Weekly Global Update for August 24, 2016

The following economic analysis was excerpted with permission from the August 2016 edition of the Henderson Electronic Market Forecast www.HendersonVentures.com

BREXIT WILL CAST A LONG ECONOMIC SHADOW

With the dubious help of false promises from populist politicians, the Brexit vote brought to a boil the long-simmering dissatisfaction with rules promulgated by Brussels. Despite warnings of the economic costs associated with a withdrawal from the EU, the Brits voted to take firmer control of their national destiny. Border management and immigration were high on the list of motivators. So too was economic dislocation because globalization continued to erase numerous blue-collar jobs outside of London. The voters’ distain for uncontrolled immigration was reinforced by a growing fear of terrorism. That sentiment is shared by roughly 20 percent of voters in the Eurozone who now back populist parties promising to close borders and increase living standards.

Concerns over economic welfare are justified. 65-70 percent of households in rich countries saw their real income stagnate between 2005 and 2014. Many blame globalization for their economic plight. They are partially right. While trade helps to boost overall GDP, the benefits are spread unevenly. Consequently, populist parties in Greece, Hungary, Poland, Italy, Spain and Sweden are rising rapidly in the polls. And did we mention the U.S.? The British referendum has reenergized political parties that also favor withdrawal from the EU, despite the real possibility that a deep recession could result from an unraveling of the EU fabric.

But that’s not the only threat to European prosperity. The end of the Cold War had seemed to usher in an unstoppable spread of democracy and ever-greater European integration. The Russian annexation of Crimea and the invasion of Eastern Ukraine in 2014 shattered that pleasant picture. What’s more, the gradual transition from democracy to autocracy orchestrated by Russian President Vladimir Putin is being partially emulated by three NATO members: Turkey, Hungary and Poland. Straying from democratic ideals put NATO and, therefore, European security at risk.

The solidarity within the NATO alliance is also being threatened by ill-considered remarks by Donald Trump who questions America’s promise to defend countries who have not paid their fair share of defense spending. Certainly, they should pony up, but the suggestion that the U.S. might not defend the Baltic States of Estonia, Latvia and Lithuania only invites Russian meddling similar to the ongoing military intimidation in Eastern Ukraine.

In short, the ongoing socio-political forces are creating increasing economic uncertainty, which undercuts business investment and consumer spending. Arguably, three of the greatest political threats are found in the upcoming elections in France, Italy and the U.S.. In France, Marine Le Pen promises to take France out of the EU should she be elected president. Italy’s Five Star Movement, founded by comedian Beppe Grillo, wants to dispense with the euro as its currency. And Donald Trump vowed to “rip up” US trade agreements he doesn’t like, thereby endangering viability of future treaties.

THE LONG AND WINDING BREXIT ROAD

The UK-EU breakup will officially enter divorce proceedings when the UK chooses to trigger Article 50 of the Treaty of Lisbon. The withdrawal process must be completed within two years of notification to exit. But the deadline could be extended if all parties agree. However, if no agreement is reached, the EU can unilaterally define the future relationship in regard to hundreds, and probably thousands, of laws and codes.

The new UK Prime Minister, Theresa May, has signaled that she will not pull the Article 50 trigger until she has her strategy nailed down. A crucial part of the negotiations will revolve around the unobstructed movement of capital and labor. The UK exit vote was driven by anti-immigration forces that demanded greater control of the border. The bargaining will be difficult given the EU’s fundamental code of free-flow of people in a single market. And although the EU 27 is anxious to complete the divorce proceedings as quickly as possible, and on “amicable” terms, economic growth-sapping uncertainty is likely to prevail for years.

THE CHALLENGE OF MINIMIZING THE BREXIT FALLOUT

Over the past 43 years the UK’s financial and economic fabrics have become ever more tightly woven into the EU. Untangling the threads without doing substantial damage to either political entity will be a herculean task over the next two years or so. But an amicable negotiation process that facilitates a smooth UK withdrawal from the EU is not necessarily compatible with the political objective to demonstrate that a withdrawal from the EU will create substantial economic cost to future exiters. Prime Minister Merkel captured EU sentiment succinctly relative to Britain with the following statement. “Anyone who wants to leave this family can’t expect to get rid of all the obligations while holding on to the privileges,” as she was quoted on June 28.

The impending UK exit has upset investment and consumer sentiment across global financial markets. The uncertainties weigh heavily on banks that are already in trouble. There has been huge downward pressure on shares of fragile Italian and Portuguese banks who are flirting with bankruptcy. The fear is that a more aggressive monetary stimulus policy in the form of even lower interest rates would nudge those institutions into insolvency. Savers would lose money and business borrowing would be stunted. Consumer spending and business investment would suffer.

