The malaise behind a Brexit surprise

The markets’ dramatic reactions may have been triggered by Britain’s vote but aren’t solely due to it.

It’s very obvious that the result of the “Brexit” vote took the markets by surprise, with near-unprecedented movements in currency markets and extreme volatility in financial markets more generally.

There are, however, some critical questions embedded in that reaction. Why does it matter so much to global financial markets that a relatively minor actor on the global economic stage casts itself free of a sclerotic Eurozone? Why was the reaction so dramatic? Does the vote reflect wider anxieties about the state of the global economy, financial system and social stability in the developed world?

The second question first. The biggest fall in sterling against the US dollar in more than three decades – worse than during the financial crisis when the UK banking sector was bailed out by taxpayers, or George Soros’ 1992 assault on the pound – could be attributed to the complacency about the outcome of the vote that had been built into the markets in the lead-up to the vote.

After weeks of quite significant volatility, with markets fluctuating in line with the outcome of each poll of voting intentions, over recent days the markets had convinced themselves that the UK would vote to remain in the European Union.

Thus, as the actual results started to flow and it became clear that they’d got it wrong, investors and traders hit the sell buttons in time-zones that are inherently less liquid than the northern hemisphere and in markets that, thanks to post-crisis regulatory initiatives, are structurally less liquid.

That’s a combination that would inevitably generate extreme gyrations in financial asset prices and a stampede towards perceived safer havens. The Aussie dollar, for instance, fluctuated between about US76.45 cents and US73 cents today, tumbling as the probability of Brexit became clearer.

It is implicit in the nature and scale of the reaction that global investors see Brexit as a negative for the UK and, perhaps, for global markets.

That could be simply a reflex action. Uncertainty does equate to risk in markets and there are now a lot of uncertainties surrounding not just the UK, but Europe more generally.

At a fundamental level a Brexit is probably at least a near to medium negative for the outlook for the UK economy and financial sector. It will take some years for the UK to negotiate the terms of its exit and the post-exit trade and financial relationships it will have with the EU in future.

The EU authorities have made it clear they don’t plan to be generous and that’s probably not an empty threat.

With Eurosceptic parties and sentiment rising across Europe, in large part because of deep and intractable economic malaise that has settled across the Eurozone since the financial crisis, there is a very real threat posed by the success of the Brexit campaigners to a “European Project’’ that has been nearly 60 years in the making and which is as much about European political stability as it is about trade. The UK will have to be punished if the EU is to dissuade others from emulating it.

For the UK itself, whatever the longer-term benefits of distancing itself from the costly and autocratic EU bureaucracy in Brussels, the near-term implications are unpleasant. The UK Treasury has warned of a significant recession and a diminished role for the UK as a global financial centre.

The prospect of a UK recession isn’t of major significance for the rest of us – it may be the world’s fifth-largest economy (the second-largest in the EU) but it is no global economic powerhouse.

The threat to London’s role as the world’s second-most important financial centre and the major conduit of financial flows into the broader EU financial system is probably more disruptive and carries less obvious implications.

It could lead to a fragmentation of a major pool of global liquidity if it leads to financial institutions shifting or splitting the locations of their core markets operations and that activity, and the liquidity associated with it, shifting elsewhere.

The difficulty in trying to understand what the Brexit vote might mean for the UK, Europe or the rest of the world is that no-one really knows. The situation is unprecedented and the path forward and the impacts it might have on the UK, Europe and the rest of the world aren’t defined.

It is instructive that expectations of any rise in US rates have pulled back sharply and expectations of more Reserve Bank of Australia rate cuts have risen just as sharply in the wake of the vote – the markets are signalling that they do believe the vote has implications for the rest of the world.

What is very apparent is that the uncertainty about the flow-on effects of Brexit has been absorbed into financial markets, hence the wild swings in the lead-up to the vote and in response to the abrupt dawning of its outcome as the early results started to flow.

The dramatic nature of the markets responses may have been triggered by the Brexit vote but aren’t solely due to it – it’s more of a trigger than the core of the explanation.

The markets have become increasingly fragile and volatile as the post-crisis years have stretched out, with few signs, other than modest growth in the US, that the unprecedented measures central banks have taken and doubled and trebled up on since 2008 have been effective.

With investors being given incentives/coerced into taking more and more risk for lower and lower returns it doesn’t take much to ignite a stampede for the exits. Brexit provides an ‘’event’’ – and signal, or excuse, to sell out of risk exposures that has the potential to have reverberations in markets well beyond its direct effects.

The Eurozone, despite the European Central Banks policies – or perhaps because of them – is still stagnating eight years after the crisis, with no obvious pathway towards a recovery in economic growth and increasing political tensions as a consequence.

Its banking regulators never quite confronted the deep fissures in the system that regulators in the US and UK responded far more decisively (and painfully) to and, indeed, the ECB’s recent policies have been counter-productive, draining profitability and the willingness to lend from institutions that the cynical would say are far more vulnerable than their financial statements might suggest.

The Eurozone has been a potential source of another bout of threatening global financial instability since the 2008 crisis and the myriad of unknowns thrown up by the UK vote can only make it more vulnerable.

More widely, the world is caught up in the unintended consequences of global central bank responses to the financial crisis and an addiction to unconventional, ultra-low-rate monetary policies from which there is no easy or obvious exit route without risking a meltdown in financial markets, as the US Federal Reserve Board has come to appreciate this year.

Apart from the extreme fragility and sensitivity of financial markets to even the slightest shift in perceptions of risk, the crisis and the response of governments and their regulators to it – and the flow-on effects of conflict in the Middle East and Africa -- have created an economic, social and political climate which has produced the Brexit vote in the UK, the Trump candidacy in the US and the fragmentation of the political centres in much of the developed world.

The mood of communities, and voters, increasingly reflects the uncertainty and anxieties the post-crisis era has generated.

Approaching a decade after the crisis the policymakers have virtually exhausted their policy armouries and capacity to respond to any new threat and there has been a discernible increase in political instability throughout the developed and developing world.

It is little wonder financial markets are brittle and volatile or that there was sufficient support in the UK for a dramatic revolt by the voters against their circumstances.

The Brexit vote gave UK citizens a chance to protest and global financial market participants to flee to safety. They all took that opportunity.