The unexpected ‘Leave’ victory in the recent referendum on EU membership introduces considerable political risk by elevating tail risk scenarios to reasonable worst case status. However, in a global economy that is already slow and already lacks policy space, the referendum outcome also introduces economic and financial risk. Below I have some general thoughts on those risks, with the US dollar, Italian banks, and Japanese deflation foremost among them. At a later point, I hope to also go into some more detailed scenario handicapping.
Now that we have a little distance between the vote and the market outcomes, I feel it is a good point to start talking about longer-term repercussions. Let me say at the outset here that the EU referendum is more of a political outcome than it is a financial or economic outcome. And it has driven some very partisan political commentary as a result. Most of that commentary can best be described as motivated reasoning, which is not objective, and therefore is not particularly helpful in discerning what medium- or long-term economic outcomes are likely to be.
Let me use a university psychologist department’s research to better describe what I mean by motivated reasoning. Here’s what they say:
In political science, cognitive science, economics, law, and business, the predominant models of judgment and decision making today might be called “almost-rational man” models. These models suggest that people are rational within limits imposed by cognitive shortcuts and heuristics that can bias reasoning. In political science, a long-standing body of research on “partisan” biases in political judgment points to another set of limits to rational judgment imposed by motivated reasoning i.e., reasoning biased to produce emotionally preferable conclusions. Motivated reasoning can be viewed as a form of implicit affect regulation, in which the brain converges on solutions that minimize negative and maximize positive affect states.
What Drew Westen and his team are basically saying is that we are not hard-wired to deal logically with non-confirmatory evidence. We are hard-wired to seek confirmatory information that minimizes emotional stress. And therefore, we use what is called motivated reasoning to fit new incoming data into our pre-conceived world view. I believe this is what is happening post-Brexit vote on both sides of the equation because of the emotionally impactive nature of the vote. So my sense is that we are getting an over-dramatized and exaggerated view of how likely outlier events have now become. If you’re interested, you can read similar thoughts I had about the economy in May 2009 when I accurately called the recovery.
Having said that, I look at the Brexit vote as having introduced tail risk. The mental model I use for thinking about this is something I described last year during the Greece meltdown. It’s a decision-tree model whereby incumbent leaders are biased toward outcomes with relatively fewer potential future outcomes because those are decisions that limit policy error. What we have here with the Brexit vote is a decision by David Cameron which – now that Britain has voted ‘Leave’ – introduces a lot of potential outcomes, many of which are extremely negative politically and potentially economically as well. In effect, Cameron has chosen the risky node in the decision tree, increasing the probability of policy error, outlier situations and black swan events. Think Lehman Brothers.
So where are we now?
Well, having made a bet that holding a referendum would yield positive results, David Cameron won his bet in Scotland last year, with the Scottish voting 55% to 45% to remain a part of the UK. And so he pressed his hand further with a vote on the EU for the whole of the UK. And he lost that bet. So that puts us at a decision tree node with a gazillion different outcomes, some of which are pretty nasty. The markets, sensing this, panicked and went into free-fall. But now they are stabilizing, even retracing some of the initial moves as they realize that the sky really isn’t falling. I expect this retracement to continue until it is clear whether there are any decisive short- and medium-term impacts for earnings and economic growth.
My base case scenario is that there are minimal medium-to longer-term impacts on the economy or earnings. I don’t foresee a massive move lower in the UK’s exchange rate or higher in US exchange rates. I also do not see a huge decline in shares going forward. For the UK, a lower currency actually aids the Bank of England in its fight to boost inflation toward target. And it might also have some mild boost to exports and tourism as evidenced by this Bloomberg article on tourism.
Overall, then, the base case here is one in which the Brexit vote has a limited impact on the UK economy and the EU economy, and therefore even more of a limited impact on the global economy. And with that the impact on markets will be equally muted. The whole sturm and drang about economic catastrophe is mostly an emotional and exaggerated sense of doom that comes from the confirmation bias of those of us who expected ‘Remain’ to win. It’s not coming from the ‘Brexit’ side because they have always downplayed the tail-risk scenarios.
Yet, there are three outcomes that I am looking out for downside risk. And as I go into them, let me say from the start that some of this depends on how the UK government is structured. The most important question politically is: who will lead the new government after David Cameron and what will their negotiating stance toward the EU be? And here there are a lot of wildly different options. Right now I am handicapping three different PMs, Boris Johnson and Theresa May, the frontrunners, and Andrea Leadsom, a prominent Leave campaigner.
Johnson is toxic right now, so emotional is the aftermath of the campaign. To the degree the Conservatives pick a successor to Cameron sooner than later, this works against Johnson. I reckon the Conservatives will want someone who can best build bridges within the UK and also with the UK’s EU partners. And right now, Johnson is not looking like that person – though in a month’s time he could do.
