The biggest threat to the European Union (EU) is a potential Brexit — the withdrawal of the United Kingdom from the EU — both in terms of its possible impact and the uncertainty surrounding its likelihood, says Michala Marcussen, CFA, global head of economics at Societe Generale Corporate and Investment Banking.
Marcussen, the keynote speaker at this year’s European Investment Conference, predicted that a referendum on EU membership will be held in the third quarter of 2016, and she estimated the probability of Brexit at 45% — too great a likelihood for investors to ignore.
A Brexit, she predicted, would result in a reduction of between 0.5% and 1.0% in GDP growth per annum due to three factors:
- There will be an uncertainty shock that will cause some level of economic dislocation. For example, the Brexit could trigger a second Scottish independence referendum.
- Considerable foreign direct investment into the United Kingdom occurs on the basis of its membership in the EU. That capital could depart if the United Kingdom votes to withdraw.
- The City of London will likely see a more concerted effort by the eurozone to repatriate crucial financial functions back to the Continent.
The downsides of a Brexit will not be confined to the United Kingdom. Marcussen estimated that for every 1% of economic growth lost by the United Kingdom, the EU will lose around 0.25%.
Regarding the EU in general, Marcussen was relatively more optimistic about the “European house,” which she said was being built too slowly and with patchy workmanship in some places but was nevertheless going up. Progress is occurring against a backdrop of a very slow but very conventional economic recovery in Europe, with the oil price decline driving most of the consumption-led growth.
One possible worry is that the recovery is not based on trade, with the relationship between GDP growth and trade growth decoupling to some extent. This, Marcussen said, could explain why the devaluation policies of such countries as Japan seem to not be having the desired effect.
Causes of this weak world trade could be that the eurozone’s problems have dampened intra-European trade and that China’s proportion of intermediate-goods imports has fallen — that is, China has “onshored” more of its supply chain. The final factor, Marcussen suggested, could be lackluster investment spending globally, with investment goods typically being import intensive and thus generating a lot of trade.
Marcussen argued that the two causes of Europe’s slow recovery are overleveraging and nonperforming loans. The former, in particular, is a problem, she believes, because we have reached the limits of credit-based economic expansion. Further, modern economies have never experienced periods of deleveraging, so it is unclear how they will react in the future. As a result of these two factors, her forecast for future potential growth has been permanently halved.
A possible game changer for her forecasts, though, is an increased pace of reform. She sees the critical missing bricks of the “European house” to be the Capital Markets Union, a deposit guarantee scheme for the Banking Union, and a fiscal union. Given the EU’s track record in this area, however, she noted there was not much point holding out hope for reforms to help economic growth in the short or medium term.
The European Central Bank (ECB) has more leeway to act, and Marcussen expects it to expand its quantitative easing (QE) program in the coming months, at the same time as the US Federal Reserve begins increasing interest rates in the United States. This combined with the recent shift to fiscal expansion among such countries as France and Spain also provides some rare upside risk for the EU economy.
Marcussen concluded by reiterating that the EU is a work in progress and that Europe has historically needed a crisis to move forward with difficult reforms. Nonetheless, she believes that the outlook is better than people may think, with a number of positive economic tail winds in action.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Photo credit: Paul White