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After The Earthquake

30 June 2016

Last Thursday, confounding the opinion polls, the UK voted by a narrow margin to leave the European Union (EU). It was a campaign marked by bitterness, with Remain campaigners accused of running Project Fear. By contrast, the Leave Campaign was accused of running Project Lie, making promises for the UK post Brexit that would be impossible to deliver.

In this note, we look at why the UK voted the way they did, what the likely next steps will be, and the risk of contagion. We then analyse the economic impact, on the UK, the wider EU and on the world at large.

The Unhappy Neighbour

Britain has never been an enthusiastic member of the European project. Despite the repeated entreaties of its continental neighbours, it shunned membership of the European Coal and Steel Community when it was formed in 1951.

When, almost a quarter century later, it did join, it was a controversial decision, with many concerned that it would lead to the eventual absorption of the UK into a European superstate. The British people have never been particularly comfortable with the concept of ever closer union, and the decision to join the EU (then called the EEC) was primarily an economic one.

This ambivalence towards Europe, with a desire to benefit from economic links, while being skeptical of political ties, is rooted in British history and tradition. Europe, to many, is a place where trouble comes from: whether Hitler or Napolean.

The legal and political systems in the UK, with their adversarial bent, are fundamentally different to those found in the Continent. It is common law versus Roman law; it is first past the post and single party government versus proportional representation and coalitions.

The result of this this is that the UK has chafed at every extension of the EU’s powers: Maastricht, the abortive constitution, the Euro, the Lisbon Treaty – all were bitterly opposed by many, and the need for successive governments to claim exceptions and opt-outs shows how skin-deep has been the UK commitment to the EU.

Three Pillars of Discontent

Despite these issues, until recently the idea that the UK might leave the EU was fanciful. Ignoring 1983, when the Labour Party manifesto proposed leaving the EU, the Conservative, Labour, and Liberal Democrat Parties have been steadfast in their support for continued membership of the EU. Underlying this consensus (of “the elites”, to use the latest parlance) was the belief that – while Britain was not entirely happy with the direction of the EU – the country had done pretty well economically out of membership. From the sick man of Europe in 1973, a country riven by strikes, and lagging the tiger economies of Germany, France and Italy, had risen a modern, productive, successful economy.

But over the last five years, this cosy consensus changed. And we see three reasons behind this:

Immigration. In 2010, the Conservative Party campaigned on a platform of reducing immigration “to the tens of thousands per year”. Today, net immigration runs at 330,000[i]. This immigration is not all EU related (it splits roughly 50:50 between the EU and the rest of the world), but given the provisions in the EU “for the free movement of goods, services, people and capital” it is correctly deduced that the UK government has no control over immigration from the EU. Immigration is blamed for many things: for changing the nature of neighbourhoods, for over-stretching public services, raising indigenous unemployment, and suppressing wages. Whether these things are true or not is beside the point: many people are concerned that immigration levels are too high, and leaving the EU is seen as the best way to solve the issue.

The Eurozone Crisis. While the rest of the EU was growing rapidly, the economic benefits of membership were clear to many. But the last five years have not been kind to the economies of the Eurozone. Spain, Greece, Italy and Portugal are seen as fundamentally damaged economies, and the consensus view of most in the UK is that another – perhaps even more serious – Eurozone crisis is inevitable. One Leave campaigner compared Remaining in the EU to being “shackled to a corpse.” This further feeds the immigration concerns: if Continental economies continue to struggle, will we not see another wave of immigrants from the EU?

A General Discontent in the Developed World. The last two decades have seen stagnant real wages in much of the developed world. For the first time in the post Second World War period, children are no longer richer than their parents, and levels of economic optimism are at all time lows. This is not just an EU problem: real wages have not grown in Japan or the United States either. Stagnation has driven scepticism about “the elites”, which has manifested itself in the rise of Euroscepticism in the UK, the Front National in France, the PVV in the Netherlands, and – of course – Donald Trump in the US.

