The result of the U.K. referendum on June 23 to leave the EU unleashed a shockwave through the global financial markets. While measures of financial stress have almost recovered to their pre-referendum levels in the rest of the world, heightened volatility continues to dominate in Europe--and in the U.K. in particular. Indeed, we think that Britain's decision represents a major political and economic shock to Europe as a whole. The negative economic effects are likely to be concentrated in the U.K., but will have important ramifications for the rest of Europe, and especially the eurozone. We now forecast that Brexit will produce a drag amounting to 1.2% of GDP for the U.K. in 2017 and 1% in 2018, assuming that access to the single market is maintained in 2017 and 2018, and that the Bank of England (BoE) succeeds in keeping market turmoil in check.
- The Bank of England's financial policy committee announcement last week that it would use macroprudential tools to ease credit is consistent with expectations of a wider easing policy response.
- Investors' conviction that central banks will keep policy rates low for longer is further flattening yield curves.
- Losses in the equity prices of eurozone banks could dampen credit intermediation at a time when lending to the private sector has shown signs of revival.
- In the U.K., high household debt levels, deteriorating market affordability, and the recent rise in the buy-to-let segment could amplify negative movements in the housing market.
Financial markets are venturing further into uncharted territory
Prior to the referendum, we argued that in the event of a leave vote, the Bank of England's monetary policy committee (MPC) would likely prioritize economic growth prospects over inflation and shift monetary policy to a more accommodative stance, perhaps as soon as this month. Meanwhile, the BoE financial policy committee's (FPC) announcement last week that it would use macroprudential tools to ease credit is consistent with expectations of a wider easing policy response. On July 5, The FPC decided to lower its countercyclical capital requirement to 0% from 0.5% of risk-weighted assets at least until June 2017 to improve credit intermediation. The bank claims it would free up lending capacity of £150 billion for British banks. Overall, we assume the central bank will slash its policy rate to zero and restart its quantitative easing program in 2017 with perhaps as much as £100 billion in additional purchases of government securities in each of the next two years.
Expectations for policy easing from the major central banks are causing bond yields to collapse, with long-term sovereign bond yields falling to historical lows. The U.K. government bond yield fell 63 basis points (bps) between June 23 and July 8 to 0.74%, while U.S. Treasuries fell 37 bps to 1.37% over the same period. Investors' conviction that central banks will keep policy rates low for longer is further flattening yield curves. For instance, the U.S. and U.K. two-year to 10-year yield curves are at their flattest since 2008 and the recessionary period thereafter (see chart 1). What's more, uncertainty about the political implications of Brexit for the EU is pushing investors toward safe-haven assets. Similarly, French, Dutch, Finnish, and Belgian yields curve are more negative, with German 15-year yields now in negative territory.
Uncertainty about the future relationship between the U.K. and the EU, and falls in capital inflows were associated with further downward pressure on the exchange rate. The sterling lost 3% against the dollar since the start of the week, after having lost 10% in the prior week. In trade-weighted terms, the sterling was down 11% since June 23 (see chart 2). Our forecast has the pound exchange rate against the dollar falling to $1.22 in the third quarter, given potential concerns over Britain's political stability, and averaging $1.33 in 2016 (compared with $1.53 in 2015), and $1.29 in 2017.
European equity markets have experienced severe losses in what is the second substantial sell-off since the start of the year. The Italian stock market was the hardest-hit, and was still some 11% down from its pre-referendum level on Friday July 8, weighed down by the fragility of its banking sector. Meanwhile, the European equity market (the EuroStoxx 600 Index) was down 5.5% over the same period. Losses in the equity prices of eurozone banks could dampen credit intermediation at a time when lending to the private sector has shown signs of revival. In the U.K., while the FTSE All-Share index was up 4% from pre-referendum levels, the more domestic components of the index have fallen sharply. The FTSE 250 (perhaps a better gauge of the overall U.K. domestic economy) has been down 6.7% since the vote. More significantly, DataStream's Home Construction Index lost 32%, highlighting concerns about the property market in the country.
The housing market: The U.K. economy's Achilles' heel
The spillover from financial turmoil to the real economy became more visible when major property funds suspended redemptions, to avoid fire sales of the underlying commercial real estate assets. The sterling's dive has led to lower or negative returns for nonresident investors, consistent with a reduction in the willingness of foreign investors to hold sterling assets.
The BoE singled out the commercial real estate (CRE) market as a potential risk to financial stability in its Financial Stability Report published July 5, noting the market "had experienced particularly strong inflows of capital from overseas and where valuations in some segments of the market had become stretched." Foreign investors have accounted for 45% of the value of transactions going into CRE since 2009, which have been a major source of financing for the current account deficit. However, in the first quarter, the volume of transactions involving foreign investors fell by almost 50% from the previous quarter, driving a slowdown in overall market transactions, according to the report. Research by BoE staff suggests that every 10% fall in U.K. CRE prices is associated with a 1% decline in economywide investment.
Also concerning is the vulnerability of the housing market. U.K. households have a high level of indebtedness, which stood at 132% of their annual income in the first quarter. With the market experiencing strong price increases in the past four years, affordability has deteriorated (see chart 3). According to Nationwide, a building society, the house price-to-average earnings ratio for first-time buyers has risen to 5.3x in second-quarter 2016, from a low of 4.3x earnings in late 2012. In London, house prices are 10.4x average earnings (versus 6.4x in late 2012).
A deterioration in the economic outlook leading to higher unemployment could weaken the capacity of some households to service debt. (We expect the unemployment rate to rise to 5.7% next year and 6.4% in 2018, from 5.1% in 2015.) What's more, the buy-to-let (BTL) segment has been growing rapidly, with investors seeking yield in a low interest rate environment. The Council of Mortgage Lenders estimates that BTL mortgages now make up 16% of the total stock of all outstanding mortgages. The BTL investors have more incentives to sell their homes in anticipation of future price decreases, which could amplify negative movements in the housing market.