It was a referendum no one asked for, orchestrated by a Prime Minister who believed he could win it, and didn’t. The vote is for the United Kingdom of Great Britain to leave the European Union (EU), the body which issues the currency (The Euro) and promotes free trade and free passage between its countries. The UK will become again its own independent country and has now been validated by the people. The questions now are: how to go about doing this and what are the implications of it.
There is, at this hour, a concerted effort to reverse the referendum. Some 3.3 million Britons have signed a petition asking for another referendum before severance talks begin. However, this would require that the current session of parliament decide not to honor a legitimate vote of the people. In order to do so, general elections will need to be called, and aside from replacing the Prime Minister, none are being discussed at this time.
The laundry list of complaints against the EU center around the lack of transparency and its tendency to issue rules and regulations without input. There is also a tax burden to support the EU government in Brussels, which some British resent.
However, the real issue that moved people to vote to leave the EU was immigration. The EU has a policy of open borders. Once an immigrant gains access to any EU country, he or she can travel and settle in whatever country of their choosing. Many have come to the UK due to its more dynamic economy. Some of the locals, especially in rural areas, resent that.
So a policy that was considered vital to the more metropolitan areas, like London, was at the same time held in contempt by those in outlying areas, who suffered from the effects of globalization. This was how the vote came to 51.9 percent in favor of leaving the EU, and 48.1 percent in favor of staying in the EU.
So, unless there is some reversal of the referendum, exit talks are to commence with a new Prime Minister, lasting no longer than two years from probably this October. Feelings are running high on all sides, so it is perhaps best that there be some time before discussions commence.
Scotland, Ireland and Gibraltar all voted to stay in the EU, and are expected to come forth with their own applications. Scotland will do so by declaring its own independence from the UK. Thus one effect of the referendum is for the UK to literally shrink in terms of size and influence.
There will be other shrinkages as well. The British Pound could well lose its role as a reserve currency. London will decline as a financial center, perhaps to be replaced by Frankfurt, Germany. The decline in the value of the British Pound relative to other currencies will make imports more expensive in the UK, fueling inflation. Whatever competitive advantage afforded by a cheaper pound will be offset by tariffs, especially with the EU.
Advocates for exiting the EU talked of forming a trade block of the US, Canada and Australia to offset the loss of EU markets. This overlooks the fact that Britain does not make a lot of what the world wants to buy at competitive prices. Foreign investment in the UK will be scared off by the volatility of its currency. It is hard to see the UK with the investment appeal of some third world country. This has all the elements of a disaster.
At the end, this is a sad story. Most of those who voted to exit the EU were older, less educated and less tolerant of those outside their social circle. Instead of making Britain great again, they have accelerated its marginalization and demise. Even the appeal of tax reduction has to be balanced against those who want to use the tax revenues to support and expand government programs. The victors are hardly united in what they want from this. Without the EU markets to serve, what shape will the economy be in to generate taxes anyway?
Even the issue of immigration has to be put into context. According to the British government, 335,600 net migrants came to the UK in 2015. In a country of 65 million, this is just more than half of a percent of the population. Since most of the immigrants were in their 20s and 30s, they helped to arrest the demographic aging of the population. Net natural population growth came to 171,800. Thus immigration caused the population to increase at almost three times the rate it would have otherwise.
Aside from somehow winning another referendum, there is nothing that can be done. From a plebiscite that the public never asked for, there will be significant changes made in the next two years. While some would argue that it was the EU that needed reforming more than the UK, that issue was not on the ballot. Be careful what you wish for.
The US economy continues its steady pace. While not immune from the vote in the UK, the effect is far smaller than the EU. With time, the British situation may be a slight advantage to the US in terms of opening new markets for American goods.
Labor markets show further signs of tightening. However, businesses do not at this time have the incentive to invest for additional capacity or productivity. A strong public works program would help to kick start the next level of economic development. Given the nature of things, nothing is expected to be done until after the elections.
Interest rates have fallen further, as international investors flee to safe havens such as the dollar, while waiting to see how the British referendum shakes out.
Inflation is the biggest driver of potentially higher interest rates. As discussed below, interest rates are supposed to be kept above the inflation rate. Given the skewing of the data by oil prices, there are a lot of false signals being thrown off as to when interest rates will be raised. As oil prices track higher year over year, expect these false signals to fall away.
There is some evidence that inflation is beginning to form a pattern at a higher level than last year. This is a necessary condition for the raising of interest rates in the US. As the Federal Reserve is mandated to hold inflation in check, look for aggressive interest rate moves if the inflation rate goes above two percent per annum on a sustained basis.
Aside from energy prices, labor rates hold the key. As labor participation increases, expect higher pressure to raise wages. Without offsetting productivity increases, the effect will be inflationary.
The Stock Market
The stock market took news of the exit of the UK from the EU badly, retreating to the level not seen since the previous Thursday. In actuality, the market marched up a hill on the expectation of a referendum outcome for the UK to stay in the EU. When this did not happen, it marched back down.
In essence, this has been the story of the stock market most all of this year. Stocks keep acting like a recession is imminent, while the real economy marches on. At some point one or the other will be proven correct. With interest rates so low, it would seem that stocks as a category would be seen as having greater protection than bonds in terms of an investment going forward. Fixed yields do not go up when interest rates rise. If the economy is strong, dividends generally do.
Warren M. Barnett, CFA
June 28, 2016