The Path From Here

There are – in theory at least – two ways for the UK to leave the EU. The most immediate would be for parliament to vote to repeal the European Communities Act 1972, which would result in the UK no longer recognising the decisions of the European Court of Justice, and would halt all payments to the centre.

The other option is for the UK to invoke Article 50 of the Lisbon Treaty. This kicks off a two year process of separation between the UK and the EU. Once Article 50 has been invoked there is no going back: the EU and the UK will be separate within two years.

The UK has not yet invoked Article 50. This is partly because Prime Minister David Cameron has resigned, and feels this is the responsibility for his successor, but perhaps more pressing is the issue that the UK itself has not decided what relationship it wishes to have with the EU going forward.

The first thing that must happen, then, is that the Conservative Party elects a new leader. The two leading candidates are Lord Chancellor Michael Gove, and Home Secretary Theresa May. Irrespective of who wins, the onus will be on them to trigger Article 50. However, it is our view that they will be in no hurry to do so; both would like a broad outline of a deal to be in place before triggering an irreversible divorce.

The problem both candidates will have is simple: the promises made by the Leave campaign are impossible to achieve. Nevertheless, the new Conservative Party leader has two broad options:

  1. EFTA/EEA. This is the Norway option, and it would (largely) preserve access to the single market, and in particular financial passporting rights. This would be the least disruptive to the British economy. However, for a substantial minority of Leave voters, this would be considered a betrayal as it would maintain the “Four Freedoms” of Capital, Goods, Services and Labour.
  2. Canada. A free trade deal would be agreed, which would allow goods and services to be sold tariff free between the UK and the EU. Under this scenario, the UK could have an immigration policy that treated EU and non-EU citizens the same, and substantially reduce EU migration. However, there would be no financial passporting, which would likely be a very significant blow to London’s role as financial capital of Europe.

In other words: does the new leader disappoint those working class voters who believed the rhetoric about reducing immigration to the tens of thousands? Or do they go down a path that could lead to the UK financial services industry decamping to Dublin?

We suspect that the Conservative Party will go for EFTA/EEA, as it is supported by the vast majority of Remain supporters, and by a substantial minority of Leavers. Nevertheless, it would set up a powerful ‘betrayal’ narrative, and likely result in substantial gains for UKIP in Northern England in a future General Election.

There is another possible outcome, and that is that the new Prime Minister might call a General Election, where each political party could put forward a policy for what the future relationship between the EU and the UK should be. Assuming the Labour Party has a new leader by then – which is no sure thing – then we would imagine the four main parties platforms would be:

  1. UKIP. Leave the EU as soon as possible and pursue a deal like the Canada/EU FTA.
  2. Conservatives. Leave the EU and join EFTA/EEA.
  3. Labour. Remain in the EU, but attempt to negotiate restrictions on freedom of movement.
  4. Liberal Democrats. Remain in the EU.

It seems likely that under this scenario, UKIP could make meaningful gains from the Labour Party in the North of England and in Wales. We also suspect that South West London, which largely had high votes for Remain would see the Conservatives lose seats to the Liberal Democrats.

It is by no means clear that another election would result in a single party achieving a majority, especially if Labour were led by a more conventional leader. A hung parliament, where the only workable options are Conservative/UKIP or Conservative/LibDem would potentially usher in further chaos.

For this reason, we think it is likely that the new Prime Minister will not call an election, and will – instead – opt for EFTA/EEA. Such an outcome would likely be taken positively by the markets, as it would bring minimum disruption to the UK economy in the near term. The political consequences of this, however, will be that UKIP is likely to remain as a significant force in the UK, pushing for a further loosening of the UK/EU relationship. This means that, although EFTA/EEA largely maintains Britain’s relationship with the EU in the near-term, it does still increase uncertainty, and make the UK a less attractive place for foreign investment.

While we believe EFTA/EEA is the most likely outcome, it is by no means the only possibility. One candidate for the Conservative leadership, Stephen Crabb, has suggested not invoking Article 50 “until the country is healed”, which would – we imagine – involve it being postponed indefinitely. Another possibility would be an election at which a pro-EU, Labour-Liberal Democrat coalition is elected. Indeed, it is the sheer range of possible outcomes – from an acrimonious split to not leaving the EU at all – which makes the situation so difficult for investors.

