Global economic growth appeared to be picking up at mid-year, as had been suggested by a rise in real narrow money expansion in late 2015. The view here is that the Brexit vote shock may delay but is unlikely to derail a further improvement in economic momentum during the second half. This view will be reassessed if narrow money trends weaken, which is not expected.
The suggestion of a mid-year pick-up is supported by industrial output data and business surveys. The six-month change in global (i.e. G7 plus emerging E7) industrial output appears to have risen to a seven-month high in May, based on available data. Manufacturing purchasing managers’ surveys for June reported increases in new orders indices in the US, Japan, Eurozone and UK. The sum of the import and export orders indices in the US ISM survey rose to a 14-month high, consistent with a recovery in global trade volumes – see first chart.
A pick-up had been signalled by a rise in global six-month real narrow money expansion in late 2015, with this signal confirmed in early 2016 by an upturn in a non-monetary leading indicator based on OECD country leading indicator data. Real money growth continued to rise during the first half, reaching its highest level since 2011 in May, suggesting strong second-half economic prospects – second chart.
As previously discussed, the global implications of expected post-Brexit-vote UK economic weakness are minor, even for the rest of Europe – the UK accounts for 2% of the IMF’s world GDP measure, while exports to the UK represent 3% of the GDP of the rest of the European Union. The concern is that the shock may trigger other negative developments resulting in a sustained “risk-off” move in markets that feeds back into weaker demand globally.
The market response to date has been reassuring, with “safe” government bond yields down sharply but equity market indices and credit spreads broadly stable – expectations of easier monetary policy, in other words, have prevented an investor shift towards economic pessimism.
The fall in yields, unless reversed, is likely to be reflected in further reductions in bank deposit and lending rates, suggesting that monetary trends are more likely to strengthen than weaken as a result of the shock.
The annual change in an average of G7 short-term rates and 10-year government yields is an inverse long leading indicator of economic growth. The current average is 40 basis points lower than a year ago, representing a significant turnaround from a small annual rise in December / January – third chart.
A possible analogy is the aftermath of the 1987 stock market crash, which damaged business confidence and led many economists to predict a recession. It occurred, however, against a backdrop of an improving economy and a post-crash drop in interest rates provided further stimulus, resulting in stronger-than-expected growth in 1988.
Global business surveys for July are quite likely to show a knee-jerk negative response to the Brexit vote shock. The focus here, instead, will be on whether recent strong narrow money trends start to reverse. An initial assessment will be possible in late August following release of July monetary data for the major economies.
Data this week confirm that the UK economy was growing solidly before the EU referendum, in line with the positive assessment in previous posts here but contrary to consensus gloom.
Revised figures show that GDP grew by 0.45% in the first quarter, up from a previous estimate of 0.36%. The consensus had expected a sharp slowdown, or even stagnation, in the second quarter. Output of the key services sector, however, increased significantly in April (as had been suggested by turnover data), to stand 0.5% above its first-quarter average.
With previously-released data showing large gains in industrial and construction output, April GDP is estimated to have grown by 0.6% from its first-quarter level.
The April numbers were probably flattered by the early timing of Easter, suggesting a relapse in May / June. On current evidence, however, the first estimate of second-quarter GDP growth to be released on 27 July is unlikely to be less than 0.4%.
The Markit manufacturing purchasing managers’ survey for June, meanwhile, was upbeat, with the forward-looking new orders component at its strongest level since October.
UK corporate money trends have weakened since late 2015, consistent with companies putting expansion plans on hold pending the result of last week's referendum.
Corporate money (i.e. held by private non-financial corporations, or PNFCs) will be a key indicator for assessing whether the referendum shock will push the economy into a recession. Corporate money leads business investment and overall activity, probably because companies adjust their liquidity position to reflect their spending / hiring plans. Real (i.e. inflation-adjusted) corporate money contracted before the 1979-81, 1990-91 and 2008-09 recessions, as well as the 2011-12 “double-dip” slowdown.
The first chart shows six-month growth rates of real corporate narrow money M1 and broad money M4, along with the two-quarter change in GDP*. Both measures were strong last autumn, consistent with recent “hard” data suggesting solid GDP expansion during the first half of 2016, allowing for a typical nine-month lead from money to activity.
The six-month change in real corporate M1, however, has fallen significantly since February, while that of real M4 has turned slightly negative. M1 is preferred here for forecasting purposes: it is closer to the concept of "transactions money" and appears to work better empirically. An example of the superior performance of real M1 was its mild contraction before the 2011-12 slowdown; a much larger fall in real M4 seemed to predict a recession. The recent decline in real M1 growth suggests that companies were planning for slower expansion but not a fall in activity before the referendum.
