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Brexit signals shift: Political risk hits long­-stable economies

Richard Satran  Financial Journalist, Thomson Reuters Regulatory Intelligence

Richard Satran  Financial Journalist, Thomson Reuters Regulatory Intelligence

The idea that the biggest risk faced by the global economy no longer comes from the Middle East or somewhere along the Cold War fault line is not entirely new. But the Brexit vote and its aftermath underscores the need for risk professionals to understand the implications of the growing revolt against elites sweeping through the part of the world long viewed as the most stable.

The UK vote to leave the European Union, dubbed “Brexit,” came as a shock. It should not
have. Polls running up to the British election showed the vote would be close. Still political forecasters were irrationally certain that voters would make a rational choice in turning back an initiative that had few backers among establishment leaders.

U.S. election after Brexit

“The UK’s rejection of the EU marries traditional British euroscepticism with general Western disillusionment with globalization, simmering since the 2008­-09 financial crisis,” said the London-­based consultancy, Control Risks. It warned that the “populist insurgency against ‘elite’ political and economic establishments” may be “a harbinger of further political shifts in Western countries against globalization.”

The polls at this stage of the U.S. presidential campaign weigh against the likelihood of a victory by Republican Donald Trump. But the consequences of a surprise by the real estate mogul could be even larger and more sustained than the trillions of dollars in market losses, credit­-rating downgrades and the historic plunge of the British pound triggered by Brexit.

Economic historians see stocks being highly correlated to the U.S. four-­year election cycle. The two­-year period following an inauguration is typically volatile, even when supposed market-­friendly candidates win. That risk may not yet be factored in to the markets.

Pivotal point, or bad year for pollsters

The U.S. election is an important risk factor not only for Wall Street but also for global markets, which tend to follow the same election year pattern. This presidential vote comes at a time of immense challenge to leaders throughout the West. No one expects a popular uprising on the level of the Arab Spring or a Tiananmen Square to overwhelm a Western power.

But Brexit shows that it does not require an all-­out revolt on the streets to disrupt the global economy. A peaceful democratic election can be just as disruptive.

Consider the present list of global risks just issued for July 2016 by the Economist Intelligence Unit Economist Intelligence Unit. The usual risk suspects — jihadist extremism and a flareup over China’s claims in the South China Sea — are there.

But of the top 10, the majority are in some way related to the vulnerability of Western governments and institutions: Donald Trump winning the White House, a fracturing of the EU, and a lack of investment in energy infrastructure are among the top 10 risks.

The risk of lesser developed countries harming the global outlook has eased from other years, indeed, turned on its head. The Economist unit said the “emerging markets may be about to undergo a surprisingly rapid economic rebound” that could lead a global economic surge. That might be disruptive, but not destabilizing.

Black Swans and 100-­year floods

Through the post­-World War II era the stable, advanced nations in the West have been the bulwark providing stability through such far­-ranging events such as the breakup of the former Soviet Union, a series of oil shocks, and third world debt debacles.

The Black Swan view of global risk that gained currency after the financial crisis largely followed the same theoretical model. It viewed the Western powers as the stable pillars of the global economy, although they were susceptible to unexpected “9/11” type disasters. In this view, the financial crisis of 2008 was an economic version of a 100-­year flood or magnitude­-9.0 earthquakes.

A recovery of the financial markets in the aftermath of the “leave” vote may be seen as a sign that the old order is being quickly restored to its old footings. The Bank of England was lending support and the U.S. Treasury stood ready. But “keep calm and carry on” may not be the only takeaway from the Brexit vote, especially if it leads to more of the same denial that preceded Britain’s election.

“The Brexit vote has recalibrated the survival instincts of the world’s politicians from protecting the status quo to embracing their constituents’ anger and frustration,” said Legg Mason global strategist Paul Ehrlichman.

It might not make dollar sense

Politicians are quick to blame the economy for problems, and to appeal to disenfranchised workers who see global free trade as the culprit. But the U.K. and U.S. elections are taking place in two of the world’s strongest economies at the moment. Politicians take note: Maybe this time it’s not entirely “the economy, stupid.”

In elections “appeals to rational economic principles fall flat in the face of intense emotion,” said a blog by the editors of the Harvard Business Review. The “stayers” warned Brexit would seriously harm the UK economy. But “that argument clearly fell flat. It not only ignores history, social institutions, and heritage, it diminishes and often dismisses them.” In such times, Trump’s vague patter on the economy may not disqualify him in voters’ minds. Easy answers are in style, and not just from the right, but also from the left, where Democratic primary candidate Bernie Sanders’ made a strong run at the nomination with pared­-down­-to­-basics stump speeches on big banks and billionaires.

The takeaway is that “old buoys” guiding political risk assessment no longer are enough. Risk analysts increasingly need to look inward as well as outward, and closely, to see threats that are harder to spot than pirates on the main or barbarians at the gates. They must gauge the steady erosion of trust on Main Street and in their own changing workplaces. As they search for risk threats, the elites who base forecasts on Big Data analytics and predictive modeling might also embrace the Okefenokee swamp wisdom of cartoon character Pogo, whose barbed satire was aimed at Watergate era elites: “We have met the enemy and he is us.”

The list of top threats from the July 2016 list from the Economist Intelligence Unit:

  • China experiences a hard landing
  • Currency volatility and persistent commodity prices weakness culminates in an emerging markets corpo
  • Donald Trump wins the U.S. presidential election
  • Beset by external and internal pressures, the EU begins to fracture
  • “Grexit” is followed by a euro zone break­up
  • The rising threat of jihadi terrorism destabilises the global economy
  • Global growth surges in 2017 as emerging markets rally
  • The UK votes to leave the EU
  • Chinese expansionism prompts a clash of arms in the South China Sea
  • A collapse in investment in the oil sector prompts a future oil price shock

About Thomson Reuters Regulatory Intelligence

This article was produced by Thomson Reuters Regulatory Intelligence, and initially posted on July 5th, 2016.

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