Brexit is Here – Bremain Brational

The UK has decided to leave the EU. It’s a strange vote given how little support there was from reputable economic experts.  The estimates of the economic impact of Brexit were virtually all negative. This makes sense given that leaving the EU only makes trade more difficult, labor less mobile and most things more costly. It’s actually hard to come up with reasonable long-term positive outcomes here. As Oxford and the London School of Economics both noted, the risks here are asymmetric to downside.  But the risks aren’t huge as worst case scenarios are in the -3.5% GDP range. So let’s put some of this in the right perspective:

• The UK is just 4% of global GDP. Even in a worst case scenario this economy is not large enough to derail the global economy. If they experience something like a 3.5% decline in GDP then it will be bad for the UK, but it will be a pimple on the rear-end of the global economy.
• I downplayed China (correctly) last year and I would downplay this event significantly more. For perspective, China is 4 times larger than the UK and their economic slowdown has had relatively modest global impacts.
• Although the Brexit vote is likely to be ratified this process will take YEARS to play out. The renegotiation of trade treaties and the actual exit from the EU will require huge amounts of red tape removal. This will not be a fast process and the negative impact will be muted further due to the slow process of the exit. This means that any negative impact here will be long, drawn out and appear more muted due to the slow process of the exit.

The markets, however, are having a much more visceral reaction than what I’ve described above. At last check, S&P futures were off 5%, German stocks are off 9%, the Pound is down 10% and UK stocks are set to open down 10%. These are huge moves. But the markets are likely jumping the gun here. They’re not asking if this is bad for the UK (which it is, though not catastrophic). They’re asking if this is the start of something much bigger – the beginning of the collapse of the EU and the EMU.  That’s a real outlier risk and one that should be considered, however, it appears extremely unlikely given that the UK was always distanced from the EU to begin with since they were never a part of the EMU. I wouldn’t get overly concerned about a collapse of the EMU until we started to see real disintegration within the EMU. At this time, Brexit isn’t a sign of this.

So, bremain brational. Brexit will create a lot of uncertainty and emotional reactions in the markets, but I suspect this won’t derail the global economy and we’ll have to find something new to get scared about in the coming months and years.

NB – I write about this event reluctantly. I think it’s a much smaller deal than it’s been made out to be. And anyone who has a well diversified portfolio of stocks and bonds should not care about this sort of stuff. But given the widespread attention this is getting it’s useful to look into these kinds of events in more detail so we can put things in the right perspective.