Catching a Cold?

Across the EU, Eurosceptic parties have made substantial goals over the last few years. The weak economic growth and stubbornly high unemployment that followed the Global Financial and Eurozone crises has eroded trust in the historic parties of government. The table below shows the major insurgent party – and current opinion poll share – for a selection of major EU countries.

  Party Share Notes
Austria FPÖ 34% Leading in the polls
Belgium Vlaams Belang 14% Flemish nationalist party
Denmark DPP 19% Came second in 2015 election
Finland The Finns 9% Junior member of governing coalition
France Front National 28% Presidential poll, assuming Juppe is LR candidate
Germany AfD 13% Die Linke is also Eurosceptic, and gets c. 9% in polls
Greece SYRIZA 26% SYRIZA is the current party of government
Italy M5S 30% Close second behind DP
Netherlands PVV 25% Leading in the polls
Poland Law and Justice 35% Party of government
Portugal Left Bloc 10% Junior member of governing coalition
Spain Podemos 21% Lost 3% since December 2015 election
Sweden Sweden Democrats 23% Second in current opinion polls
Source: Wikipedia, June 2016

Investors are understandably concerned that Britain’s exit from the EU will trigger the collapse of the whole block. We think this is unlikely for three reasons:

Not all Euroscepticism is created equally: the Law & Justice Party is considered Eurosceptic, but despite having a majority in the Polish parliament, have made no moves to reconsider Poland’s membership of the EU. In Italy, the Five Star Movement of Beppe Grillo applied for their MEPs to join the Alliance of Liberals and Democrats grouping at the European parliament, a very pro-European group. (It was only after their application was rejected that they joined the UKIP led Europe of Freedom and Direct Democracy. It’s fair to say that doctrinal consistency is not high on the list of priorities for the Five Star Movement.) Further, the rise of many of these groupings seems to be more associated with opposition to immigration from the Middle East rather than outright hostility to the EU. (Germany’s AfD surged in the polls as a consequence of Angela Merkel’s Syrian policy.)

Opinion polls across the EU show Britain’s Euroscepticism is an anomaly. The EU publishes a “Eurobarometer” approximately every six months. This is a series of opinion polls taken by established polling companies across the EU, talking to approximately 1,000 people per country. On almost every measure, the UK stands out as the outlier. The chart below makes the point:

Question: Are you in favour of a European Economic and Monetary Union with one single currency, the Euro.

After The Earthquake chart1
Source: Eurobarometer Autumn 2015

As can be seen, support for the Euro is much higher than might be supposed from a cursory reading of the British press! It is notable that even in the Netherlands, where the leading party proposes a return to the Guilder, support for the Euro is a net 54%, with proponents outnumbering those opposed more than three-to-one. Our view is that support for the Euro is a good proxy for support for the EU. Those countries where support is high are extremely unlikely to seek to leave the EU.

Leaving the EU would be much more difficult for other countries. Of all the EU countries, the UK is the least integrated at a trade level. As the chart below shows, the UK has by far the lowest exports to the EU as a percentage of GDP – although even for the UK it a sizeable 12%. For a Belgium, Portugal or Italy, leaving the EU would have even more negative economic consequences.

Exports to the EU as a Percent of GDP, 2013/14

After The Earthquake chart2
Source: World Bank, Eurostat, 2013/14

It’s also worth remembering that most of the other EU countries are Eurozone members. It would be an order of magnitude more difficult for most countries to unwind that. Those who would find it easiest – i.e. those who would see new national currencies appreciate against the Euro – are also those who are most dependent on intra-EU trade, i.e. the Netherlands and Germany.

Fears of a ‘domino effect’ also seem overdone. While there are few data points, we have seen both a Swedish opinion poll on EU membership since the Brexit vote, and the Spanish general election. In both cases we saw no evidence of any contagion. The Swedish poll – once Don’t Knows were stripped out – showed support for staying in the EU had almost a two-to-one lead. In Spain, the Eurosceptic Podemos lost 3.4% of their vote[ii], while pro-European parties (the PP, PSOE, and Citizen’s) added 4.2%[iii].