THREE VIABLE EXIT SCENARIOS

While there are a myriad of combinations and permutations that may apply to the UK exit, three plausible paths will be briefly described. The first would have Britain join countries such as Norway in the European Free Trade Association (EFTA). Given that the rules of the road for the EFTA-EU relationship are firmly established, the possibility of a speedy transition with minimal economic fallout is quite attractive. The UK would have access to the European single market for goods and services. But the disadvantages would be huge. EFTA members make large payments into the EU budget and observe all single-market regulations with no input to legislating them. More troublesome for the UK is that EFTA members must accept free movement of labor. Such an agreement would approximate the pre-Brexit setup. That is, the UK has its own currency and does not now subscribe to total free flow of people that is called for in the EU Schengen agreement. While Scenario 1 probably produces the least economic damage, it is unlikely to be agreed to by the 27 residual EU members since it may encourage other exiters. Nor is it palatable to those who voted for Brexit because it essentially returns the UK to its pre-Brexit position but with even less immigration control. The probability of Scenario 1 emerging is put at 10 percent.

Scenario 2 appears to be the one currently emerging. That is, uncertainty is causing consumers to postpone purchases. Businesses will defer large capital investment projects because while the initial outlays will be known, future returns would be dependent on a still-to-be-negotiated arrangement with the EU. The economic damage would be partially offset by the ongoing devaluation of the pound. While exports would benefit from increased affordability, imports become more expensive to the detriment of UK living standards. Under Scenario 2, UK GDP is likely to lose roughly 1 percentage point of growth in 2016 and 2 percentage points in 2017. The EU as a whole would suffer little in 2016, but lose about 1 percentage point in 2017.

The third scenario is a hard landing. The absence of a clear path to a new trade agreement could further deepen uncertainty on the Continent. Moreover, demand for referendums among some of the 27 remaining EU members could further sour investment. Referendums are also likely to be demanded by Scotland (again) and Northern Ireland. Fragile banks could cut back on lending and consumers and businesses would retrench until the situation clears. Furthermore, Russia might take advantage of the growing disunity within the EU and NATO to further destabilize a tenuous socio-political environment. Scenario 3 would lead to a serious EU recession and a significant deceleration of global GDP. The probability of Scenario 3 is also put at 10 percent.

Although the UK accounts for less than four percent of global GDP, its role as an international financial hub and its above-average influence on EU policies is likely to have a greater-than-expected impact on global economic performance, especially if there is a hard landing. Given our three scenarios it is clear that there is little in the way of upside potential but enormous downside danger even if the probability is small for Scenario 3.

GAUGING THE ECONOMIC FALLOUT

There were more than 360,000 people employed in the London financial sector last year. And it is this European financial hub that may be at the greatest risk. That is, new rules would have to be established for the UK financial industry interfacing with their current counterparts in the EU. The new ground rules would include those governing sales of financial instruments, taxable transactions, the legal status of subsidiaries and much, much more. The cleanest solution would be to permit UK financial institutions to continue to be governed by the current rules. But that is an unlikely prospect given the expansion ambitions of the financial centers of Paris and Frankfurt. And Dublin, the English-speaking capital of the Republic of Ireland, would be an attractive new base for jobs currently held in London. In fact, it has been estimated that 75,000 financial jobs could go to Dublin, because Ireland is a Eurozone EU member.

Given that Scenario 2 currently appears to be the most likely outcome, our global economic forecast, illustrated below, is not drastically lower than that published in our last monthly report. However, the projections for Europe are significantly less attractive.

EUROPEAN AUTOMOTIVE INDUSTRY WILL BE DENTED – AN EXAMPLE

The UK-EU divorce will prompt an exodus of companies that have little in the way of fixed capital in the country. Obvious industries include financial and other service sectors such as Information Technology. Other corporations may be tempted to switch their headquarters or address for tax or tariff reasons. However, the automotive industry has deep roots that will be difficult to transplant. That includes the 800,000 people working in the industry.

The UK is the second-largest European automotive market after Germany. UK automotive purchases reached a record high a 2.6 million vehicles in 2015. The falling pound will effectively boost the cost of imported vehicles just as job security fears are building. It has been forecast that the British exit from the EU will subtract about 1 million UK vehicle sales over the next three years. Some estimates have automotive earnings down as much as $9 billion. Automotive suppliers such as Delphi and BorgWarner saw their stocks lose 10 percent of their value recently.

Production wise, the UK manufactured 1.6 million vehicles last year. Eighty percent of them were exported. Looking ahead, unless the UK reaches a pleasing agreement with the EU, future exports to the residual EU 27 members will entail tariffs of perhaps 10 percent. The tariff would be partially offset by any decline in the pound. But whereas exchange rates fluctuate, the tariffs could very well be permanent. The same may be true of automotive assemblies. For example, Ford does not manufacture any vehicles in the UK, but it employs 14,000 workers manufacturing assemblies. That includes two engine plants. Almost 60 percent of the engines go for European light vehicle production. While the simplest longer-term solution may be to establish tariff-free automotive trade, the EU 27 may not smile on that option if for no other reason than it would encourage other countries to file for divorce.

Our September Quarterly Report will deliver detailed forecasts of economic prospects and electronic equipment production breakdowns for 46 countries and regions.