Hard Brexit All But Certain Now, Yet Markets Don't Even Flinch

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Includes: ADRU, DBEU, DBEZ, DEZU, EEA, EPV, EURL, EZU, FEP, FEU, FEUZ, FEZ, FIEE, GSEU, HEDJ, HEZU, HFXE, IEUR, IEV, PTEU, RFEU, UPV, VGK
by: Zoltan Ban
Summary

With UK Parliament prorogued for most of the period between now and October, 31, a no-deal Brexit is now the most likely outcome.

Economic fallout will be severe on both sides of the English Channel.

Markets have been complacent so far, even though an EU economic crisis would have far-reaching global market implications.

With Boris Johnson, the UK's new Prime Minister, having successfully maneuvered to prorogue Parliament this fall, a move which was approved by the Queen, there is now very little reason left to doubt that Britain intends to leave the EU on October 31, whether there is a deal in place or not. The previous divisions in the UK parliament, between hardline Brexiteers, moderate Brexiteers, as well as the Remainers who want to stop this from happening at all costs, are all irrelevant now. All that Boris Johnson has to do is allow it to happen. There is no need for a new vote, or any other procedure. There will only be a vote if the EU offers the UK something new to vote on. But the EU does not see that to be in its interests. It wants to make it as hard for the UK to leave as possible, as a way to dampen any desires in other member states to head for the exit. After all, if the world's fifth-largest economy, which is also the least dependent on trade with the rest of the EU of all member states, cannot easily leave the union, then surely it would not be a good idea for a country like Poland or Bulgaria to try. The most likely outcome will therefore be a no-deal Brexit, which will probably happen in two months, and it will lead to severe economic pain. The pain will be felt on both sides of the English Channel, and it will then spill over into a global economic crisis.

Job loss estimates

No-deal Brexit Job Loss Map Source: Express

As the map shows, no country will be more heavily impacted by a no-deal Brexit outcome than the UK. But if we add up all the job losses, which the rest of the EU will incur, it amounts to about twice as many jobs being lost as in the UK. While the impact will be felt by a population that is about seven times larger, and an economy that is about five times larger, it will nevertheless be a significant drag on the economy of the entire continent. We should keep in mind that, just two weeks ago, we had EU economic growth data come out, which was outright ugly, with Germany and the UK seeing a quarterly contraction, while Italy is stagnated on a quarterly and yearly basis. The part that is not factored into the job loss map above is the likely secondary fallout effects caused by a combination of the effects of Brexit, on top of the already weak economic environment.

Secondary effects and other factors can easily lead to an EU-wide, full-blown economic, political and social crisis

As the potential job loss map shows, by far, the most jobs that will be lost will be in the UK, and I do believe that, in the short to medium term, it has to prepare for a difficult economic period. Having said that, the British economy does have a few advantages, including its own currency and central bank, which can go a long way in helping to adjust the economy in the wake of the initial shocks. After Brexit, it will also be able to adjust its legislation and engage in trade deals independent of the rest of the EU. There is in fact some talk of a US-UK trade deal being in the works. If that were to come through, while EU-US relations remain subdued, the UK might see a rush of EU companies moving some operations to the UK, in order to profit from the deal. I personally believe that the Brexit move could potentially lead to the UK being economically better off in the longer run, but in the next few years, it will encounter some serious difficulties. Those difficulties might get exacerbated if Scottish and Northern Irish voters might decide they want to leave the UK.

Germany is the second most vulnerable from the major EU economies. But Germany does have plenty of fiscal room to deal with it, which should help keep its economy afloat. The job loss scenario would also be less painful, given that it has one of the lowest unemployment rates in the EU.

