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OPINION

The Brexit paradox

The Brexit paradox
July 5, 2016
The Brexit paradox

Most economists agree with Mark Carney's claim last week that "the economic outlook has deteriorated". "The UK economy is headed for recession," says John Llewellyn of Llewellyn Consulting. Conall MacCollie at Davy Research agrees, saying that real GDP will fall over the winter. Even those who are more optimistic are only slightly so: Berenberg's Kallum Pickering foresees a "virtual stagnation" in GDP for the rest of this year.

This is because economists believe the uncertainty created by Brexit will lead to companies cutting investment and freezing hiring. Mr MacCollie fears that business investment could fall by 10 per cent and that rising unemployment and rising prices caused by sterling's fall will cause "a squeeze on real wages".

Worse still, the hit might not be temporary. Many believe the UK's long-run trend growth rate might fall, if we face less access to the single market and difficulties in redirecting exports to other countries.

Granted, there are big uncertainties here: because no major country has left the EU, we've no strong guide to how great the blow to business confidence will be. And there will be some cushions for the economy: the weaker pound will help exporters; Bank rate will probably be cut, and government borrowing will increase, so providing an automatic stabiliser. Most economists, however, believe these won't fully offset falling capital spending. As Dr Carney said, "monetary policy cannot immediately or fully offset the economic implications of a large, negative shock".

All this poses the question: why, then, has the FTSE 250 rallied? One reason is that it overshot in the immediate gloom of the Brexit vote. As I write, it is 6.3 per cent below its pre-referendum level, which is close to many economists' estimate of the long-term GDP cost of Brexit.

There is, though, another reason: markets are pricing in a non-negligible possibility that the UK might not leave the EU. Although the favourite candidate for next prime minister, Theresa May, has said that "Brexit means Brexit", many believe there are big obstacles to this.

One is a legal one. Some lawyers believe that triggering Article 50 (the formal process to leave) requires parliamentary approval. Given that most MPs favour remaining in the EU, this might not be forthcoming. (Lawyers disagree on this: the fact that the matter was not clarified before the referendum is yet more evidence that the whole process has been a mismanaged mess.)

Another possibility is that the terms of leaving might be so bad - or the collateral damage such as the break-up of the UK - might be so high that the government draws back from Brexit. Or, alternatively, the process of leaving might be so tedious and draining that people just think better of it: do we really want the next few years of politics to be dominated by arguments about the price of beans?

Now, you might have your own view of these issues - although personally I suspect that any strong one owes more to overconfidence than to evidence. But that's not the point. The point is that small changes in (perhaps small) probabilities can generate big market volatility: this is true of all scenarios, not just Brexit. In this sense, equities face not just uncertainty, but uncertainty about uncertainty. And that means not just volatility but also changes in volatility.