The UK’s vote to exit the European Union (EU) has sent a seismic shock through financial markets. Many market participants have been caught by surprise by the outcome and appear to have been poorly positioned for the “Out” vote. Over the past week or so, there has been a strong rally in risk assets - both in the UK and globally - as investors became more convinced that the UK would vote to remain in the EU.
For the remainder of the day we expect to see extreme volatility across risk markets. Now that the result is clear the reaction of central banks and politicians will be key in limiting the fall out. We expect the Bank of England to make a statement before the market opens offering liquidity and stating the determination to ensure financial stability.
Unfortunately, while the short term market reaction is obviously negative, the longer-term outlook for the UK economy and financial markets is potentially even worse. The full extent of the UK’s new trading relationship with the EU will not be finalised for many months and potentially years. This level of uncertainty will likely have a significant impact on investment and job creation for the UK economy, at least while the negotiations take place. We may begin to see UK-based manufacturers moving production to mainland Europe in expectation of trade barriers and tariffs against UK goods.
In addition to the added uncertainty, the headwinds to the economy that were in place before the referendum remain. The UK economy remains very unbalanced; it has high budget and current account deficits – the “twin deficit” – as well as weak wages and productivity. The budget deficit has remained stubbornly high relative to the expectations of the Chancellor of the Exchequer, George Osborne, and will have to be addressed now the EU vote is out of the way.
The prospect of higher taxes and lower spending will surely make the UK consumer more cautious. Moreover, as the energy dividend fades and wages remain stagnant, we are left concerned that the UK economy may not recover from this shock for some time.