How a no-deal Brexit may become a problem for the world economy

If Britain crashes out of the European Union without a transition pact, the knock-on effects would undermine an already fragile global economy.

The 2016 vote to leave inflicted an immediate confidence shock that quickly dissipated from global markets, but the worst-case scenario of a no-deal Brexit is guaranteed to damage the U.K., with Bloomberg Economics predicting it would tip the economy into a recession.

The question is how much pain would be transmitted elsewhere at a time when the U.S.-China trade war has already helped plunge global manufacturing into a slump. 

The second-biggest victim would be the euro-area, with the European Central Bank estimating the region would feel a hit equivalent to a 10%-30% of what the U.K. suffers. That’s potentially the difference between slowdown and outright recession.

“The consequences of a no-deal Brexit would be very severe for the U.K. I’m afraid, but also for each of our EU member states,” former Italian Prime Minister Mario Monti told Bloomberg Television this week.

As for elsewhere, New York University Professor Nouriel Roubini wrote this week that “a blowup over Brexit might not by itself cause a global recession, but it would certainly trigger a European one, which would then spill over to other companies.”

Another risk is that, after being buffeted by months of trade tension and political uncertainty, a no-deal Brexit is the proverbial straw that breaks the camel’s back for global sentiment. That could kickstart a downward spiral in markets. 

“This is a very big issue for the globe,” said Tom di Galoma, managing director of government trading and strategy at Seaport Global Holdings LLC, a U.S.-based investment bank and advisory firm.

“It will end up being a huge-risk off trade. There are a lot of hot spots in the world and Brexit is one of them.”

A sure sign of concern over global growth can be found in the benchmark 10-year Treasury yield. It’s hovering just above 1.5%, down from 2.62% at the start of the year and not far from a record low of 1.32% reached in 2016. 

A no-deal Brexit is a “catastrophic type risk” that would spark a rush to safer assets such as German bunds and U.S. Treasuries, di Galoma said. 

“There is a huge stall in global growth, mostly on the back of U.S.-China trade issues by Brexit is adding to it.”

The U.K. is currently scheduled to depart the bloc at the end of October, and Prime Minister Boris Johnson has promised to stick to that deadline with or without a divorce agreement. 

The Bank of England’s latest assessment of the “worst-case no-deal no-transition scenario” is for a drop in gross domestic product of 5.5% from peak to trough. That shows the magnitude of the damage that could be caused.

“Our estimates suggest that for every 1% less U.K. GDP, euro-area GDP will be down by 0.2% to 0.25%,” Klaus Baader, global chief economist at Societe Generale, said in a Bloomberg interview Tuesday. 

“A really deep recession in the U.K. could very much push the euro area into recession.”

ECB policy maker Olli Rehn said last month that the impact on Europe would be “unevenly spread: Ireland would suffer the most, and then countries that export a lot to the U.K.” 

Part of the problem for Europe is that the ECB has already used up much of its policy ammunition in fighting the latest slowdown in the euro area, leaving it with little firepower if Brexit sparks more serious turmoil.

Outgoing President Mario Draghi noted last month that the number of dangers faced by the 19-nation region, including a no-deal Brexit, have gone up.

Germany, a key trading partner of China and the U.S., could have a bigger spillover for the rest of the world, which is already suffering from the trade war between the two biggest economies.

“It’s another piece of uncertainty,” said Thomas Graff, head of fixed income at Brown Advisory, which managed $6.2 billion in assets. “Uncertainty in general is already weighing on confidence at companies in the U.S. And if companies stop spending on capex as they want to wait and see regarding Brexit, that’s enough to put us into a recession or at least a further slowdown.”

Those wider consequences are currently being overlooked outside of Europe, according to SocGen’s Baader.

“The uncertainty is a problem for everybody,” he said. “It’s in part seen as a bit of a sideshow – whcih it isn’t.” If a no-deal Brexit causes a euro-area recession “then that really becomes a global issue,” he said.

What Bloomberg’s economists say:

“Sketching out how a no-deal Brexit could impact the world economy isn’t hard: the shock in the U.K. hits the ailing European economy hard and the impact reverberates round the globe. Things could be made a lot worse if a messy departure adds to the already elevated levels of uncertainty that have been created by the trade war.” – Dan Hanson 

 

– With assistance by Francine Lacqua and Matthew Miller