EU unemployment rate by country Source: Eurostat

While France and Italy are not forecast to take as big of a hit as Germany or the UK, it is worth looking where these countries are on the unemployment chart, as an indicator of just how vulnerable they are to any further economic disruptions. Italy is by far the most vulnerable in this regard. It is burdened by public debt at 132% of GDP, while its economy is stagnated. The unemployment rate is already high, so adding to it will be a real tough hit for the population. It has no real chance of using fiscal stimulus to remedy things, while being part of the Eurozone keeps it from being able to devalue its currency in order to soften the blow. The Brexit shock might be just the thing which might throw Italy's economy into a recessionary spiral, which might lead to a similar situation like we saw with Greece, where economic contraction led to austerity, which then in turn led to more economic contraction.

France is not looking particularly solid either, with the unemployment rate somewhat lower than it is in Italy, as well as some economic growth, in the 1.5%/year range, but it is potentially facing budget deficits that could get out of control in the absence of austerity or tax increase measures. The deficit for this year is forecast to be around 3.1%, which is already over the 3% limit threshold, as mandated by EU treaty. It was forecast to ease after this year, but if France will see economic stagnation or even contraction going forward, due to EU and global effects and then suffer a Brexit shock to the system on top of it, it could potentially run into some serious economic difficulties. Both countries could also suffer from social upheaval, as many people feel that they have been putting up with rough economic times for many years now. More economic pain is the last thing that many segments of society want to hear about or experience. Both these countries could end up experiencing a socio-economic meltdown in my view, which would feed on itself and deepen the economic crisis.

Other potentially damaging factors, making timing of Brexit particularly bad

The current dramatic economic slowdown we are seeing in Germany and in the EU as a whole is in large part a side-effect of deteriorating trade relations, especially between the US and China. Germany's exports in particular ended up becoming collateral damage. If the trade frictions will intensify, we can expect to also see a further deterioration in European economic growth. Europe has extensive trade relationships with both the US and China, as well as much of the rest of the world. It is currently running a surplus of about $250 billion per year, based on latest trade data.

EU international trade Source: Eurostat

A worsening global trade environment is likely to become a significant drag on the EU economy for many years to come. The fact that the rest of the world is also seeing a significant deceleration in economic growth is also having an effect, regardless of the trade issue.

The EU is also grappling with a number of other internal and external issues. The relationship with Russia remains strained. It may still lead to the failure of the Nord Stream 2 project, while it is not clear whether Russia has any intentions of continuing to export any natural gas through Ukraine starting in the new year, which is when the current deal expires. Russia can afford to do without both Nord Stream 2 and the Ukraine transit system, given that exports of gas to China and to Turkey through new pipelines will start at the end of this year. Those volumes would partially offset the loss of current exports of natural gas through Ukraine. For the EU, this could mean natural gas shortages this winter, leading to industrial disruptions.

Add to it all the continued acrimony between states, with East-West as well as North-South differences over a wide range of issues, some of the highest energy prices on the world, as part of the Green initiatives, which are being intensified, and we are looking at very few bright spots within the EU economy. Brexit is happening right at a time when Europe is already grappling with a number of headwinds. There seem to be those who continue to believe in an eleventh hour deal to either further delay or compromise in a manner which will spare the continent of the worst effects of the divorce, which is perhaps why markets are still complacent. Then, there are those who perhaps mistakenly believe that a European economic crisis will not infect the global markets.

If we take a glance at the EU trade stats in the graph above, it becomes clear that it will have a global effect. EU exports and imports amount to a monthly combined total of about $350 billion with the rest of the world. By comparison, US-China trade volumes are in the under $60 billion/month range. Then, there are all the foreign companies with operations in Europe which stand to lose revenues and profits as the EU economy slows. Just as an example, Caterpillar (CAT) achieved about a fifth of its sales revenue in the region in the past quarter. Most other US multinationals have significant operations and sales in Europe. I personally don't believe that there is any reason to be complacent in regards to this issue. Brexit will most likely happen within two months. It will most likely involve an acrimonious parting between the UK and the EU. It will inflict a major blow on an economy that is already suffering, and it will have global consequences. October 31 will most likely be the day of reckoning. Investors should be prepared for it, whichever way they see fit. We should definitely not ignore it.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.