Although U.S. politics has dominated headlines lately, arguably the most lasting political event to occur recently wasn't in the United States, but the United Kingdom. On March 29, U.K. Prime Minster Theresa May triggered Article 50, beginning Britain's two-year withdrawal from the European Union (EU).
Article 50 has never been triggered before, so nobody really knows for sure how an exit from the EU will unfold or how long it may take for the U.K. to form new relationships. But it poses a risk for investors even in the near term, because the potential for major changes can have a negative economic impact. For example, when the U.K. entered the precursor to the EU, the European Economic Community in January 1973, the economy slipped into a recession shortly afterward.
A recession quickly followed the U.K.’s entering the EU’s precursor in 1973
Source: Charles Schwab, U.K. office for National Statistics data as of 3/29/2017.
The Bank of England , which is the U.K.'s central bank, is planning to stress-test banks in the U.K. this year for what might happen if the Brexit goes badly. These tests include a sharp rise in inflation, interest rates, and unemployment during a period of a shrinking economy, reduced global trade and high levels of consumer debt. These are some of the worst-case outcomes that could come from a plunging currency and rising trade barriers. The central bank won't know results of the theoretical tests until the fourth quarter.
In the real world, U.K. households already appear to be cutting back on their spending. For example, during the three months ending in February, U.K. retail sales declined by the greatest amount during a three-month period since 2010, according to the U.K. Office for National Statistics. Slowing consumer spending could act as a major drag on the U.K.'s first quarter gross domestic product growth.
Also, inflation is jumping higher. Imports now cost more after a 15% drop in the value of the British pound versus the U.S. dollar since Britons voted in June 2016 to leave the EU—and wages aren't keeping up. Measured in U.S. dollars, U.K. wages are the lowest in 10 years.
The economic data bear watching, but markets also may react to the negotiations. Now that Article 50 has been triggered, more will be heard about Article 218, which governs the terms of negotiation. The back and forth will likely influence how consumers and businesses assess the potential outcomes and adjust their behavior. It could lead to volatility in the markets.
The worst-case scenario of a Brexit-induced recession and financial crisis is far from a sure thing, however. According to the U.K. yield curve (which measures the spread in yield between short-term and long-term U.K. government debt and has been a good forecaster of recessions in the past), the odds of a U.K. recession in the next 12 months are currently 30-40%, based on 50 years of history. So there's an elevated chance of recession, but it's not the base case.
“A U.K. recession doesn't appear to be in the cards at this point, but risks have risen,” says Jeffrey Kleintop, Schwab’s chief global investment strategist.
Investors should pay attention to changes to the yield curve, Jeffrey says. If short-term interest rates in the U.K. rise relative to long-term rates, it would be a sign of deepening concern and rising probability of a coming recession that could negatively affect global stock prices.
The latest polls show that only 29% of U.K. consumers think the economy will fare better after Brexit; that could mean a lot of pessimism is already reflected in consumer behavior and markets. Investors should stay diversified and invested according to their asset allocations—the most reliable indicators it isn't time for a more defensive stance. But it’s worth keeping an eye on them as Brexit negotiations develop.