Goldman Economies ACS | Research European Economics Daily: The UK decides to leave the EU 2A June 2018 European News: Consequences of UK referendum result across Europe ‘Andean Barta = The UK votes to Leave the EU... ‘Leave’ won yesterday's UK referendum on Souman Sac wen EU membership, with 61.9% of the vote. (For our assessment of the result, including its near-term market consequences, see here.) =... precipitating David Cameron's decision to stand down as Prime Minister. Following the referendum result, Mr. Cameron announced that he will stand down as Prime Minister by the time of the Conservative Party conference in October. Under the rules governing the selection of the Conservative Party leader, Conservative MPs choose a shortlist of two candidates. The Party membership then chooses its leader (and by implication the Prime Minister) from. these two candidates. = Exit process likely to be formally activated in the autumn. In line with the comments of most leading UK politicians, Mr. Cameron stated that he interprets the referendum result as “an instruction that must be delivered”. He implied that his successor should activate the formal process of exit (via Article 50 of the EU ‘Treaty), thereby leaving some ambiguity on the timing, while pointing implicitly to the autumn, BoE stands ready to support market functioning. As we expected in the event of a Leave decision, BoE Governor Camey stated that the BoE will “support the functioning of markets "including through the operation of its normal liquidity facilities. The Governor signalled that an assessment of whether a further policy response is needed will be made "in the coming weeks" Below, we reiterate our view that we do not expect an emergency rate cut from the BoE, and describe the package of policy easing measures we expect: credit easing at the July 14 MPC meeting, followed by a rate cut in August. = ECB statement signals readiness “to provide additional liquidity, if needed, in euro and foreign currencies”. The ECB has released a statement in the aftermath of the referendum outcome that itis “closely monitoring financial markets” and is in close contact with other central banks and with the private Investors should consider this report as only a single factor in making their investment decision, For Reg AC Certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/r fhodge htmlGoldman Sachs Exropean Economics Daly sector (in particular, banks that it supervises). It also signalled readiness “to provide additional liquidity, if needed, in euro and foreign currencies” Scandinavian central banks have issued similar statements, = ECB allots EUR400bn in T-LTRO 2..The ECB announced that it had allotted slightly below EUR400bn in its first operation under the second programme of targeted longerterm refinancing operations (FLTROs). Since this was accompanied by a significant repayment of outstanding borrowing under the first ‘FLTRO programme, this implies a net liquidity injection of approximately EUR32bn, somewhat below consensus expectations. Focus: The UK decides to leave the EU = Moves in foreign exchange and equities markets from the end of last week until the day before the referendum had reflected rising confidence in a Remain vote, The Leave outcome has led to a market correction this morning. GBP/USD has fallon by over 6% and the FTSE 250 by 9%. | Our macroeconomic forecasts ahead of the referendum (for the UK and the rest of Europe were based on the (technical) assumption of a decision to Remain in the EU. All these forecasts are now placed under review. We are waiting for the dust created by the market fallout from the referendum result to settle before revising our forecasts. = Governor Mark Camey has stated that the Bank of England stands ready to implement policy measures aimed at maintaining market functioning. He signalled a preparedness to activate swap lines with other major central banks and conduct additional liquidity operations, including the provision of torm funding for UK banks. These announcements should help mitigate foreign exchange volatility and support bank funding (including in foreign currency). We expect the BoE to announce credit easing measures at its July 14 MPC meeting, including purchases of corporate credit and an extension of the Funding for Lending Scheme in response to an expected rise in bank funding costs. We also expect a 25bp interest rate cut at or before the August MPC meeting once Sterling has stabilised. = Second-round political risks contribute to an expected rise in uncertainty that will weigh on the UK and European macro outlook. The domestic political fallout in the UK has already proved to be substantial, with PM Cameron's announcement that he would step down in the Autumn. The composition and leadership of the UK government are now uncertain, ‘The UK voted to leave the EU in yesterday's in/out referendum. Prior to the referendum, polling data and bookmakers’ odds had pointed to a close vote. While poling data reported a close call (essentially neck and necki, betting odds had suggested around a 25% chance of a Leave decision. dune 2016 Page 2Goldman Sachs Exropean Economics Daly Moves in foreign exchange and equity markets since the end of last week reflected, however, rising confidence in a Remain vote. The Leave outcome has tharefore led to a market correction this morning, GBP/USD has fallen by over 6% and the FTSE 250 by 9%. Expecting central bank actions, starting today, to maintain market funetioning We had expected the BoE to stand behind markets and to maintain market functioning today. Mr Carey's statement this morning focused on that message. ‘Our view was that Governor Carney would activate swap lines agreed with other ‘major central banks, including the Fed and ECB. In his statement, Governor Carney indicated that the BoE can provide substantial liquidity in foreign currency "if needed These announcements are intended to mitigate foreign exchange volatility and support bank funding, including foreign currency funding. Many of these facilities were put in place in response to earlier market tensions (see here and here). We expect further policy easing to be announced by the BoE at its July 14 MPC meeting, focused on credit easing measures. We expect @ programme of asset purchases to be announced focused on (non-bank) corporate debt. Should bank funding costs rise, as seems quite likely, we would also expect the BoE and HM ‘Treasury to announce an extension of the Funding for Lending Scheme. Such policies support domestic demand in the event of a loss of domestic confidence and yet do not contribute to a more severe weakening in Sterling, We expect a 25bp cut in the Bank's policy interest rate at (or before) the August MPC meeting. A cut in Bank rate alongside the August Inflation Report would