The immediate financial consequences were in line with expectations. The economic effects are uncertain in size, but will surely be negative. On the political front, it will take a few months to even only officialise the United Kingdom’s request to leave the Union, and to replace Cameron at the head of the conservative party…….
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Intesa Sanpaolo – Research Department For professional investors and advisers only
Over recent months, we have repeatedly discussed in the possible effects of the referendum on the UK’s European Union membership: two papers, published as part of our WEM, focused on institutional and macro economic aspects, and others considered the possible implications for the pound and sovereign euro area spreads. In the past few hours, reactions to the news that the UK has opted to leave the European Union have essentially been in line with our expectations: sterling has weakened significantly, the euro has dropped in terms of its effective exchange rate, the BTP-Bund spread has widened by around 40 bps (now gradually tightening back a little), and stock indices are plummeting.
The economic consequences will be rather obvious in terms of their direction, less so in terms of size. Also, it will take some time before useful indications come from data, as in these cases confidence surveys risk capturing emotional reactions more than substantial ones. Based on our assessments, assuming a significant shock to fixed investments in the United Kingdom (-1 deviation standard), in addition to a 12% depreciation of sterling in terms of the effective exchange rate, or to a drop in stock indices and a 50 bps widening of the sovereign spreads of peripheral countries vs. Germany, we forecast a 0.3% reduction of GDP growth in 2017. This is no catastrophe, although it implies a probable slowdown in European growth in 2017 compared to this year. We expect this to prompt a cooling of calls for fiscal tightening next year.
For the time being, financial conditions in the euro area are tightening on two fronts: in a widespread manner through the decline of stock indices, and through the increase of credit risk premiums; and selectively in peripheral euro area countries, through a widening of Italian government bond spreads, offset in part by the decline in core country rates. On the other hand, the net movement of the euro is moderately expansive. Compared to previous phases of financial turbulence, the new monetary policy instruments introduced by the ECB (CSPP, TLTRO II) should help contain negative repercussions on the availability and cost of credit. Also, the ECB has said that it is ready to inject further liquidity in euros and in other currencies, signalling that it has prepared for this outcome staying in contact with other central banks, and that it is “ready to guarantee price stability and financial stability”. However, no particularly alarming tensions were recorded on liquidity today.
Furthermore, the PSPP could be used to buffer the impact on sovereign spreads. To this avail, two courses of action are possible: the first, which would not require changes to the programme’s parameters, and which may even be activated today, is a change in the modulation of purchases in terms of timing and maturity; the second, which would require a specific decision of the Council, and probably rest on evidence of persistent and very substantial dislocations, is the possibility of announcing an extension in duration, or a change in allocation based on capital keys.
For what concerns the political process, Prime Minister Cameron has preannounced his intention to resign by October. This will give the Conservative Party time to appoint a successor, but also implies that the official withdrawal procedure will not start so soon – and may be left to the next Conservative leader. The risk of the process grinding to a halt, or leading to a government crisis and early elections, will depend on the whether the economic and financial consequences for the United Kingdom in the next few months prove to be much worse than forecast, prompting a shift in public opinion and splitting the Conservative Party to the point of stripping it of its parliamentary majority
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