Market analysis: Brexit may not be as bad as you think

The fallout from the United Kingdom’s referendum is likely to be with us for some time, given the probable protracted nature of exit negotiations.

Although the medium- to long-term prospects for the UK could actually benefit from Britain leaving the European Union, it is difficult to disagree that UK growth will suffer a short-term hit. This may be for no other reason than that the Project Fear campaign run by the Remain camp looks set to turn into a self-fulfilling prophecy that has the capacity to trigger a dip in UK growth, with even the possibility of a short-lived recession.

However, this is likely to be far less destructive than what the media predicts. The way the referendum has been portrayed is akin to the Lehman event of 2008, whereas the reality is likely to be much less severe, for the UK and for the rest of the world.

In fact, under good stewardship there is no reason to think that the outcome may not be too dissimilar to the 1992 ERM crisis, when the pound was ejected from the Exchange Rate Mechanism.

The pound at the time dropped by 30 per cent and the UK economy went on to enjoy on one of its strongest periods of uninterrupted growth since the Second World War.

This time around it seems unlikely that the pound will fall by that much, but even a further 10 per cent decline on top of the 10 per cent fall since the referendum result could still do much to alleviate downside risks emanating from uncertainty. A depreciating exchange rate improves export competitiveness, which will improve the UK’s trade balance, boost GDP and encourage investment.

In the immediate future the main risks stemming from the Brexit decision reflect uncertainty. Uncertainty is an intangible phenomenon, but it can lead to companies curbing investment and deferring hiring. Currently, there is no shortage of uncertainties. David Cameron, the prime minister, has resigned and will leave office in October, leaving the ruling Conservative Party needing a new leader and the country a new prime minister before the negotiations for Britain’s withdrawal from the EU can even start. And when they do begin, these talks could last for as long as two years.

S&P and Fitch have already removed the UK’s AAA credit rating, while Moody’s has downgraded the UK’s sovereign outlook to negative. Many international businesses with UK premises are thought to be considering whether to relocate their operations. The Bank of England has pledged £250bn (Dh1.21 trillion) to safeguard the financial system, adding that it has further measures if needed to deal with a period of uncertainty and adjustment, which probably means keeping the door open to cut interest rates.

Complicating matters, a campaign to overturn the result of the referendum has already started. At a broader level the Brexit outcome has reopened the issue of Scottish independence and it has also given rise to the possibility of referendums taking place in other EU countries, which could ultimately lead to the dismantling of the whole EU integration project. Political risk ahead of the Dutch, French and German elections next year can weigh on euro-zone markets. The wider financial market volatility after the UK decision may also weigh further on the US Federal Reserve to delay raising interest rates. However, uncertainty is usually a temporary rather than a permanent phenomenon.

Sterling was always likely to be the first casualty of Brexit. Although it has declined by 11 per cent from the US$1.50 level it reached before the result was known, it is surprising that it has not fallen further. However, it is probably only a matter of time before more losses are registered, as it is difficult to conceive that a slowing economy will not require a lower exchange rate to enable the country’s a current account deficit of 7 per cent of GDP to be funded.

Untangling the frameworks related to British membership of the EU will be complicated and take time, and there will no doubt be a high degree of uncertainty. Financial market volatility will probably only add to that uncertainty, but once the dust has settled it may well be that any weakness in sterling will generate significant new opportunities.

Tim Fox is the chief economist and head of research at Emirates NBD.

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