Jason Broomer, head of investment, Square Mile Investment Consulting and Research
A UK exit from the EU will bring great uncertainty for businesses and this will affect their investment intentions. However, Brexit could prove a great issue for fragile European economies that are riddled with structural imbalances, leaving them vulnerable to shocks.
- We believe that the risks for Europe are rising and internal pressures will grow within the region over coming months
- The UK economy should be flexible enough to withstand the shock of Brexit, and sterling will absorb much of this impact
- Once the period of adjustment is complete, the UK’s flexibility and robustness may offer an attractive alternative to Europe
The news that the UK will be leaving the EU has been ill received by financial markets. Stockmarkets have fallen, and fallen sharply in the immediate aftermath of the vote, as they were not expecting such a result. Sterling too has tumbled in the foreign exchange markets. Around 75% of FTSE 100 companies’ revenues come from abroad and these will directly benefit from the lower price of sterling. As a result, large caps with international earnings have rallied from their initial falls. Share prices of companies with more of a domestic focus such as the banks and smaller companies remain under heavy pressure.
In contrast, gilt prices have soared. Gilts at the beginning of the year promised to provide a 20% return over the next 10 years. Returns so far this year have already delivered half of this gain. This leaves buy and hold investors a mere 10% to trickle in over the next 9½ years. Ahead of the vote, gilts were already trading at yields never previously seen in over 400 years. Since the vote, they have fallen still further.
“The UK’s exit from the EU may prove to be the first cracks in a creaking dam wall."
However, this is not to say that our economy is going to come to a juddering halt and nor shall the global economy. A UK exit from the EU will bring great uncertainty for businesses and this will affect their investment intentions. We believe that the UK economy will be flexible enough to withstand the shock that this vote has brought and the price of sterling will act to absorb much of this impact.
We think that Brexit may be more of an issue for European economies. The fragile Eurozone economies are riddled with structural imbalances and this inflexibility leaves them vulnerable to shocks such as this. We think the internal pressures, both political and economic, will grow within the region over the coming months. European markets have taken the Brexit news badly and we think that they may be vulnerable to further falls as the full implications begin to sink in. European problems do not stop with Greece, Portugal and Spain. Over the last quarter, we have been reminded about the structural problems elsewhere.
Italian banks are hamstrung by a huge swathe of dud loans on their balance sheets and there appears to be few mechanisms within EU law to permit these to be addressed. Nominal GDP growth is only just hovering above 0% so there is little that will erode the debt stock, and remember Italian government debt obligations also amount to over 130% of GDP. Productivity has been at a standstill for well over a decade, a disgrace during a technological revolution. Italy has a dreadful demographic profile and while unemployment levels have fallen from the post crisis peak of 13%, over the last 18 months appear stuck at around 11%. Youth unemployment is particularly grim with over a third of 15-24 year olds seeking work. Yet by European standards, the country doesn’t even qualify as a basket case.
France is sleep walking to disaster. Recent attempts to modestly soften France’s over protective labour laws have sent the unions to the streets. Life in La Belle France is just too sweet. Who would want change? The political elite seem aware of the unsustainability of the country’s path but are impotent to act. Already the State dictates over half of all spending and as each year passes, more and more of the population are moving into the nation’s overly generous pension system. A major crisis is required to rouse the nation from its slumber.
The UK referendum should have been a shoo-in for the remain camp but the dissatisfaction within the UK underlines quite how much of the benefits of European integration have been squandered through messy compromises made for political expediency. Dissatisfaction within other EU member states is also growing. The UK’s exit from the EU may prove to be the first cracks in a creaking dam wall. We believe that the risks for Europe are rising. Once the period of adjustment is complete, the flexibility and robustness offered by the UK economy and financial markets may be seen as an attractive alternative to the sclerotic continent.