Political risks to the fore

Political uncertainty created by the UK’s vote to leave the EU will dampen already weak global economic activity and force policymakers to be more supportive, not only through monetary but especially fiscal means.

Downgrading growth forecasts
How was the world before the shock of the UK’s EU referendum?
For the second year running, the global economy started the year with a whimper rather than a bang. First-quarter global GDP growth was about 2.5% in annualised terms, well below our estimates for trend, leaving the global economy close to the weakest it has been since the 2011-12 Eurozone crisis.
Coincidentally, it is now Europe that is helping to hold up the global economy; the Eurozone grew at a 2.2% annualised pace in Q1, led by domestic demand, which was faster than Japan (1.9%), the UK (1.6%) and the US (0.8%). Across the large emerging markets, measured Indian growth improved to 9.2% annualised, though we have doubts about the veracity of the data, while the Chinese economy appears to have slowed to 4.4% annualised despite the recent rebound. Meanwhile, the Brazilian and Russian economies continued to contract, albeit at a slower pace. While global headline inflation dropped again, thanks to the precipitous decline in commodity prices, core inflation was under pressure.

Business confidence indicators suggest this subdued trend in global growth continued into Q2. The global purchasing managers’ index (PMI) produced by JP Morgan is about its lowest for three-and-a-half years. Subdued sentiment has been broadly based; the global manufacturing PMI is about the expansion/contraction level of 50 (see Chart 1), while the new orders component suggests stagnant industrial conditions ahead. The global services PMI is a little better at 51-52 but this is well below its long-term average. Within the developed and emerging world, particular areas of weakness include contractionary conditions in Japan, the substantial drop in the US non-manufacturing sector’s sentiment, and weaker manufacturing activity in East Asia.

Despite these subdued near-term growth signals, we had been confident that global activity would strengthen through 2016 into 2017 – and then the UK voted to leave the EU (see Chart 2). The main factors that have been weighing on US growth – declining energy investment, inventory destocking, tighter financial conditions and the stronger dollar – were expected to fade. Though China’s monetary policy is unsustainable over the longer term, the recent credit stimulus has helped activity, while Japan should benefit as the Abe administration has put off raising consumption taxes and is set to loosen fiscal policy.
There are also growing signs that the Brazilian and Russian recessions are drawing to a close, helped by a current account improvement.

The impact of Brexit
The EU referendum result requires a much more cautious outlook, especially in the UK but also the Eurozone. Close to 50% of UK trade is carried out with EU member states and 7% of UK employees are (non British) EU nationals. Moreover, the UK financial sector is heavily integrated with the rest of Europe, as are a huge range of professional services. With no clear template for a post-exit relationship with the EU, businesses with ties to the continent are likely to face uncertainty for at least two years during Article 50 negotiations and probably longer. This increases the risk that investment and hiring plans for those companies sensitive to EU trade will be shelved, which will rapidly pass through to connected sectors of the economy. Consumer sentiment will take a smaller hit in the first instance, although this is likely to increase as the shock feeds through to the labour market. Real incomes will also be squeezed as inflation responds to the much lower currency.
There will also be an increase in financial stress while credit conditions are likely to tighten – depending on the degree of policy action. We expect these effects to be powerful enough to provide a marked drag on activity.

The Bank of England (BoE) will need to be proactive against this recessionary backdrop. It has already added liquidity to support the banking system and we expect a rate cut of at least 25 basis points during the summer, most likely followed by the recommencement of asset purchases. The trajectory of fiscal policy is also likely to alter as fiscal tightening gives way to easing, initially via automatic stabilisers that allow for higher spending and eventually through structural measures.
The combination of looser fiscal and monetary policies should provide some support for the economy, although this is unlikely to offset completely the near-term shock.

The economic impact on the Eurozone will be less pronounced but still noticeable. We are especially conscious of the political ramifications in the wake of increased anti-EU/Eurozone sentiment across many member states. The Italians have their own referendum on constitutional matters in October, with potential implications for the Renzi administration, while France, Germany and the Netherlands all go to the polls in 2017. Like the BoE, the European Central Bank (ECB) has already injected liquidity into the Eurosystem and signalled its willingness to do more. Triggers for further action include severe stress in the banking sector, pronounced widening of peripheral bond spreads and signs of weaker growth in core economies.

Effects outside of the UK and Europe should be more moderate, although risks require central bank vigilance. The referendum result has sparked renewed stress in global financial markets (see Chart 3), through the appreciation of safe-haven currencies such as the yen and dollar, lower equity prices, especially for financials, wider corporate bond spreads and various pressures on emerging market assets. All this comes at a difficult time for the US Federal Reserve (Fed). After a period of surprisingly resilient US employment growth, the combination of poor corporate earnings and deteriorating credit availability meant employment growth in May was the slowest in more than six years. The unexpected softening in the labour market had already led the Fed to mothball plans to lift interest rates before September; Brexit and the associated increase in financial stress probably delays any tightening until 2017.

Where next for bond yields?
Even if the Fed is able to lift interest rates before the year is out, we remain very cautious about the outlook for long-term interest rates. Ten-year government bond yields have fallen to a four-year low in the US and to historic lows in the UK, Germany and Japan, with the Japanese yield curve trading negative all the way out to 15 years. US inflation expectations are lower than in March despite oil prices having increased by 15% since then.

Politics is one driver; the Brexit vote has reinforced investors’ broader concerns about political risks, strengthening the desire for safe-haven assets. Yields also continue to be ground down by the relentless flow of ECB and Bank of Japan bond purchase programmes; both central banks are purchasing more government bonds than their governments are issuing, and many of the institutions selling their bonds need to reinvest the proceeds into other markets with a positive yield.
In the US Treasury market, these factors have helped to push term premia – the premium bond owners require to take on long-term interest rate risk – deeply into negative territory.

Meanwhile, there is little evidence that the global saving glut that has been suppressing real interest rates is fading. Easy monetary conditions have been successful in limiting stress in financial markets, but not sufficient to trigger increases in desired private investment or persuade governments to launch large-scale infrastructure investment programmes. Investors may have become less worried about recession risks in recent months, but they are also yet to be convinced that growth and inflation will move much higher, or that markets and economies have become any less dependent on low interest rates.

The Fed also appears to be losing confidence in the economy’s ability to absorb high real interest rates. In June 2015, the median FOMC member was projecting a fed funds rate of 2.875% by end-2017, and a longer-run average of 3.75%.
This optimistic view was predicated on the expectation that the neutral real interest rate would recover from just above zero today to around 1.5% in the medium term. In June 2016, members’ end-2017 projections have dropped to 1.6% and their long-term projection to 3% – a hefty change in just 12 months.

The only realistic trigger for a meaningful lift in real interest rates is a shift in firms’ willingness to invest in productive capita, that in turn lifts productivity growth, corporate profits and real wages. There is little sign of that in the data, political uncertainty makes that less likely, and it is beyond the ability of central banks alone to deliver. What the world needs is a coordinated loosening of fiscal and monetary policy amidst widespread structural reforms designed to return productivity growth to historic norms. Economists have been recommending such action for some time but governments have yet to receive the message. We can only hope that global growth does not need to decelerate much further before political pressures force policymakers to listen.

Jeremy Lawson – Chief Economist – Standard Life Investments