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Economic Insights

Here is a look at what’s at stake for economies and key asset classes as the deadline for the departure of United Kingdom from the European Union draws near.

With the October 31 deadline fast approaching for departure of the United Kingdom from the European Union, most analysts believe the chances are better than even that there will be a “Brexit” delay as opposed to an orderly or disorderly, exit on that date. Given this outcome, analysts expect the delay would then be followed by an election disputed between the Labor (headed by Jeremy Corbyn), Conservative (Boris Johnson), Brexit (Nigel Farage), and Liberal Democrats (Jo Swinson) parties. The Democratic Unionist Party headed by Arlene Foster could also play a key role in an eventual coalition government.

We think the election would inevitably become another referendum on Brexit, although the dispute over the form of association that would prevail—customs union, free trade agreement, common market, or some other arrangement—if the United Kingdom does eventually leave the European Union would likely continue. The course is likely set for some form of political and market upheaval, in our view; those hoping for an Emily Litella1 outcome, in which all parties put aside the three years of bitter controversy following the June 2016 vote and agree to maintain the status quo, are likely to be disappointed.

Potential Economic Impact
The International Monetary Fund (IMF) estimates that gross domestic product (GDP) in the United Kingdom is already 2–3% lower than it would have been if the trend in place ahead of the Brexit vote in June 2016 had persisted. Thus, the U.K. economy has already suffered a fall in economic activity—mostly investment-related—due to uncertainty over what Brexit means for the future relationship between the United Kingdom and the European Union.

If the United Kingdom were to leave the 28-country bloc without an agreement, it would revert to trade under World Trade Organization (WTO) rules and the free flow of goods and services across its border with the European Union would cease. In addition, treaties with other countries that the United Kingdom has by virtue of its EU membership would be voided in most cases, and new agreements would have to be renegotiated. The resultant increase in trade barriers would have an immediate negative effect on domestic and foreign demand. In addition, the United Kingdom would also suffer economic losses from stricter immigration policies and potential financial tightening.

The IMF estimates that this would reduce U.K. GDP by an additional 3.5% and EU GDP by 0.5% by 2021. The effect on global GDP is estimated at a 0.2% reduction, almost entirely due to the direct effects on the United Kingdom and European Union, i.e., the IMF estimates that Brexit spillover to third parties will be negligible.

The cumulative loss to U.K. GDP is estimated by the IMF at 6%–7%, including the current shortfall versus the 2016 baseline and the additional losses due to a reversion to trade under WTO rules. That figure is almost in the middle of the 3%–10% decline in GDP predicted by a variety of other analysts.

Investment Implications
Thus far, the most significant effect of Brexit has been on the exchange rate; the pound sterling is 12% lower in real effective terms and 17% lower against the euro than it was before the vote in June 2016, based on Bloomberg data. Inasmuch as most investors are not assuming that the United Kingdom will leave the European Union without an agreement on October 31 (just as they were assuming the “Leave” side would be defeated in the original referendum) an unexpected departure that crystallized the negative impact on the economy would likely result in another sharp drop in the currency and a selloff in the U.K. stock market.

But the more likely outcome, in our view, is that the issue will be punted again, and that a new government will be forced to re-enter negotiations that ultimately specify the terms of departure. In that case, the impact on asset prices will become contingent on the ultimate agreement.

 

1After offering opinions on topics like “violins on television” and “conserving natural racehorses” on Saturday Night Live’s parody newscast, op-ed contributor Emily Litella (portrayed by Gilda Radner) would inevitably shrug off her addled commentary with a cheery “never mind.”

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