Meanwhile Theresa May, who kept a low profile during the campaign, is a member of the ‘Remain’ camp. And that is attractive because, as she isn’t tainted by the campaign, she can help take some of the more divisive outcomes off the table. For example, if the situation calms enough and May delays the Article 50 invocation, she would be well positioned to keep Scotland in the UK. Now, even though Scotland has its own parliament, it still needs permission from Westminster to hold a second national referendum on leaving the UK. May would be a good face in Westminster to make rejecting a referendum palatable.
Finally, there are people like Andrea Leadsom. I have heard Leadsom’s position on the debate and hers is one that makes the most sense from a Leave perspective in that she unequivocally says that Britain will not seek membership in the single market. As such, the UK under Leadsom could leave the EU and the single market altogether and unilaterally enact trade barriers for the EU of the exact same level as it has with the US, while the UK works to secure a trade deal with the EU. The point here is that, under Leadsom, the EU would have zero leverage to squeeze the UK on trade because the starting negotiating position would be to create a trade relationship with the EU equivalent to the one with the US unless the EU works to secure better terms. The real question for her is the City of London as a financial center. But Leadsom also has experience in the City, and therefore would be more likely to win over the financial sector.
Cameron met with other EU leaders yesterday and made clear that the UK will leave the EU. It will be hard to go back on this statement now. Moreover, at the same summitI, Angela Merkel said their will be no formal or informal talks on the British leaving the UK before Article 50 is invoked. That means the UK will not be able to iron out any issues until the clock is ticking. The totality of these factors says that not only is the UK likely to leave the EU, it is also likely to leave the single market as well. That makes Leadsom a good choice, if not the frontrunner. I see Johnson as the biggest risk here. And to the degree markets agree with me, the US dollar could rise, which would be a de facto tightening of US monetary policy. A lot of people have been touting the fact that Sterling had fallen to 31-year lows against the US dollar to show how catastrophic the Brexit outcome is.
And while that level of capital flight is worrying, especially were it to continue, I have to point out that a lot of this is dollar strength and not Sterling weakness.
Sterling was at a seven-year high on a trade-weighted basis just a month ago and is at the comparable lows in 1993, 2002, and 2009. So, on a trade-weighted basis, with the euro being significantly more important than the dollar…
I look at this as less a Sterling problem and more of a Dollar problem. And the problem with dollar strength is that it is the world’s reserve currency, tied to all kinds of debt contracts for emerging market debtors. And it also linked to the Chinese Yuan. The de facto tightening of US monetary policy through dollar strength could be just enough to tip major economies into recession. So that is the first outlier scenario that has now become a reasonable worst case.
The second new worst case scenario is the one about Italian banks, where I have been worried for a while. This is the scenario I wrote about last year regarding the euro’s failure:
“Italy has had no growth for decades now. And it also has weak nominal GDP growth, such that despite a primary budget surplus, the Italian government debt to GDP is 140% and rising. Italy will be challenged at the next recession because the deficit will rise to perhaps the 150% or 160% of GDP level. That’s very close to Greek levels today. Would Italian banks be well capitalized? How many bad loans would mount due to recession? Would bail-ins feed a loss of tax revenue? All of this matters regarding contingent liabilities and private sector debt deflation if those contingent liabilities are not met. In the next recession in Italy, someone will have to increase the debt burden to replace the lost income due to souring debt. And if not, the lost income will result in a decline in GDP and tax revenue. Either way, government debt will go up substantially.”
We know that Italy is much more important to the European project than Greece. And so, as people talk about the need for the Italian government to inject 40 billion euros into Italian banks, we need to be concerned. This is both a problem in terms of the bail-in rules in the eurozone, contagion within the periphery as well as regarding the sovereign-bank nexus where the pain in one feeds on the other. The black swan outcome here is a collapse of the Italian banking sector causing the eurozone to break apart.
And finally, my third outlier scenario is Japan where the Yen is appreciating. (click link below)
Britain and Japan stand out as losers here after 5 days. Where will things be in two months? pic.twitter.com/HKswd89WaT
— Edward Harrison (@edwardnh)
Clearly Abenomics has failed. It has not meant sustained GDP growth or an escape from deflation. Japan is nearing the end of the line here – and if the Yen’s appreciation continues, it could push Japan into as yet unthinkable policy actions. I see Japan, therefore, as the unknown unknown. So that’s my first cut here. We need to sift through the emotionalism and post-referendum noise; the base case is still muddle through. Brexit has not changed much in terms of global growth outcomes except through its increase of downside risk. That is supportive of safe assets. I would discount the doom economic scenarios for now. Let’s see how the UK negotiating team gets on with the EU in a couple months’ time.