Well it’s over; the referendum is done and the UK has voted to leave the EU. The outcome in terms of the political vacuum created by Brexit could not reasonably have been predicted by anyone.
In the lead up to the vote, I anticipated that a decision to leave would trigger a short period of intense uncertainty and market volatility; this would be followed by a period of calm descending as the realisation dawned that the process of withdrawal and extraction would be more complex and drawn out than anticipated.
Well, we’ve certainly got some uncertainty. In this article, I will try to piece together the current situation and what we might expect over the rest of the summer.
Whither the decision makers?
At the time of writing we have a new Prime Minister in Theresa May, a tense leadership contest within the Opposition and the resignation of the person who for years has championed leaving the EU, Nigel Farage.
All this means that at a point of extreme uncertainty in the wake of what some are calling (and I agree) a seismic decision, we are bereft of political leadership.
Is there real uncertainty? Absolutely; so far there seems to be no concrete plan for implementing Brexit, with conflicting noises from both sides of the English Channel.
The economic data is conflicting too; for example we have this from The Telegraph:
"S&P said the Eurozone recovery is now in full swing as fiscal austerity eases and QE gains traction, all helped by cheap oil. The growth of consumer credit has jumped from zero to 5.4pc over the last year, and car sales are up 18.4pc1."
Conversely, in The Guardian recently reported:
"Eurozone service sector growth hits 17-month low2."
And they report an economist from MARKIT:
"The eurozone economy failed to gain momentum in June, rounding off a disappointing second quarter. Faster manufacturing growth was countered by a slowdown in the service sector, leaving the overall pace of expansion of business activity unchanged since May3."
This is not to pass comment on either source, but simply to illustrate how quickly data change can cast a different light on the same issue. Although other data does shows that claims of recovery in the Eurozone are well founded, the point remains - growth in the EU is positive but erratic. The impact of the UK leaving could stall that recovery.
The UK needs some steering at the moment and yet there seems to be little in the form of strong, clear guidance from the political class. What is needed it seems is someone calm, cool and analytical: someone who possesses the ability to think clearly under pressure, strive for evidence and not seek headlines. Who might that be? Step forward Mark Carney, Governor of The Bank of England.
Mr Carney delivered a briefing in the wake of the vote, in which he spoke about three sources of uncertainty; geo-political uncertainty, economic uncertainty and economic policy uncertainty.4
At this point, it might be useful to distinguish between risk and uncertainty. Risk is the balancing of probabilities to determine the outcome of an event. Uncertainty is risk magnified: a complete lack of information pertaining to both probability and outcome, or in more recent parlance ‘unknown unknowns’. This distinction helps as it seems individuals are happier dealing with risk than uncertainty.
Are we in a period of economic uncertainty? Well it certainly feels like it (and as I write this a third UK fund manager has closed a UK property fund to redemptions). The data also seems to suggest so. The following chart is from the Bank of England and uses the VIX index among other indicators to measure uncertainty.
Uncertainty is a strange thing in economics; it is difficult to model and it tends not to be included in macroeconomic models. Does it matter? Almost certainly – the Bank of England states:
"All this uncertainty has contributed to a form of economic post-traumatic stress disorder amongst households and businesses, as well as in financial markets – that is, a heightened sensitivity to downside tail risks."
In other words, there may be an embedded effect following a prior shock such that investors remain sensitive to similar effects further down the line.
How might this manifest itself? One of the issues for uncertainty is quantifying the impact on behaviour. For the Bank of England the impact can be described as:
"Today, uncertainty has meant an inchoate sense of economic insecurity for many people despite generalised economic prosperity. Across the advanced economies, employment appears less secure, wages more subdued, and inequality more pronounced."
There now seems to be growing acceptance that these kinds of effects, at least in part, account for some of the decision to vote leave. At the micro level, uncertainty over one’s future employment, uncontrolled variation in the level of that employment, a low or minimum wage and little prospect for increasing one’s hourly rate must weigh heavily on decision making.
Further, the Bank of England adds:
"And its precautionary effects can mean spending is deferred because there is often a real option value to waiting. Firms delay investment decisions. Investors seek safe returns. Households put off buying durables. The common thread is that any economic decision that requires finance, has a sunk cost, or an uncertain payoff, is affected." (Carney op.cit.)
There is already evidence of uncertainty weighing on the economy before the referendum date: business investment decreased by 0.8% between Quarter 1 2015 and Quarter 1 2016, from £44.0 billion to £43.7 billion, revised down from the previously estimated 0.4% decrease.5
There is further evidence of this economic uncertainty today with car registrations having slowed in June in the lead up to the referendum.6
Markit reported that UK service sector growth in June was also low, matching the 38 month low set in April. This is reflected in business expectations too, as can be seen below.7
So, there is evidence that the economy may have been slowing down before the referendum.
Was the economy heading for a downturn anyway?
The key question though is to what extent this was happening due to the referendum taking place, or was it simply part of the normal business cycle? It is too soon to say for certain and we need a fair few quarters of data before we can model the effects. However, we can say that the normal path of the business cycle is such that peak to peak (or trough to trough) is on average anywhere between 7 to 10 years.
In macroeconomics we usually think of unemployment as a lagging indicator; that is, GDP can be recovering from a recession and increasing quarter-on-quarter while unemployment is still rising. With that in mind, look at the following diagram:
Source: Bank of England
It shows the level of unemployment over time in the UK and with the periods of recession in grey. The lagged effect is clear following the end of a recession. What is also clear but less often commented on is that recessions seem to begin when unemployment is at the lowest point.
UK unemployment is currently 5% - essentially the same level as 2006/8 (i.e. 8 to 10 years ago) and vacancies are running at 749,000. Maybe the economy is set to turn anyway? The Brexit vote won’t have helped in that it may be the event which triggers a downturn. We will know soon enough.
The markets are spooked.
The markets seem to be pricing in the economic uncertainty, with the market risk premium (basically the difference between returns to riskier equities and returns to safer government bonds) looking elevated.
The FTSE 250 (representing largely UK focused companies) has seen a 10% drop since 23rd June and following the fund redemption news of 4th July the exchange rate has fallen to £1/€1.17 - and Mark Carney has delivered a third press briefing on the publication for the latest Financial Stability Report.
We are now in a period of uncertainty devoid of political leadership – cue Carney:
"When uncertainty is high, policymakers should have three objectives. First, conduct a sober, objective assessment of the outlook and the risks to it. Second, develop and communicate a plan to reduce those risks and to seize new opportunities. And third, do no harm, by minimising any possible confusion about the commitment to core macroeconomic policy frameworks themselves."
The Bank of England is doing its best to manage policy uncertainty and hopefully through into shaping people’s expectations regarding economic uncertainty.
Roy Daintith, Senior Consultant of Macroeconomics, Leadership and Professional Development at Kaplan, believes that economics is fundamentally relevant to business performance and is passionate that decision makers should understand the bigger forces shaping and driving their industry.
1 The Telegraph ‘S&P scoffs at 'Armageddon' warnings for Britain, July 4th 2016
2 The Guardian ‘UK service sector hit by Brexit worries’, 5th July 2016
3 Markit Economics Press Releases, Markit Eurozone Composite PMI® – final data, 5th July
4 Bank of England; Uncertainty, the economy and policy, Mark Carney, 30 June 2016
5 ONS; Business Investment: Quarter 1 (Jan to Mar) 2016 30 June 2016
6 UK car sales fell ahead of EU vote, SMMT , The Guardian, 5 July 2016
7 Markit economics; Markit/CIPS UK Services PMI® July 5th 2016