July European Issue Focus




Brexit vote catches markets out…

The UK Brexit vote sparked a sharp sell-off in global financial markets: world stocks fell around 7.0 per cent from June 23 to 27, before paring back those losses in the following days. But what is the likely fallout for the global real economy?

In our view, the initial market losses were overdone and hard to understand in the context of likely changes in the economic situation within the UK. The UK accounts for around 3.5 per cent of world output, and our estimates across various scenarios suggest an average impact of Brexit on the long-term level of UK GDP of around -2.0 per cent. With liberal policy settings, the loss of GDP could be only 1.0 per cent.

…but not a ‘Lehman moment’

We expect UK growth to be considerably lower in the short term as a result of the Brexit vote. We now expect UK GDP to rise 1.1 per cent in 2017 and 1.4 per cent in 2018, down from previous forecasts of 2.2-2.3 per cent for these years. This reflects in large part a negative ‘confidence shock’, offset to some extent by a weaker currency and looser monetary and fiscal policy.

However, we think the global ripples from the UK Brexit vote will be small. We expect Eurozone growth to be weaker by 0.2 percentage points per year in 2017-18, at 1.5 per cent per year. We also expect Japanese growth to be 0.2 percentage points lower next year at 0.3 per cent, the result of strong recent gains in the yen driven by increased global risk aversion. These are the main losers.

Meanwhile, in the U.S. we now expect only one rate hike by the Fed this year, and this cautious monetary policy approach means little change in our U.S. growth forecasts post-Brexit. We also have no change in China and even some upgrades in emerging market countries, reflecting recently firmer commodity prices.

Overall, our world growth forecast is unchanged this year at 2.3 per cent, with the forecasts down 0.1 percentage points in 2017, and 2018 at 2.6 per cent and 2.8 per cent, respectively.

In our view, the financial market reaction to the UK vote is not a ‘Lehman Brothers moment’ as some observers have suggested. World stocks fell only 2.5 per cent between June 23 and July 8, and key financial market stress indicators, such as the VIX index, are not showing danger signals (see Chart 1). Perhaps more striking has been the reaction of government bond markets: core yields have dropped very sharply in the U.S., UK and Eurozone.

The drop in bond yields suggests investor concerns about global growth, and the balance of risks to our new forecasts is skewed to the downside. One risk is that recent events cause a big drop in global consumer and business confidence. We would caution, however, that the extent of such effects is often exaggerated. The financial market decline at the start of this year was more intense than the post-Brexit vote one, with global stocks down 12.0 per cent at one point. Yet the effect on key survey indicators in the major economies was quite modest compared to 2008-09 or 2011-12 (see Chart 2).

We also think that the UK Brexit vote may have focused investors’ minds on other, pre-existing, weaknesses in the global economy. These include:

Slow global (trend?) growth: World growth has been disappointing in recent years, and even before the vote, our forecast was for a very subdued global expansion this year of just 2.3 per cent. Growth has been especially disappointing in the U.S. and emerging markets.

Eurozone fragility: The recent cyclical upswing in the Eurozone has been encouraging, but may have masked considerable structural problems. Despite GDP growth in 2015 of 1.6 per cent, the level of Eurozone GDP has barely risen since 2007. Moreover, financial vulnerabilities remain, such as the problem with bad loans in Italy, which make up some 18.0 per cent of loans, amounting to €360 billion.

Markets also appear to have interpreted the UK Brexit vote as meaning a quite high risk of financial instability in the EU, involving issues, such as the integrity of the EU and of the euro and sovereign debt restructuring. These fears look overdone to us, but the fact that they have surfaced does suggest underlying problems, such as slow progress in bolstering the euro through institutional reform, still-high debt levels as well as imbalances, such as the massive German current account surplus.

Tightening financial conditions: Global financial conditions have been tightening for some time. The recent stock market losses continue a negative trend that has been visible since mid-2015, and represent the second abrupt sell-off this year. This negative trend has arguably already been restraining world growth.

Other indicators have also been worrying. Bank credit standards for corporates in emerging markets and the U.S. have been tightening for several quarters. High-yield corporate bond spreads have also widened significantly over the last year, and global banking stocks have been on a steep slide since last June, with the MSCI index down 30.0 per cent from its peak (see Chart 3).

Overvalued stock markets: Global corporate earnings performance has been poor in recent quarters, and this ‘earnings recession’ has posed downside risks to equity markets for some time. Markets may well have been poised for a sell-off even before the UK Brexit vote, with the vote being the catalyst rather than the cause.

China devaluation fears: The market volatility in January and February resulted in part from concerns that China was planning a large currency depreciation, which could create fresh global deflationary impulses.

These fears had subsided somewhat recently, but with the dollar gaining a renewed ‘safe haven’ bid in recent days, the danger of China moving the RMB significantly down against the dollar has risen again; the CNY/$ rate weakened 1.6 per cent between June 23 and July 8.

Policy errors: Arguably, policy settings look inappropriate in some countries. G20 fiscal policy is set to tighten next year, which makes little sense in the context of sluggish world growth. Meanwhile, negative interest rate policies have had an ambiguous economic impact, flattening yield curves but damaging banks.

Given the existence of these global weaknesses, there is a significant risk that world growth slips below 2.0 per cent this year or early next: on a quarterly annualised basis world growth could drop towards the post-global financial crisis low of 1.6 per cent seen in Q4 2012 (see Chart 4). This would imply world GDP per head growing less than 1.0 per cent; not quite recession territory, but it might feel like it.

This update was researched and written by Oxford Economic Forecasting Ltd., 121 St. Aldates, Oxford, OX1 1HB, England, as of 8 July 2016.