Throughout the second quarter of 2016, the specter of a “Brexit” vote hung over fixed income markets. Federal Reserve policymakers said as much in mid-June, when Chair Janet Yellen admitted that concerns about Britain leaving the European Union (EU) were a factor in the U.S. central bank’s decision not to raise short term interest rates. “It was fair to say it was one of the factors that factored into today’s decision,” she said on June 15th, adding that Brexit “could have consequences” for the US economic outlook. Now that the vote is over, and the British people did in fact vote to leave the EU, we thought it would be helpful to explore the potential consequences for both the U.S. economy and the bond market.
The first thing to realize is that Brexit, if and when it happens, could take a while. To initiate the process, Britain’s new Prime Minister, Theresa May, must invoke Article 50 of the EU charter. This would begin the (up to) 2 year process of Britain divorcing itself from the EU. PM May has already indicated that she might not start the clock, so to speak, on Article 50 for as much as a year from the date of the vote, in order to allow enough time for extensive “pre-negotiations” to occur.
Concerns surrounding the timeline are not the chief worry about Brexit, however. The biggest unknown is the response of EU leadership, and the worry that EU leadership is going to want to punish Britain for leaving the union. How could they do that? They could make the terms of trade between Britain and the remaining members of the EU much more onerous. They could block British companies from trading with firms that have remained in the EU. EU leadership obviously wants to prevent other member nations from taking the “exit” route, and can do so by making it simply too painful to execute. By making it difficult, the EU could basically say to remaining nations: “Look, we’re going to make it really painful for you to do what the British have done. So, we’re going to limit the amount of trade. We’re going to limit the ability of the British banks to function. We’re going to basically make it really, really difficult for the Brits to continue to trade in the way that they had previously as members of the EU, and all the potential issues that go with that.”
The counter to this is that Britain still holds some really good “cards” as well. The first is that Britain runs a substantial trade deficit with the remainder of the EU. That is, they buy more goods and services from the remaining members of the EU than they sell. Why would the EU purposely reject one of their largest customers? Only a fraction of the cars sold in Britain are made there, for example. The rest are imports, many of them German. The CEO of Mercedes will therefore have much to say about the terms of Brexit. The bottom line is that by shutting out British customers, the EU would be cutting off their nose to spite their face. Nigel Farage, a former member of the EU Parliament who was a big proponent of Brexit, said exactly that the day after the vote.
So the question for the future becomes: is a (somewhat petulant) EU leadership going to take actions which could backfire on their member countries? We don’t know the answer yet, and it’s what we’re watching most closely as investors. London has become the banking center for all of Europe, for example. Some market observers worry that many of the multinational banks now headquartered in London could be forced to move their headquarters to Brussels, the Hague or elsewhere within the EU. This may happen. If it does, it will likely be more of a cost and legal/ technical issue than anything else, but EU leaders need to remember that economic change happens at the margin, and small cost changes could be enough to tip (already stressed) financial institutions into severe distress. This is the last thing Europe needs right now.
In the end, we think the potential for “scorched earth” on the part of the EU is actually very limited. There are plenty of suppliers of goods and services in Germany, France, Portugal, Spain and Italy—who sell to Britain— who are going to say: We don’t want to shut out the British. So that outcome has a very low probability. As long as this is made clear early in the Article 50 negotiations, markets should adjust readily and function normally. We’ve obviously already seen some indications of this. After an initial “flight to quality” in the U.S. bond market in the days immediately following the vote (the yield on the 10-year Treasury fell from 1.74% to 1.37%), domestic interest rates have rebounded strongly. Maybe Brexit isn’t a big deal after all.