It is possible, of course, that Euroscepticism continues to rise across the EU. However, at present, we think the possibility of another EU country following Britain’s path is remote: leaving the EU is not as popular as is believed by many British commentators, and the countries of the continent’s economies are far more tightly entwined than is realised.

The Hollow Façade

From the outside, the UK appears to have a prosperous, even a booming economy. GDP is well above pre crisis levels, there is close to full employment, and asset prices have been rising. But the UK economy is also fundamentally unbalanced, which makes it particularly vulnerable to economic shocks. This vulnerability can be seen in five – interlinked – issues:

Current Account Deficit. The UK has the second largest US Dollar current account deficit in the world, lagging only the United States. As a percentage of GDP, it is the largest of any large economy, and is not far from the levels achieved by Spain on the eve of the Eurozone crisis.

Current account surplus/deficit (as % of GDP), 2015

After The Earthquake chart3
Source: Trading economics, accessed June 2016

The current account matters because it means the UK needs to import capital. Money in must equal money out: and as money goes out to meet the need for oil and iPhones, it must be found from somewhere. Of late, the UK current account has been funded by a combination of investment into the UK, the sale of government debt, and investments in the UK property market by overseas investors.

Savings Rate. The reason the UK has such a significant current account deficit is because its citizens spend too much and save too little. Countries with high savings rates, such as Germany, Switzerland and China tend to have current account surpluses, while those with low savings rates, such as the UK and US, tend to run deficits.

Current account (as % of GDP) v saving rate, 2014

After The Earthquake chart4
Source: OECD, June 2016

Consumer Debt
. The UK has one of the highest levels of consumer debt in the world. This means there is relatively little opportunity for households to increase leverage to maintain spending during a downturn.

Household debt to GDP, 2015

After The Earthquake chart5
Source: Trading Economics, June 2016

Government Deficit
. While the UK government “talked a good game” about austerity, real government spending was not cut. Unlike in places like Ireland, Spain, Portugal, or Greece, there were no wholesale reductions in civil servant salaries, and changes to retirement ages were modest. This meant the UK economy did not suffer from the multiplier effect where government spending cuts led to lower economic activity which in turn led to a larger than anticipated deficit, and the need for further cuts.

Budget deficit (as % of GDP), 2015

After The Earthquake chart6
Source: Trading Economics, June 2016

But it also meant that the UK deficit is one of the largest in the developed world, and debt-to-GDP is at elevated levels. It will be difficult to use fiscal policy to support the economy in a downturn.

An Economy Dominated by Property. UK houses are expensive relative to incomes and in comparison to other developed countries. In Central London, prices have risen ten-fold over the last two decades, while nominal GDP has only doubled. Such increases mean housing dominates household wealth, to a degree unmatched in any other country.

Rebalancing the Hard Way

The UK economy on the eve of the Brexit vote looks eerily like Spain’s in 2007. A superficially successful economy with buoyant employment, but one with large imbalances, excessive levels of debt, and a reliance on the sale of property to foreigners. The UK must balance its current account, something that will be substantially harder when it loses its status as a safe haven inside the EU.

The best way to close the gap would be to increase exports. There are hopes that the depreciation of Sterling that we are currently seeing will ease that process. Such hopes are likely to be in vain. In late 2007, Sterling briefly bought $2.10; barely a year later, it was less than $1.40. The dramatic decline of Sterling failed to boost exports meaningfully. The chart below makes the point: despite the Euro declining substantially less than Sterling in the wake of the Global Financial Crisis, exports as a percentage of GDP barely budged in the UK against substantial rises at Eurozone peers.

Exports as a Percentage of GDP, 2009 vs 2014

After The Earthquake chart7
Source: World Bank

British exports benefit less from a weak currency than might be supposed because they tend to be of services rather than manufactured product. There is inherently less leverage to services sales than goods, because while you might be able to charge more in Sterling terms in the event of a devaluation, you are unlikely to be able to sell more. People’s hours do not scale like factory output.


