Brexit fears of market contagion look overdone

Posted on July 22, 2016

A statue of Charles 1st is seen with a european flag in Trafalgar square.©Charlie Bibby

It is a month since the Leave result in the UK referendum on membership of the EU delivered a jolt to financial markets around the world. Yet since the initial movements, only some of the traces of the Brexit shock remain outside the UK. More than anything, those remnants of the initial impact serve as a reminder of the fragility of global growth. In the UK itself, the early data available suggest there is a clear risk of the real economy slowing sharply.

The fact that opinion polls, and even more so betting markets, pointed to a Remain victory evidently lulled investors into a false sense of security. The initial impact of the Leave result was dramatic. Equity prices around the world dropped as what appeared to be a “risk-off” flight to quality took hold. Bond yields also plunged: the yield on the benchmark 10-year German Bund, which had already dipped below zero for the first time days before the vote, dropped more firmly into negative territory.

    Some even talked of replicating the shock delivered by the collapse of Lehman Brothers in 2008 which caused the global financial system almost to freeze up completely and precipitated a worldwide crisis whose legacy still lives with us.

    A month on, those fears of global contagion look heavily overdone. The main stock indices in the US and continental Europe have recovered — in the latter case despite record outflows from European equity funds. Emerging market assets, traditionally the victim of risk-off episodes, have proved remarkably stable. And while government bond yields have remained lower than before the poll, including US Treasuries and German Bunds, they have recovered to what looks like the continuation of a medium-term downward drift rather than a plunge.

    The situation in the UK itself looks rather less sanguine. Equities first fell and then recovered, but sterling has dropped to a three-decade low against the dollar. Even more concerning, certainly for the average Briton, is initial evidence that a serious shock is hitting the real economy.

    On Friday the purchasing managers’ indices, which have proved a reasonable leading indicator of economic growth, plunged to their lowest level since 2009, suggesting a big hit to business confidence. Moreover, anecdotal evidence suggests that the housing market, traditionally a source of instability for the UK economy, has slowed sharply over the past month.

    In this context, the Bank of England was right to signal that it would cut interest rates: indeed, it could have chosen to move this month instead of next. Waiting for hard data to confirm that the economy has slumped could take months, and there is little cost when inflation is so low in taking out an insurance policy against such an outcome.

    Another welcome response was the new government’s decision to abandon former chancellor George Osborne’s peculiarly constructed fiscal surplus rule. A more flexible approach means it has more room to respond to a slowdown with tax cuts or spending increases, and with bond yields so low there is little risk that increased borrowing will lead to a solvency crisis.

    A month after the UK referendum, the financial and economic shock looks more like a self-inflicted wound than it does a trigger for a global dislocation. Central banks around the world should take it as another argument for easing policy or at least keeping it on hold, though probably not a decisive one.

    In Britain, though, both monetary and fiscal policy need to start moving in the direction of stimulus to cushion against likely shocks to come.

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