Why we should brace for a second shockwave from Brexit

July 13, 2016 18:03
London's property prices have been supported by financial services firms in recent years. But now the Brexit vote threatens to change all that. Photo: Bloomberg

The stock market has seemingly recovered from the fallout of Brexit. However, I still believe there will be more profound impact going forward.

The upcoming shock will mainly manifest in three levels. First, it will cause volatility in short-term asset prices. Second, it will reshape the financial landscape and weigh on property prices. Third, it will cause spill-over to real economy and affect national power.

Big financial institutions such as HSBC and Goldman Sachs might halve their headcount in the UK if the country no longer provides operational convenience and easy access to other EU nations.

Property prices in London have been supported by the financial sector, which provides services for other European nations and helped the city become a big draw for European billionaires.

If UK's financial services in EU nations contract, business and financial activities in London will also cool off slowly.

In that case, London might lose its status as one of the world's top two financial centers. Other European cities like Frankfurt in Germany and Paris in France might catch up with London as a key financial hub within five years.

UK’s GDP growth might contract by 3 to 5 percent. Wales and Scotland might call for independence referendums as the majority of their citizens want to remain in the EU. The UK might degrade into a second-tier nation once its financial services heft and political power shrink.

The second wave of the Brexit shock might emerge in the last quarter of this year or early 2017. Market sentiment might turn cautious as the nation faces reduced investment and acceleration in business and financial relocation elsewhere.

Several UK property funds have already halted trading due to rising redemptions. Any big property sell-off in London will leave investors unnerved about falling asset prices and weakening sterling.

The British currency has plunged to 1.29 against the US dollar from 1.49 before the EU referendum. It appears that the sterling has further downside to 1.15 at the end of this year or first half of 2017, reflecting economic contraction and capital outflow from the region.

We've also seen some spill-over effect of Brexit, as weaker euro has exerted shock to Italy’s banking sector. Three banks in Italy need government capital to stay in business.

The second wave of Brexit shock will ripple into financial and service operations. Hence, we might see the impact in financial sector in next two or three months, and in the real economy later this year or first half of 2017.

Previously I laid out three sources of risk for the world today: Brexit, US presidential election and Fed rate hike. The first has already materialized. As for the rate hike, the odds are small that the Fed will tighten policy before the November election.

Major economies are all pumping massive liquidity into the market. Observers expect the EU and Japan to continue their easing. However, it' not a good thing if we rely too much on money-printing to support growth.

History shows the world economy goes through a cyclical adjustment every seven to eight years. Currently, major central banks are adopting loose monetary policy or even negative interest rates in a bid to delay the adjustment. The longer it is postponed, the most drastic the future adjustment will be.

The second wave of Brexit fallout might trigger a worldwide correction like we've seen in 2008 and 2009. Investors should stay alert.

This article appeared in the Hong Kong Economic Journal on July 13.

Translation by Julie Zhu

[Chinese version 中文版]

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adjunct professor in the Department of Finance at HKUST Business School