communicate a policy of ‘looking through’ a period of above-target inflation owing to a sharp weakening in Sterling. Ths is likely to imply extending the MPC's policy horizon for returning inflation to target to “around 3 years” Key decisions now facing the UK ‘The referendum itself was advisory, rather than legally binding. Nonetheless, Mr. Cameron has cleariy indicated his interpretation of the vote result as “an instruction by the British people" that “must be delivered” He has announced he will stand down on that basis. Article 60 of the EU Treatias gives the legal framework for withdrawal. The EU ‘Treaties provide for a 2-year process of withdrawal once Article 50 has been activated. Mr. Cameron confirmed that he believed Article 50 should be activated by his successor, to be appointed by the time of the Conservative Party Conference in October. Notification through Article 50 determines when the 2-year window on withdrawal starts. The candidate to succeed the Prime Minister will need to clarify what type of trading relationship with the EU the govarnment envisages, recognising that access to the Single Market also comes with additional obligations. ‘The composition and leadership of the goverment are likely to be uncertain, at least initially. Such political uncertainties may further complicate how a definitive referendum outcome is translated into a formal procedure. dune 2016 Page 8Goldman Sachs Exropean Economics Daly ‘The main macroeconomic effects ofthe Leave vote Given the uncertainties outlined above, macroeconomic policy uncertainty is a key channel for the Leave decision to weaken the UK's growth outlook, with implications for the rest of Europe. Over time, there will be additional, direct macro effects. Most notably, this includes an adverse terms of trade effect as the UK's access to ‘major export markets is reduced or made more costly. Whether financial conditions tighten, and if so by how much, will also be key and these effects may go beyond ‘what their past link with uncertainty would imply. ‘Our macroeconomic forecasts ahead of the referendum (both for the UK and the rest of Europe) have been based on the (technical) assumption of a decision to remain in the EU. All these forecasts are now placed under review, while we wait for the dust created by the market fallout from the referendum result to settle. In previous analysis ahead of the referendum, we had estimated that the rise in ‘macro uncertainty associated with a Leave decision would reduce UK real GDP by 1- 2% over the next 12-18 months, leaving the UK economy flirting with recession. The growth impact on the Euro area would be around -0.5% over the next year. These: estimates (shown in Exhibit 1 for a one standard deviation rise in uncertainty) are sensitive to assumptions about the magnitude of the uncertainty created by the referendum outcome, and the nature and effectiveness of policy responses to it in the UK and the rest of Europe. Our expectation is therefore that the Leave vote in the referendum will weigh on activity and lead to a downward revision to growth, hrough normal trade linkages with the UK and the effects of other policy uncertaintios, the wider European outlook is also subject to being downgraded and placed under review. Exhibit: An uncertainty shock will weigh onthe outlook i) epertowe In addition to facing a weaker macro outlook, we expect Sterling to depreciate sharply. Our FX Strategists estimated that Sterling could weaken sharply, by around 10% (in trade-weighted terms} in a Lehman-type scenario over the coming months, although this too is sensitive to broader financial conditions. Weaker Sterling will push up on the inflation outlook, at least temnporarily, as will the adverse terms of trade shock (see Exhibit 2 and here). Relative to that benchmark, Sterling's fall today has not been unduly large. dune 2016 Page 4Goldman Sachs Exropean Economics Daly ise impor prices and scene ag gg Foot Tighter financial conditions could add to that weaker outlook, should financial conditions tighten by more than historical links with macro uncertainty would imply, and despite the policy announcements made by the BoE, ECB (and other major central banks]. The period of political uncertainty we now anticipate is likely to exacerbate this risk. ‘Which second-round political risks apply in the rest of the EU? We expect the rest of the EU to reaffirm its desire to make the EU, including the Euro area, more workable. Yet, given previous experience with imperfect follow-up to such statements (for example, completing banking union without an agreed deposit insurance scheme), itis doubtful whether this will have much credibility in financial markets. ‘The UK's exit from the EU comes on top of a subdued recovery in large parts of Europe, yet controversy in Germany over ECB activism to support that recovery, and ropean refugee crisis. These challenges expose political tensions within and between countries. Europe has not resolved the tension that exists between a need to integrate in order to underpin a more workable monetary union and its reluctance to relinquish national sovereignty. Euro-sceptic elements will be emboldened by the UK's decision to leave the EU. Given that tension, Europe's practical steps to signal “more Europe” will be limited, European assets that benefit from investors’ adopting a consolidated view of European assets — including peripheral bond yields and banks backed by weaker sovereigns ~ are likely to come under some additional pressure, albeit contained largely by ECB policies and other political commitments, dune 2016 Page 5Goldman Sachs Exropean Economics Daly Disclosure Appendix Reg AC |, Anctew Bente, hereby carily that al ofthe vews expressed in his topo acewatelyrlect my personal views, which have not heen influenced by ‘considerations ofthe fins business or can estionehps Unless otherwise stated, he individuals sted on te cover page ofthis roport are analysts in Goldman Sechs' Global Investment Research vison Disclosures Global product; distributing entities “Tae Gooal investment Aesearen Division of Goleman Sachs preduces and distbutes research sraducts for clients of Goldman Sachs on a global bass Analyte based in Goleman Saens afiens sound the word produce equity roeesreh an neues and companies, ane research on mmae"oeeonomie, urencies, commodites and portale sratgy Tris research s esarmneted in Austaa by Goldman Sache Australa Pry Ltd (ABN 21 008 797 897) 9 Bras by Goldman Sachs do BraslCoreto's do Tiulose Vaores Mobics SA; In Canaca by ether Gclaman Sachs Cenada In. o” Goleman, Sachs Co. in eng Kong by Gotaman Sachs IAs LLC. mica by Goldman Sachs (sla) Secures Private Les n Japan by Geldrman Sachs Japan Co [Lal n he Republe of Koren by Godman Sechs (isi) LLC. 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