Brexit fallout — markets v economists

Posted on September 15, 2016

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Rarely have economists and markets seemed as much at odds as they do today over one of the biggest issues facing the UK — the country’s prospects after its vote to leave the EU.

Despite predictions of recession from both the Treasury and many mainstream economists, economic indicators in recent weeks have consistently been better than expectations.

Some market bulls have hailed a “Brexit bounce” — a triumph for British resilience in the face of misplaced warnings.

“I recall that the entire ‘establishment’ declared total catastrophe in the UK in the event of Brexit,” says Stephen Jen, partner at Eurizon SLJ Capital, who notes caustically that Britain still “has not sunk into the Atlantic Ocean after Brexit”.

As the Bank of England gathers on Thursday to consider how to steer monetary policy in the wake of the June 23 vote to leave, the question is whether the financial markets’ buoyancy is a better guide to the future than economists’ continuing worries about a bust.

Markets throw off the warnings

A Treasury analysis of the “immediate economic impact” of a vote to leave warned in May that such a decision would risk recession and a rise in unemployment in the two years after the vote.

At first, the Treasury’s warnings seemed to hit the mark. The overwhelming majority of indicators were indeed weak in the immediate aftermath of the referendum. Purchasing managers’ numbers pointed directly to recession. But strong retail figures published on August 18 marked a turn in the tide. Since then, the positive signals have barely stopped and sterling has rebounded.

At about $1.32, the pound is still about 13 per cent below its pre-referendum level against the dollar, but its performance has belied predictions of a continued slide and it is comfortably above its July low of $1.28.

Meanwhile, equity markets — even the domestically oriented FTSE 250 — have hovered near record highs, above their levels on referendum day.

Economists’ reply

Economists are clearly on the defensive. Credit Suisse and Morgan Stanley scrapped their predictions of a recession, raising growth predictions for 2016 and 2017.

But both institutions still expect the Brexit vote to hold growth back, particularly over time.

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Before the June referendum, economists warned a UK vote to leave the EU would tip the economy into recession.

Most economists were less influenced by the Treasury’s forecast of an immediate recession than by arguments in the Treasury’s long-term analysis, which warned that by 2020 Brexit would leave the economy 5.8 per cent smaller than otherwise would be the case.

Samuel Tombs of Pantheon Macroeconomics acknowledges that there was a “scope for a lot of error” about economists’ predictions for the short-term fallout from the Brexit vote, partly because confidence has proved much more resilient than expected.

But, he says, dismissing the notion of a Brexit bounce, “that does not challenge our overall conclusion that Brexit is bad for Britain’s economy”. Despite their relative resilience, the economic data still point to a slowdown.

“Economists are taking the longer view,” adds Victoria Clarke, an economist at Investec, who warns that after a lag sterling’s fall will bring about a “big shock” of higher prices that will squeeze household incomes.

“Are markets even thinking about the long-term costs of Brexit?” asks Richard Barwell, senior economist at BNP Paribas Investment Partners. “I think not.”

Blurred battle lines

Some on both sides say the dispute is largely artificial. Not all financial markets unanimously point to good times ahead. Lower yields on government bonds suggest that borrowing costs will have to remain lower for longer because of economic weakness.

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Read more: Brexit: the great headscratcher for the pound

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George Buckley, UK economist at Deutsche Bank, also points out that the Bank of England’s quantitative easing programme was specifically designed to boost asset prices — and so help the economy adjust to the referendum’s aftermath. “I am not sure there is a big disconnect,” he says.

Some market participants are also reluctant to claim victory over the economists. “I don’t think the warnings were misplaced,” says Alan Wilde, head of fixed income at Baring Asset Management. “Frankly it is way too early to judge.”

As for the weeks immediately after the vote, he says a worse outcome was prevented by two factors: the Bank of England’s speedy actions and the “relatively quick” transition as Theresa May succeeded David Cameron as prime minister.

Other financial professionals take an even longer, broader view. Matthew Cobon, portfolio manager at Columbia Threadneedle, sees Brexit as “the cementing of the beginning of structural changes in markets away from free trade, towards more insular domestic agendas globally”.

He adds that “the implications are huge” but “could take years to truly become appreciated fully by markets”.

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