UK takes the jump into the unknown - MUFG

Derek Halpenny, European Head of GMR at MUFG, notes that the UK has voted to leave the EU with 52% in favour of ‘Leave‘ and 48% in favour of ‘Remain’.

Key Quotes

“The vote has profound implications for the UK political and economic outlook with a protracted period of uncertainty lying ahead. The financial markets adjustment has been immediate with moves in foreign exchange so far within the consensus ranges that had been cited as possible in response to a vote to ‘Leave’. We believe the key initial issues for the financial markets will be as follows:

1) The immediate consequences for PM Cameron and Chancellor Osborne.

A letter signed by 84 Conservative MPs was delivered to 10 Downing Street last night offering support for PM Cameron whatever the result of the referendum. While that points to support within the Tory party, the total number of signatures implies one-third of ‘Leave’ Campaigning Tories did not sign the letter. At this early stage we envisage it being very difficult for PM Cameron to remain as PM. We find it even more difficult to envisage Chancellor Osborne remaining in his position. The likelihood of the government now announcing any form of austerity is close to nil and that will soon expose Chancellor Osborne. We see it as very difficult for both Cameron and Osborne to remain in office. We would expect a statement from PM Cameron from Downing Street early this morning.

2) The handling of Article 50 of the Lisbon Treaty

We would be very surprised to see Article 50 triggered any time soon. Triggering Article 50 gives the EU the stronger negotiating hand given any extension of time beyond the stated two years must be agreed by all the other 27 EU countries.

3) The response from the BOE

We have already stated that we would expect the BOE to ease its monetary stance in the event of victory for ‘Leave’. We believe the first action would most likely be a cut to Bank Rate. However, the BOE is unlikely to rush into any monetary policy action. We would even argue that is possible, the BOE would prefer to wait until the August meeting when the Quarterly Inflation Report will be released to provide a clearer backdrop to the decision.

4) The response from Europe

This vote will have profound implications for the European project that creates huge political uncertainty in terms of the future direction of Europe. Comments from senior EU officials later this morning will perhaps give the first indications of how early negotiations with the UK might go. Just now Geert Wilders, from the Dutch right-wing Freedom Party has called for a referendum on the Netherlands membership of the EU.

5) The internal political tensions in the UK may escalate rapidly

It is clear that the EU referendum results have highlighted the divisions that exist within the UK and how this evolves over the near-term and long-term will be crucial. The Scottish vote in particular will inevitably fuel speculation on another referendum for independence. Tensions will quickly escalate between the devolved parliaments in Scotland and Northern Ireland and parliament in London.

6) International response

BOJ Governor Kuroda has already spoken this morning in a statement saying that the BOJ stands ready to “provide sufficient liquidity, including utilizing the swap arrangements amongst the six central banks”. We think there’s a high probability of a G-7/G-20 statement being released later, emphasising what BOJ Governor Kuroda has just stated, ensuring the financial markets that whatever action is required will be taken in order to ensure continued market functioning. While GBP/JPY is currently around 11% lower, the movement in USD/JPY means the BOJ will probably refrain from intervention. This vote has certainly side-lined the FOMC perhaps for the year although at this stage we do not expect the Fed to flip and return to easing mode. However, the ECB is very likely to have to act again. An extension of the QE program beyond the current deadline date of March 2017 is the very least we should expect from the ECB.

7) The economic impact

The UK economy was already decelerating in part due to the impact of the uncertainty created since the start of the year. We would expect a very sharp drop in business sentiment over the coming months that is set to tip the UK economy into a recession. A short-term shock like this means sentiment is a crucial aspect of driving short-term decision making and we believe it is inevitable that the extent of pull-back on hiring and business investment decisions will be big enough to tip the economy into a recession given the weakening momentum already evident. Yes, the devaluation of the pound will help the export sector (especially given the fact that nothing changes in terms of trade with the EU for at least two years) but that will be a factor in prompting a rebound in economic activity rather than forestalling a recession. As a result of the negative implications of Brexit, the UK’s credit rating is likely to be downgraded.”