Global markets have regained some sense of calm following the turbulence that followed the unexpected result of the UK referendum that saw a vote to leave the EU.
Sterling has stabilised over the past week at around 83p-84p against the euro and $1.33 against the dollar, having fallen sharply on the referendum result.
Meanwhile, stock markets have managed to regain some lost ground.
Markets have come to realise that it is going to be some time before there are any real changes to the institutional framework that governs the UK’s relationship with the rest of the EU.
The EU authorities have made it clear that the negotiations on this can only commence when the UK triggers Article 50 of the Treaty on European Union and formally notifies the EU that it wants to leave.
The UK is in no hurry to do this. The negotiations are expected to last for two years, so it is likely to be the end of 2018 — at the earliest — before the UK departs the EU.
In the meantime, forecasts are being revised to take account of the impact of the actual ‘Leave’ vote, itself, on economic activity over the next couple of years.
There are three factors to consider in this regard; namely the heightened level of uncertainty, movements in financial markets and the response of central banks.
In regard to uncertainty, it is likely to remain at an elevated level for a prolonged time, damaging growth and hitting investment activity in particular.
Turning to financial markets, we have already seen sharp falls in sterling and stock markets, with a flight to quality driving bond yields lower.
Overall, while the moves in markets have been large, they have also been orderly and markets look like they could be settling down.
Nonetheless, sterling is likely to weaken further in the months ahead, possibly hitting 85p-86p against the euro.
Meanwhile, unlike the 2008-09 crisis, there is virtually no sign of a liquidity crunch in money markets that would be a sign of severe financial stress.
The major central banks stand ready to provide as much liquidity as required to keep markets functioning normally.
Furthermore, the Bank of England looks set to cut rates by 25 basis points over the summer to 0.25%.
We also look for a more cautious Fed, with the market now pricing in just two rate hikes in the US by the end of 2018.
Markets are also now pricing in that the ECB will cut the deposit rate by at least 10 basis points to -0.5% in the next few months.
Both the UK Treasury and British think-tank the National Institute of Economic and Social Research (NIESR) produced forecasts before the referendum on the impact of a ‘Leave’ vote on the UK economy.
These showed that UK GDP would be about 3% lower by the end of 2018 as a result of the vote.
The negative impact on UK growth comes from elevated uncertainty which hits investment in particular, as well as higher inflation, although the sharp fall in sterling will be a positive for external trade.
Meantime, the ‘Leave’ vote in the UK is likely to have a negative impact on Irish growth via four channels — a weaker UK economy, slower growth in other economies, sharp fall in sterling and the extended period of elevated uncertainty.
The biggest impact will be on those trading with the UK as a result of the marked slowdown in the British economy and big decline in sterling.
Indigenous firms that export a lot to the UK will be hardest hit, especially smaller companies that are unlikely to do currency hedging.
The tourism sector will also be hit. Imports from the UK, though, should fall in price, keeping inflation low here in the next couple of years.
We estimate that the ‘Leave’ vote could result in Irish GDP being about 2.3% lower by the end of 2018.
We now see growth of 4.7% in 2016, and 3.5% and 3% in 2017 and 2018, respectively, versus 5%, 4.5% and 4% previously.
The Department of Finance has indicated that it is likely to reduce its 2017 GDP forecast from 3.9% to 3.4%.
These are still strong growth rates, however, highlighting that the Irish economy is starting from a strong position in facing this new risk.
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