Helping clients deal with potential Brexit disruption

The short-term economic impact of the Brexit vote, which has set the U.K. on track to leave the European Union (EU), is unambiguously negative. The longer-term impact is decidedly uncertain. In the meantime, economists expect looser monetary policy amid heightened financial market volatility.

Economists are unanimous in seeing the outcome of the vote as a negative both for the economy in the U.K. and the global economy in the short-term. That view is reflected in the immediate market turmoil, which has seen stocks decline worldwide and volatility in the foreign exchange markets.

“The exit could cause the U.K. economy to meaningfully underperform, if not tip into recession,” says BMO Nesbitt Burns in a report on the referendum results.

TD Economics estimates that its current forecast for U.K. real GDP over the next couple of years will be cut in half as a result of the immediate fallout from the vote. “However,” it says, “we are ultimately in wait-and-see mode in terms of central bank and political responses that could act to temper these downgrades.”

Indeed, the vote is to have an impact on monetary policy worldwide, as central bankers grapple with the fallout of a negative-growth shock on an already weak global economy. “With Britain voting to exit the European Union, downside risks have increased for a global economy that was already sputtering,” says National Bank Financial. It expects the result to hamper global economic activity and “force the Fed to remain on the sidelines for longer.”

National Bank Financial suggests that the European Central Bank (ECB) and the Bank of Japan may have to provide more stimulus before yearend to stimulate their respective economies.

CIBC World Markets also says that the Bank of England might cut rates and expand its quantitative easing program. Plans to tighten fiscal policy in the U.K., it adds, are now “obviously off the table.” CIBC also sees the other major central banks easing policy.

BMO says that while the prospect of a rate hike by the U.S. Federal Reserve Board (Fed) in July has now been eliminated, “a move by December remains a reasonable possibility, provided markets soon calm and the near-term economic fallout is minimal, but that’s still a long way off.” Moreover, BMO says, the delay in Fed rate hikes will likely push off any hikes from the Bank of Canada (BoC) further, too. It expects the BoC to remain on hold until at least the fourth quarter of 2017. “Accordingly, look for global bond markets to be well supported, with yields likely drifting even lower in the near term,” it says.

In terms of global economic impact, TD says the vote results, “will undermine already lackluster momentum in the second half of this year in many economies, leaving global growth next year closer to 3.1% instead of our 3.4% forecast.”

For North America, the direct economic impact should be modest, BMO says, as the U.K. accounts for just 3% of U.S. trade and 2.5% of Canadian trade. For now, the biggest impact in North America will come from the heightened financial market volatility — a view that is echoed by TD.

Within Canada, TD says, the regions that will likely to feel the brunt of reduced U.K. demand are Newfoundland and Labrador and Ontario, which have the largest export exposure to the U.K. “Although spillovers via direct trade channels are small, financial and confidence spillovers could exact a larger toll on the Canadian and U.S. economies from the deterioration in stock market wealth and the rise in global economic uncertainty,” it says. Overall, TD estimates that the result “could shave about 0.5 to 1.0 percentage points off GDP growth for the U.S. and Canada in the second half of 2016, driven mainly by an expected reduction in business investment growth as a result of a rise in global economic uncertainty.” This could be exacerbated by a prolonged slump in commodity price growth and any further drag on foreign demand.

Over the longer term, economists note that there are forces that could blunt the initial negative impact of the vote. “Looking beyond today and early next week, we foresee some stability returning to financial markets, particularly as investors start to take advantage of buying opportunities. However, we expect a prolonged period of market volatility,” TD says.

Says CIBC: “While there’s likely choppier waters ahead for U.K. securities as the next steps are planned — namely a fresh election to select a new government to lead negotiations with the EU — we still think that any material blowback in North American securities will be an overreaction. There are huge incentives, ample precedent and a structure in which to negotiate a side deal on free trade. Markets will start focusing on that angle following the initial reaction.”

Looking further down the road, economists suggest that the biggest impacts will likely be political. “Markets tend to overestimate developments in the short term and underestimate them in a long term,” CIBC says. “That might be the case with the Brexit vote. The near-term damage might be less significant than currently assessed by the market, but the long-term consequences of the vote are significant.”

Those long-term impacts are “mostly political,” CIBC says, as the outcome of the U.K. vote may give strength to anti-EU sentiment elsewhere in Europe.

“While the UK exit vote marks the end of a 40-year project of closer European ties to the U.K.,” says Canaccord Genuity, “we think the bigger issue is the increased risk of European political and economic fragmentation, and possibly the beginning of the end for the Euro as we know it today.”

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