Just when you think it's safe

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One year on from the Brexit vote in June 2016, the UK is going around in circles with no political consensus on how to approach the negotiations – or even what they would like to achieve.  There is not a sufficiently large constituency for the hard Brexit approach seemingly favoured by PM May.  This opens the door for a softer, more pragmatic Brexit, with lower economic costs – but also raises the odds of the UK crashing out of the EU with no deal.

But relative to the concerns that were held in the shocked aftermath of the initial Brexit vote, the fallout has been localised.  The most obvious casualty has been the GBP: it fell by 11% against the USD on the day of the Brexit vote; and has weakened again over the past week in response to renewed political uncertainty.  And although the FTSE 100 is up on the back of accommodating monetary policy from the Bank of England and the low pound, there has been a hit on stocks that are domestically focused.  There are also signs of Brexit costs beginning to manifest in the UK: lower consumption spending, reduced business investment, and some relocation of activity away from the UK.

But these effects have not radiated very far.  Ireland was in the firing line, as an economy highly exposed to the UK.  In the weeks after the Brexit vote, the Irish equity index was down as much as 14% from pre-Brexit levels.  However, it recovered these losses by December and the index was up by about 10% in the year to June 1. Although Brexit remains a serious strategic risk to Ireland, so far the economic and market impact has been relatively modest.  And Ireland is running a successful campaign to attract investment and jobs that are relocating from the UK.  Other UK-exposed economies, such as the Netherlands or some of the Nordics, have a similar experience.  Further away, in Asia for example, it is hard to discern a Brexit effect in equity markets. Brexit is an act of strategic self-harm, with localised effects, rather than a systemic event.

Indeed, the absence of evident systemic effects has been a consistent story over the past 12 months of heightened political risk around the world.  To paraphrase Robert Solow on the productivity impact of IT, you can see political risk everywhere except in market pricing or economic data.

The combination of the Brexit and Trump votes in 2016 generated serious concern that the liberal, rules-based system was under threat.  Protectionism and populism were seen as making a comeback as public opinion seemed to turn.  But the unexpected Trump victory was received by a substantial market rally – as investors focused on expected fiscal stimulus and tax reform.  And GDP growth was strong through 2016, as emerging markets picked up.

This was also the case in small advanced economies around the world, the group of countries that I monitor to provide early, clean insight on the changing global economic and political system.  Small economy markets have performed in line with key equity benchmarks over the past 12 months, like the S&P 500 and Euro Stoxx 600.  Although the small economy equity rally was not as pronounced as in large economies after the Trump election, there has been a convergence through 2017.  This convergence has been assisted by the reduced political risk and uncertainty in Continental Europe, after elections in France and the Netherlands.  And some of the largest concerns have not yet manifested: there have not been major instances of protectionism or currency tensions, for example.  And even TPP has better odds of survival (without the US) that had been thought possible a few months back.

In general, the response of equity markets in small economies suggests an absence of perceived systemic risk in the global economic and political system.  The concern that we were ‘present at the destruction’ in 2016 seems, on this evidence at least, to have been overdone.  Small economies are acutely exposed to changes in global system; the relatively strong economic and equity market performance of these economies suggests the absence of systemic effects.  Much of the impact of change, from Brexit to NAFTA renegotiations and European populism, has been localised.  For example, the GBP after Brexit, French equities after Mr Macron, the Mexican peso in response to Mr Trump, and so on.

But this equity market and economic performance contrasts sharply with the assessment by highly exposed small economies of the risks to the global system. The risks of a more closed global system and the return of big power politics remain issues of high concern in small economies. These concerns about the outlook are perhaps better reflected in small economy bond markets, where a persistent gap has opened up between small and large economy government bond yields.

Indeed, events over the past month suggest that we should not relax.  The repeated unwillingness of the US to agree to statements rejecting protectionism at the G7 and the OECD, weakens the system; as does its unilateral withdrawal from multilateral agreements (TPP, Paris Agreement) and its behaviour with respect to allies (from NATO to Qatar).  This undermining of global and regional institutions and norms matters, making it harder to contain tensions when they arise.

And there are several areas in which these political risks are beginning to take concrete form.  The possibility of new protectionist measures by the US (on steel, for example) may attract retaliation; the tensions between China and the EU on whether to agree to market economy status for China at the WTO could affect many other elements of the relationship (notably agreement on emissions reduction, but also trade and investment); and the increasingly assertive behaviour of China in East Asia is challenging the rules-based system.  In this context, new shocks – be it in Asia, the Middle East or the Eurozone – will be increasingly difficult to manage.  

This is an increasingly challenging global context to navigate, and particularly for small advanced economies.  Just as fatalism on the future of globalisation was inappropriate in 2016, so now complacency about the outlook should be avoided.  Although markets seem to have largely discounted systemic political risk, perhaps as in the movies, just when you think it is safe – it’s probably not.

David Skilling