British people voted Thursday to leave the European Union after 43 years of membership. The decision chiefly affects the UK, but it will also reverberate well beyond its borders.
In the eurozone, we can distinguish between near-term and medium-term Brexit impacts of macro and political nature. The near-term macro implications are likely to be contained, though they are not insignificant. Eurozone exports to the UK are around 13% of total exports. If we estimate that UK GDP drops by 1%–1.5% over the next 12 months due to the decision to leave the EU, this would translate to a GDP shock for the eurozone on the order of 0.1%. This would come on top of a hit from tighter financial conditions and lower confidence. This latter effect on GDP is harder to quantify, but we would estimate it to be around 0.2%. In total, the shock might be around 0.3%, modest but not irrelevant for an economy where underlying growth is close to 1.25%. This additional shock to an already fragile recovery means that the European Central Bank may need to add yet again to its already aggressive quantitative easing program.
There may also be some longer-term macro consequences for the eurozone, but these are hard to assess at this early stage. The eurozone runs a trade surplus with the UK and to the extent that trade conditions worsen post EU renegotiations, this could be negative for the region. Against that, some of the foreign direct investment previously directed to the UK on the grounds that it was an EU member may be diverted into other EU countries.
Macro effects aside, the key spillovers into the eurozone from the UK vote are likely to be political. Market participants are already romancing the idea that similar referenda may be called elsewhere in the EU. In the near term, these don’t seem likely, as populist euroskeptic parties are currently in opposition across the EU and therefore not likely to garner enough support in parliament to trigger such consultations. In some countries – such as Italy, the Netherlands and Poland – the population can make petitions for referenda, but legal limitations make petitions for votes on international treaties unlikely to succeed.
This doesn’t mean that investors should be complacent. Populist support is strong in Europe, and one cannot exclude the possibility that euroskeptic parties will seize power in coming years. In this sense, the vote to “Leave” in the UK creates a precedent that may be used by others over time, raising the spectre of broader fragmentation. Investors will likely remain wary.
From an investment perspective, rising political risk is a key theme that emerged out of our Secular Forum a few weeks back, where we concluded that portfolios should prioritize capital preservation and be especially cautious on the eurozone. The UK vote lends emphasis to this framework.