Essentially, supply of services is not price elastic, and therefore the benefit from a lower currency is modest.

If exports cannot rise rapidly, then either the British must sell assets abroad, or raise debt. We suspect demand for UK assets is likely to be somewhat subdued going forward. Sterling depreciation will boost domestic inflation, potentially boosting yields (although QE might ameliorate that somewhat). Selling government bonds to the Bank of England also does nothing to fund the gap: unless foreigners buy gilts (and therefore exchange their currency for Sterling), then the current account deficit will not be covered.

Historically, a meaningful portion of the UK current account deficit was covered by inward investment into the UK through either corporate FDI (firms buying UK assets) or the housing market. Uncertainty about the UK’s future trading relationship with the EU will almost certainly weigh on traditional FDI. At the very least, we’d expect many deals to be postponed until things are clearer.

It’s underappreciated how important the Prime London property market was to covering the deficit. Every apartment in Victoria sold off-plan to a Singaporean investor helped fund it. Our concern is that the Prime London property market now looks extremely vulnerable for two reasons. Firstly, the most expensive areas, such as St John’s Wood, Kensington, Chelsea, Hampstead, Primrose Hill and Belsize Park, have very thin markets, with fewer than 5% percent of homes change hands in a year. Even if just a small number of people attempted to realise profits on their houses, this would increase supply dramatically. Furthermore, these areas are very international, with a lot of (mostly financial services) expatriates. In a situation where financial services firms are relocating a portion of their staff abroad, these areas would see dramatically increased supply, at a time when purchasers are likely to be very cautious. Our contention is that Brexit uncertainty depresses demand for property from overseas purchasers. We’d also suggest that a negative feedback loop is possible, where Sterling’s decline and lower house prices diminish the lustre of the London market, making it a less attractive place for investment.

The rest of the UK is likely to be less affected by Brexit: financial services is a less important part of the economy, immigrants make up a much smaller share of the market, and house prices have not swelled much compare to the capital. (See chart below.)

Regional house prices relative to 2007 peak, June 2016

After The Earthquake chart8
Source: Nationwide House Price Index, June 2016

In a scenario where exports struggle to grow meaningfully, and foreign investment in the UK is diminished (and it’s entirely possible net financial flows will be negative), there is only one way to close the current account gap: lower imports through an increased savings rate. The UK has always needed to do this, it’s just that Brexit will make the adjustment a rapid one rather than a gradual one.

We know what happens to a country where the savings rate shoots upwards to deal with an unsustainable current account deficit: it’s called Spain following the Eurozone crisis. Now, the UK does have the advantage of a depreciating currency. But this is no panacea, it merely means destruction of purchasing power happens partly through inflation. The chart below shows the scale of the problem:

UK Household Savings Ratio, 1975-2015

After The Earthquake chart9
Source: Bloomberg, as of 29/6/2016

A move back to the 40 year average savings rate of 10.8% would require a 7% increase, this is the same as that suffered by the UK economy between 1989 and 1991. This period saw a severe recession, inflation, and house prices that dropped sharply in real terms from peak to trough. The losses to the banking sector were very considerable – although we’d note that UK banks are at least better capitalised now. The chart below shows what happened to UK unemployment during the period.

UK Unemployment, 1990-1994

After The Earthquake chart10
Source: Bloomberg, as of 29/6/2016

This analysis may seem doom and gloom; but the truth is that the UK economy has been living on an unsustainable cocktail of borrowing, importing and spending for some time. Unwinding it was always going to be painful. Brexit merely makes the process more rapid and more unpleasant.

The EU’s Surprising Resilience

The fragility of the Eurozone economy is held to be self-evident to all. Yet, in many ways its economy is the polar opposite of the UK, with its problems obvious, and its strengths hidden. Certainly, there are two major problems with the EU economy: Firstly, it is too dependent on external demand (i.e. exports); Secondly, unemployment remains at elevated levels across much of the bloc.

