This post-Brexit financial world will require a lot of untangling. The FTSE 100 index closed down only 200 points, which used to be seen as a bad, but far from catastrophic, event in the stock market.
You would have got long odds on that outcome at 2am in morning, when Sunderland and Newcastle gave the first signs of the UK political earthquake in store, and even longer odds when the blue-chip index opened 500 points lower.
Appearances can be deceptive, however. The FTSE 100 is a barometer only of itself, not the UK economy. It is stuffed with companies that make most of their profits in dollars, a currency that is suddenly 8% stronger against sterling. US investors – and a few Europeans – made the currency adjustment and saw a relative bargain. Alongside the miners of African gold and Mexican silver, the big Footsie risers were all defensive dollar earners – the likes of microchip-maker Arm Holdings (up 6%) and pharmaceutical firm GlaxoSmithKline (up 4%).
On the negative side of ledger, there was no afternoon rebound. Big banks were all down 15-20% and their smaller brethren – the likes of Virgin Money and Aldermore – by up to 30%. The latter was one reason why the FTSE 250 index of mid-sized companies, which is far more skewed to the UK, fell 7%.
If a UK recession, however mild or brief, lies ahead, banks will see more loans turn sour while consumers’ appetite for fresh debt will shrink. Worse for the banks, the whiff of any medium-term rise in interest rates in the UK has disappeared. Thus the yield on 10-year government debt fell to a record low of 1.07% in the biggest one-day move since 2009. That is a hideous prospect for lenders who prefer long-term rates to be several percentage points above the cost of short-term funds – that is how they make their money.
The fear of recession also undermined the housebuilding sector, where most stocks fell by a quarter. Mortgages may remain extraordinarily cheap in the new world, but confidence in house prices is suddenly anybody’s guess. So is the political career of the chancellor, George Osborne, author of all those housebuilder-friendly help to buy schemes. Even ITV – dependent on fickle advertisers pushing consumer goods – shed a fifth of its value.
What happens next? It’s easy to imagine how financial waves from the upheaval in currency markets could spread around the world. The Bank of Japan, desperate to generate domestic inflation, will hate the rush towards the safety that produced a sharp rise in the yen, the opposite of what it wants. The US Federal Reserve, which had been expected to raise rates twice this year, could now hold fire to avoid pushing the dollar any higher. Even as things stand, the strong US dollar is creating severe pressures in China, where Beijing’s softly-softly attempt to loosen the renminbi’s peg with the US currency upset markets at the start of this year.
Dominic Rossi of fund manager Fidelity International expects lower growth across the UK and the rest of Europe, but thinks the political shock from the UK referendum will be greater than the economic one. “Political risk premia will now rise around the world and this implies lower valuations,” he warns. “Friday’s result will set off a domino effect of political risk. Whether it’s the US election later this year or the French election next year, investors are going to be far more cautious.”
Indeed, the main share index in Spain – where a general election will be held this weekend – fell 12%. The Italian bourse tumbled similarly. In Germany, Deutsche Bank’s shares fell 14% - to a level below prices seen in the 2008-09 global banking crisis. It is impossible to know if – or how – such upsets will influence the divorce negotiations between the UK and the EU. But the task of holding the eurozone together has just become harder.
In time, the shocks can be absorbed but, as Rossi argues, the pound could still be vulnerable to further falls, at least against the dollar. The pound hasn’t slipped below $1.40 for long since the mid-1980s but now stands at $1.36. Instead of serving as a floor, the $1.40 level could become a ceiling. After all, the UK is running a huge current account deficit that reached a peacetime record of 5% last year. If foreign investors are less inclined to fill the gap, the obvious cure is a weaker currency to help UK exporters and discourage consumers from buying foreign goods.
The good (ish) news was delivered by Mark Carney, governor of the Bank of England: the financial system is far stronger than it was in 2008 and banks’ capital requirements have been stressed against “scenarios more severe than the country currently faces”. There is no reason to doubt that statement.
But financial markets’ medium-term adjustment to the post-Brexit world remains deeply uncertain. Friday’s kneejerk reaction was less severe than many had forecast – but it’s always the second response that reveals more.
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