK Referendum result is that the UK will enter a two year period of negotiations with the EU about the terms of its exit. Therefore, the existing arrangements for the UK’s financial sector EU passport for providing financial services to the EU will remain in place until the terms of the exit have been negotiated.
Asian Investment Flows: The UK Referendum is expected to result in a period of weaker inward investment inflows into the UK during 2016-17, due to political uncertainty as well as lack of clarity about the details of the future exit negotiations between the UK and the EU. (*)