Will Brexit Really Upset the Global Economy?

Will Brexit Really Upset the Global Economy?

Japan and America are getting nervous.

In the wake of Brexit, there is a certain sense that the world is falling apart. But is it? Certainly, Britain and the European Union are reeling from the fallout, and the reaction from the financial market was swift. But how it will ultimately affect the UK and EU economies has yet to be seen; most of the effects have yet to be felt. After all, the breakup process is designed to take two years. And there should no illusions that the EU is going to treat the UK well in the negotiations.

When Greece and Cyprus were in negotiations with the EU, the EU sent a clear and distinct message that bad behavior would not be tolerated, and dared anyone to walk a similar path. The inclination for observers should be that negotiations with the UK will be conducted in a similar manner: to reinforce the notion that leaving is painful and undesirable. To this point, EU leaders have already stated that the UK will not be given any special treatment.

This animosity will play out in media headlines over the next two or so years as a deal is being constructed. This risk is the essence of the Fed’s “global uncertainty” pseudo-mandate. Not only will Brexit keep the Fed from moving rates higher, it may have entirely done away with the monetary tightening cycle in the United States—at the very least, rate hikes are off the table in 2016. In the United States, markets now believe the Fed is more likely to cut interest rates during the next five meetings than hike them. Similar sentiment is seen around policy decisions for the European Central Bank, and the Bank of England is expected to begin cutting rates at its next meeting in July.

Given the drawn out timeline for negotiating the departure, the Fed’s game plan is likely to involve most of the tools it has spent the last several years developing (and arguably ruining). The first and most prominent will be the use of forward guidance, followed by taking the balance sheet off the table, and possibly a shift in how its balance sheet is constructed, similar to “Operation Twist.” The Fed will be loath to lower interest rates, and—given how low rates already are—the impact would be minute.

At any rate, the Fed is done increasing rates for the foreseeable future (likely moving from tightening policy to loosening it), and this has kept the U.S. dollar relatively tame in the aftermath. An inactive Fed should keep pressure on yields on the long end of the curve as the Fed steps back and central banks step in after the decision.

Globally, the expectation is for generally slower economic growth. Not surprisingly, Britain took the greatest blow, and is now forecast to be in a recession by the winter of 2016 or early 2017. However, inflation in the UK is expected to accelerate toward the Bank of England’s 2 percent target. This—a recession with inflation—is the definition of stagflation, a highly negative outcome for any country, but especially poor for a country with little political leadership.

Outside of the UK, the EU economy is projected to decelerate as uncertainty sets in. Japan will be one of the most affected, due to the strengthening of the yen. The United States is largely insulated from the direct consequences of Brexit, since the economy is not reliant on exports. However, unforeseen spill-over effects from the global banking system are still a tail risk. Revisions to the U.S. economy have been marginal in comparison to many others, only taking 0.1 to 0.2 percent from growth.

As mentioned above, the strengthening of the yen—a member of the so-called “flight to safety” trade—is causing economists to downgrade Japan’s economic growth prospects. But it is not the currency to surge in value. The U.S. dollar jumped as the outcome became apparent, but thus far has yet to exceed the highs seen earlier in June. This should limit the extent of any potential negative consequences.

In the medium term, the almost 13 percent fall (so far) for the British pound may have the most profound and lasting consequences. Why? Because at the moment the pound remains a reserve currency. But the ramifications of the plummeting value, combined with the departure from the EU, could cause the pound to lose its reserve status—if not officially, then in practice. While the British pound has long since conceded dominance to the U.S. dollar, it remained a preferred currency. There remain benefits to being a reserve currency, and it will take time for central banks to adjust to the new reality.

So far, the spillover effects have been relatively well contained. But there are a few wild cards that could cause further problems. A significant depreciation in the Chinese yuan could cause Brexit consequences to spread quickly in a similar manner to what occurred last summer. Though the yuan has weakened, a shock has not materialized thus far. A persistent weakening of the yuan is the path of least resistance for problems to spill over to the U.S. economy in a meaningful manner. At the moment, the U.S. and global economies can ill afford a renewed yuan shock.

The combination of a stronger dollar and the prospect of slower global growth is already having an effect on the price of oil. Stably higher oil prices were benefitting global growth and inflation, as well as inflation expectations. A further fall in oil prices would pressure developing-economy growth and lower developed-world inflation. Given the strained and stretched position of many central banks, a prominent headwind to inflation would make achieving mandates even more difficult.

Brexit was certainly an unexpected development, and its consequences are going to reverberate for the foreseeable future. There is always something unseen, and something will come out of Brexit that no one expected. The next two years will be filled with headlines surrounding the negotiations to leave, and this bodes ill for both the EU and the UK. Breaking up is never easy, and this will be no exception.

Samuel Rines is the Senior Economist and Portfolio Strategist with Avalon Advisors in Houston, TX​.

Image: British pounds and euros/Pixabay (public domain).