Brexit: What Happens Next Week, Next Month?

June 24, 2016 6:00 PM

Predicting the future, even near-term, is a perilous exercise. But here goes: What we saw in markets today is the result of two factors. The first is a shift in fundamentals. The second is an increase in risk aversion—or, to use the lingo of markets, a shift from "risk on" to "risk off." What happens in the near future depends on what happens to this second factor. Over the near term, the future in turn depends on the presence or absence of undetonated financial bombs.

There is little question the Brexit vote has changed economic fundamentals in important ways. Surely, this is the case for the United Kingdom. There will be long-run costs and even larger short-run costs. The pound's depreciation will help but not compensate for a drop in investment and the adverse effects of general political and economic uncertainty. This may also be the case for the European Union, where similar political dynamics may be triggered in a number of other countries. (One may argue, however, that dismal UK performance will soon convince even the most ardent believers in exit in other countries that the economic arguments made by "experts'' before Brexit may not have been irrelevant.) This may finally be taken as a canary-in-the-coal-mine signal, that, more generally, anger is everywhere deeper than was perceived and may in turn lead to dangerous policies.

Much of what we have seen today, however, from the decrease in yields on long US Treasury bonds to the appreciation of the yen to the very large decline in some stock markets reflects an abrupt increase in global market risk aversion. Had risk aversion remained the same, there is little reason why Japan, for example, should have been much affected by the exit vote. Movements in market risk aversion can, however, be very powerful drivers of financial markets, and financial markets can move economies. If "risk off" lasts long enough, the global adverse effects of the vote may be very large.

Will it last? My guess, based on past episodes (although none quite as serious as this one), is not for very long, unless there are some undetonated financial bombs on the verge of exploding. The optimism of markets about the fate of "Remain" in the days preceding the vote may have led some hedge funds to make large bets and potentially run into trouble. Or markets may decide some euro periphery country is the next dangerous spot and requires much higher spreads on its debt, which the European Central Bank (ECB) is then unwilling or unable to control. If, however, it looks after a week or two as if no one did anything too stupid, and the central banks appear to have things under control, I would expect risk aversion to slowly decrease, markets and currencies to largely recover, and the fires to be mostly limited to the United Kingdom, and to a lesser extent, the European Union. At least, until the next referendum… .