World, We (May) Have A Problem

On the day following the UK’s vote to leave the European Union (EU), sterling fell by 11.5%, European equities fell by 10%, and U.S. equities were lower by 3.5%.¹ According to CNBC, over the subsequent two business days, the vote for Brexit shaved US$3 trillion off global wealth. But the UK accounts for only 4% of global gross domestic product (GDP)²—so what’s the big deal?

Brexit affects the non-UK world through a number of avenues. Most obviously, the departure of the UK will lead to increased frictions in global trade, including in the trade of financial services. Rising trade frictions have a direct detrimental impact on growth.

A more important avenue of contagion: Brexit raises the level of global uncertainty. Indeed, shortly after the "leave" camp declared victory, the Party for Freedom in the Netherlands and the National Front in France declared that they will seek a referendum to take Holland and France, respectively, out of the EU. All this underscores the tensions that exist within the EU (indeed within the eurozone) and frustrates decision-making: If you are uncertain about the future shape of the EU (or the eurozone), it is better to delay irreversible investment decisions until clarity emerges.

At the same time, this happens amid a backdrop where global growth—in particular, global capital formation—is already weak. Global growth has continued to be frustratingly slow, and an increasingly important reason for this has been the subdued pace of capital formation. Two main global factors weigh on investments. First, elevated uncertainty has likely raised the return on capital required for companies to invest. There is plenty for companies to be uncertain about: China rebalancing, the U.S. presidential election, and the prospects for global demand as the emerging world continues to deleverage. It is in this context that the vote for Brexit was particularly unhelpful.

Second, global profits have grown at a tepid pace. Companies tend to invest when profit growth is strong and reduce the pace of investments as profit growth weakens. Why has global profit growth slowed? In part, because segments of the developed economies have moved into the more mature stage of the business cycle, where the cost of inputs rises faster than the price of outputs. This brings margin expansion to a halt. In other parts of the world, the end of the mining boom has required a reallocation of resources across sectors—a process that traditionally weighs on labor productivity and, therefore, on profit margins.

Altogether, the most likely outcome of Brexit appears to be that this will be another headwind to global growth—a headwind that is likely to force central banks of core economies to respond with a looser monetary policy stance as the data measuring global growth turn softer. The Bank of England has already indicated that it would probably need to pump more stimulus into the UK’s economy over the summer after the shock of last month’s decision.

For the markets, the big question should be whether the softening in growth provides an environment that is conducive to carry trades or whether the hit to growth will be sufficiently severe to bring about a growth scare. As we will only see the impact on growth with a lag, the jury is still out. For now, the market has taken comfort from the consensus expectation that the impact on growth will be minor and manageable.

¹ Source: Thomson Reuters

² Source: IMF’s World Economic Outlook

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