It is worth dwelling, though, on the strengths of the Eurozone economy.

Government deficits are largely under control. Following the Global Financial Crisis and the Eurozone Crisis, budget deficits exploded. This led to concerns about the solvency of the PIIGS and – indeed – Greece, Ireland and Portugal all needed to be bailed out. Five years on, budget deficits are under control across the bloc, and government debt-to-GDP is now declining in most countries. This – along with QE from the ECB – has led to record low government bond rates. As countries refinance government deficits at lower and lower rates, it works to lower the interest charge and push out maturities. The result if this is that most Eurozone governments can respond to a Brexit slowdown with fiscal stimulus.

In most countries, bad debts have been recognised and banks recapitalised. While Italy continues to struggle with undercapitalised banks with substantial bad debts, it is very much the odd one out. Across the rest of the Eurozone, banks have significantly increased their capital buffers, and reorganised their loan books. This means that the negative feedback loop between bank and sovereign solvency is unlikely to recur.

Consumer debt levels are generally low. Since 2010, most Eurozone countries have seen their savings rates soar, leading household debt to GDP to decline almost everywhere. Unlike in the UK, consumers in the Eurozone are not likely to be pressured by a rising savings rate (and, indeed, we might see the opposite happen).

Current account balances are healthy. A decade ago, most Eurozone countries ran current account deficits, with Greece, Spain and Portugal all peaking at more than 10% of GDP. No longer. All of the PIIGS now run surpluses, as do all the major Eurozone economies except France. The Eurozone’s current account surplus now exceeds China’s.

There may, of course, be a short term impact from the UK’s vote. We see the biggest potential impact being from the UK entering a recession, which would inevitably weigh on demand for Eurozone exports. However, even if we assume that UK demand for EU exports falls 20% – which would be huge drop, commensurate with the kind of falls seen by Spain and Portugal at the height of the Eurozone crisis – then it would not knock more than 0.5% off Eurozone GDP. The table below shows the issue: the UK is not as important a trade partner to most EU countries than people realise, and only exceeds 10% of exports for Ireland and Cyprus.

After The Earthquake chart11
Source: Eurostat, 2014

We would also point out that – in 2015 – Eurozone countries were pretty much the only ones to see upwards revisions to GDP forecasts through the year. In other words, it was the only region where economists were consistently too pessimistic.


The UK’s vote to leave the European Union has come as an enormous shock to politicians and investors across the continent. But it’s important to realise that – while the economic consequence might be severe for the UK – much of the continent is relatively well insulated. The UK is less of a destination for Eurozone exports than people believe. It is important to put things in context here. If EU exports to the UK are 3.5% of GDP, and if a slowdown knocked 20% off this number (which would happen only in circumstances when the UK went into a recession of similar magnitude to that experienced by Spain in the Eurozone crisis), that would result in Eurozone GDP shrinking by a little more than 0.5%. With budget deficits having reduced so substantially, the Eurozone economy is less fragile than they appear, and our contention is that elevated savings rates will soon begin to decline, leading to a positive feedback loop of rising economic growth leading to increased optimism, which pulls savings rates down yet further.

The situation for the UK is more precarious, as its economy is highly dependent on financial services, and runs a large current account deficit. Unless a new deal based around EFTA/EEA can be rapidly agreed between the UK and the EU, then there is a very real possibility of a negative feedback loop where falling property prices drive savings rates up, lowering economic activity and government revenue. The UK economy was unbalanced even before the EU referendum, a rapid rebalancing driven by a closing of the current account deficit could be extremely painful.

There is another feature of Brexit that is worth mentioning: the UK has long been a lone voice against deeper European integration. The Eurozone may find it easier to address its structural weaknesses with the UK gone.


[i] Office for National Statistics, 26 May 2016

[ii] BBC News, “Spanish election: PP wins most seats but deadlock remains”, 27 June 2016

[iii] BBC News, “Spanish election: PP wins most seats but deadlock remains”, 27 June 2016

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