Out into the Unknown

The UK looks like it has voted to leave the EU. We see protracted political and economic uncertainty, leading to a weaker GBP, pushing inflation up, and a hit to growth. In a referendum recession, we expect easier monetary and fiscal policy.

Key consequence – profound and protracted uncertainty: Although the final votes are still being counted, it looks increasingly clear that the UK has voted to leave.Following this vote, we expect a surge in political and economic uncertainty. Initially, we expect the focus to be on the political uncertainty, especially around whether Cameron continues as Prime Minister, and whether the Conservatives can maintain a working majority in parliament. Further down the line, we see a heightened risk of a second Scottish independence referendum. Economically, we see uncertainty regarding the UK’s future trading relationship with the EU, its main trading partner, where we see a risk of a significant reduction in market access.

Economic impact – a hit to sterling and demand; a less open and more volatile economy: We think that the uncertainty after a vote to leave will have two immediate effects. First it will hit sterling, as uncertainty reduces non-residents’ appetite for UK assets against the background of the UK’s record current account deficit. Second, it will hit growth, as firms hold back on investment, and households increase precautionary savings. Longer term, we expect a less open and more volatile economy, with reduced inflows of capital and labour, and a lower rate of potential growth.

Policy response – an easing bias: We think that the MPC will have an easing bias, given the risk of lowflation from weak growth. We think it will be slow to act on rate cuts, but stands ready to intervene in case of disruptive market developments, especially in FX and gilts. In a ‘civilised divorce’ scenario, where the uncertainties are progressively reduced and the economy avoids recession, we see the MPC on hold. In an ‘acrimonious divorce’ scenario, where the uncertainties interact and amplify each other, we see the economy in a referendum recession by year-end. We expect this to trigger a cut in rates to 10bp, another £50 billion tranche of QE, and easier fiscal policy, including the possibility of a radical helicopter money experiment.

What to watch for today: i) Senior Conservative rhetoric – collaboration or brewing leadership challenge; ii) Hints at Cabinet reshuffle; iii) Central bank statements and actions.

Wider European and global impacts: Our European team sees a significant hit to eurozone growth and heightened European political risks. Our global team sees negative spillovers, particularly from further USD strength, which could put the global economy into the recession danger zone.

Morgan Stanley Research