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Question of the Week - June 27, 2016

Question of the Week - June 27, 2016

Guest Post - Monday, June 27, 2016

Now that the U.K. is leaving the EU, what now?

We discussed the 'Brexit' situation through a separate note mid-week, and economists are now reviewing various scenarios and linkages even more deeply to determine their potential effects. Politics and economics are often strange bedfellows. Much of the sentiment that resulted in the vote's outcome appeared to be driven by the immigration issue, as opposed to a deeper assessment of economic benefits by the citizenry, although voters did appear to be swayed by advertised numbers showing the U.K. contributing a substantial amount of annual funds to the EU, while the gains earned from that investment were much less certain.

This exit likely won't happen quickly—it could take up to two years per Article 50 of the original EU treaty but could end up being longer, depending on how complex the breakup becomes. Even the pending resignation of David Cameron, the U.K. Prime Minister, isn't slated to happen until October. While the British pound and equity markets have taken a severe hit locally, shock waves have diffused the further away from the region one gets, although the impact upon world markets has still been negative. The U.K. represents less than 5% of global GDP, but the financial center and cultural impacts are much larger. This will likely result in slower economic growth in the U.K., through a hesitancy to invest capital and greater trade frictions, and may result in a U.K. recession (worst case scenario); therefore, the Bank of England bank could well keep monetary strategy accommodative and enhance liquidity where possible to ease this strain. It also looks as if S&P may reduce the U.K.'s credit rating below the current AAA (a situation the U.S. also has some shared experience with).

Key concerns in future months include ramifications for the financial sector in both the Europe and U.K., trade effects (export to EU nations makes up almost 15% of U.K. GDP) in terms of how renegotiations look, as well as carryover to other nationalistic movements in Europe, including a possible redux of the Scottish referendum—especially considering the fact that the Scots were much more in favor of EU integration than was England. Depending on how the pound reacts, the aftermath could either create an inflationary environment (a weaker pound means more expensive imports) but could help U.K. exporters somewhat.

On the positive side, over time, this reduces a burden to the EU. Interestingly, some feel leaving the bloated regulatory environment of Europe could be a catalyst for stronger innovation and even freer trade over time as large multi-objective bureaucracies have a tendency to stifle such things. Britain, like the U.S. and Japan, is seen as a global 'safe haven, the status of which is unlikely to change in the near term, as such a status is based on advantages such as rule of law, financial regulations, democratic political systems and military might.

What does this mean for everyone else? As the uncoupling will likely act as a headwind to global trade, global growth rates could fall, raising the risks of a broader global slowdown. Some early estimates claim this may shave up to a quarter percent off of U.S. economic growth for the second half of 2016 (which is estimated to be low, anyway), with less transparent effects further down the road. Therefore, the Fed may use this as a reason to keep rates lower for longer if not postpone a rate increase for much longer. In terms of recession risk in the U.S., growth has been slow regardless, so the severity of any recession would likely be muted relative to what we saw during the financial crisis to be sure (as an economy needs large excesses to create the fuel for severe pullbacks). This event will just add to the continuation of slow global growth that we've written ad nauseam about for some time. We know markets overreact to bad news, though, so investment opportunities in distraught areas could be a positive.

Read our Weekly Review for June 27, 2016.

Read the previous Question of the Week for June 20, 2016.

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