Weakening corporate money growth contrasts with strengthening household trends. Six-month growth of household real M1 and M4 rose to 15- and nine-year highs respectively in May, suggesting solid near-term consumer spending prospects – see second chart. Household income and money growth, however, may slow as companies curb expansion plans and hiring. Corporate money often leads household trends: corporate real M1 contracted before household real M1 ahead of the 2008-09 recession.
The base-case assumption here is that increased uncertainty due to the referendum shock will subtract 1.0-1.5 percentage points from GDP growth over the next 12 months, implying a significant slowdown rather than a recession. This view will be revised negatively if corporate real M1 contracts over coming months.
*M1 = notes / coin + sterling sight deposits. M4 = M1 + sterling time deposits, short-term bank bonds and repos.
The EU referendum result will have a negative impact on UK economic prospects but there is little basis, at present, for assessing the magnitude of the effect.
The negative impact will occur through two key channels: an uncertainty effect on business investment and hiring, and a possible tightening of financial conditions.
The uncertainty effect alone is probably insufficient to trigger a recession. GDP was judged here to be growing at a rate of about 2.25% per annum before the shock, based on monetary trends and the most recent “hard” data. A 10% cut in private investment over the next 12 months relative to previous plans – possibly an aggressive assumption – would subtract 1.4 percentage points from GDP growth, i.e. insufficient to push the economy into contraction.
Financial conditions could tighten significantly but have yet to do so. Corporate bond spreads remain contained – see first chart – and equities have yet to breach their February low in sterling terms. The Bank of England, moreover, is likely to deliver a precautionary easing move by August. The exchange rate has so far taken the strain of the referendum result, with the sterling-US dollar rate falling to the mid-1.30s for the third time in 15 years – second chart.
Assuming no significant change in financial conditions, a reasonable base case is that GDP growth over the next 12 months will be 1.0-1.5 percentage points lower than otherwise. So, for example, 2017 growth could be 1% instead of 2.25%.
The approach here will be to adjust this base case forecast depending on corporate money trends, which should give early warning of any major retrenchment. Corporate real narrow money M1 has contracted before recessions historically, also weakening before the 2011-12 slowdown – third chart. Six-month growth fell in April, possibly reflecting pre-referendum caution; May data will be released on Wednesday.
The direct spillover effect of UK economic weakness on the rest of the European Union will be minor: exports to the UK account for only 3% of rest of EU GDP. The much bigger risk, again, is financial contagion. Monetary trends, as in the UK, were giving a positive signal for economic prospects before the shock: real non-financial M1 growth, and its corporate component, remained strong in May – fourth chart.
Recent data are consistent with the view here that US / Chinese economic growth is picking up at mid-year; the latest quarterly PBoC survey of enterprises, for example, reports an improved assessment of orders – fifth chart. The direct global impact of weaker UK / European prospects will be small and offset by looser central bank policies. A constructive assessment will be maintained barring a reversal of recent global narrow money strength.
The UK electorate voted by a 52%-48% margin to leave the European Union, with remain leads in London, Scotland and Northern Ireland outweighed by leave victories in the rest of England and Wales. This has prompted the resignation of Prime Minister David Cameron, who will be replaced by a new Conservative leader by October, but there is no plan to hold a general election. The surprise result triggered a collapse in the pound and a violent risk-off move in global markets.
The UK and the rest of the Europe now enter a period of great political uncertainty but there is unlikely to be any change to the UK's economic and financial arrangements with the EU before late 2018. The exit procedure is governed by Article 50 of the Lisbon Treaty, which allows for a two-year period for a country to negotiate terms of departure. The new Prime Minister is expected to trigger Article 50 soon after assuming office.
The rise in political and economic uncertainty will act as a drag on growth, primarily by discouraging business investment and hiring. The Treasury predicted that that the economy would enter a recession in event of a Brexit. We do not share this view because 1) recent data indicate that the economy had solid momentum before the referendum, 2) the Bank of England is likely to cut interest rates on any signs of weakness and 3) the lower level of the pound should stimulate net trade (although higher import prices will dampen consumer spending).
The UK decision will encourage anti-EU politicians in other countries but we judge it unlikely that it will trigger copycat referenda, let alone the exit of another member state. It may, indeed, cause Eurozone countries to press on with deeper economic and political integration. The EU leadership is likely to pursue a tough line in negotiations with the UK to deter other countries from considering an exit, particularly in view of French and German elections due in 2017.
The UK accounts for 2.3% of global GDP measured at “purchasing power parity”, with the current EU as a whole at 16.7%. The direct global implications of any uncertainty-related slowdown in UK / European growth are minor. The bigger risk is that the Brexit shock leads to a sustained risk-off episode in markets that feeds back into weaker demand. This is not our central scenario because: 1) the US and Chinese economies appear to be regaining momentum, with monetary trends and leading indicators suggesting solid second-half prospects; 2) global liquidity remains plentiful, as evidenced by a large positive gap between real money and output growth; and 3) the Fed and other central banks are likely to ease policies in the event of significant market weakness.