#MacroMemo: June 27 – July 1, 2016

This week we have a Brexit-filled #MacroMemo focusing on its outcome, impact, risks and the prospects on global growth.

Brexit outcome:

• In sharp contrast to complacent market expectations, British voters opted out of the European Union with a 51.9% squeaker of a vote.
• It is probably worth acknowledging that a Brexit vote is not binding on the British government. The actual likelihood of the U.K. leaving the EU is probably more like 75%, even after this vote. One reason for this remaining uncertainty is that another election seems quite possible since the majority of U.K. parliamentarians do not support Brexit and given the compromised positions of the Conservative and Labour leaders. This could conceivably allow voters to express a different sentiment. Alternately, negotiations with the EU could yield a sufficiently unattractive prospective deal that the U.K. changes its mind; or the EU could offer to improve the terms of the U.K.’s current relationship and eliminate the need for an exit. One must not forget that Greece dodged a seemingly unavoidable post-referendum bullet just last summer.
• For now, however, we must assume that Brexit proceeds.

 Brexit impact:

• Financial markets are reeling from Brexit, with an 11% decline in the pound, a 43bps drop in the U.K. 10-year yield and a 6% swoon in the value of British stocks.
• This initial market reaction is unsurprising. The pound may yet fall further and British yields should remain very low as the Bank of England delivers monetary stimulus. The stock market reaction may eventually prove overblown given that the theoretical long-term economic damage from Brexit is just 2% of U.K. GDP. But, for now, the 60% prospect (our estimate) of a shallow near-term U.K. recession should limit the extent of any immediate rebound.
• The transmission of British economic weakness to the rest of the world via trade channels should be limited.

 Brexit risks:

• The main Brexit risks come from transmission via financial conditions (near term) and political developments (long term).
• So far, financial conditions have not deteriorated too badly. In particular, credit spreads have widened out by much less than feared. So long as this remains the case, serious damage to the rest of the world should be avoided over the short run. To illustrate, the widening of high-yield and emerging market credit spreads was far greater at the end of 2015 and into early 2016 than it has been post-Brexit.
• The increase in political risk, on the other hand, is harder to dismiss. Brexit acts partly as a signal of and partly as a catalyst for additional political challenges elsewhere in the world. The likelihood of a non-centrist U.S. presidency may accordingly be higher than currently assessed by betting markets. Similarly, the risk of other European countries opting out of the EU has also gone up. Cyprus currently sports the most negative view of the EU, while Italy is a prominent example of a handful of countries in which the majority of the population does not see a net benefit to EU membership. Interestingly, Greece, Spain and Portugal are all firmly pro-EU. Any action to break apart the single currency Eurozone would be substantially more problematic than the U.K.’s proposed EU exit.

 Brexit on global growth:

• Globally, the prospect of better growth over the second half of 2016 and into 2017 now appears much less certain. Not only has policy uncertainty failed to vanish post-Brexit vote, but it has gotten worse. And financial conditions – while materially better than at the beginning of the year – are nevertheless now again deteriorating. In short, we should budget for a continuation of unusually slow economic growth. Providing a proxy for the level of global risk, we figure the U.S. recession risk for the next year has edged up from 25% to between 30% and 35%.

 Spanish election:

• For all of our talk about rising political risks in an era of “Brexit”, let us acknowledge that this is merely a probabilistic statement. Not every outcome will align to this mold.
• For instance, last weekend’s Spanish election went better than expected, and looks likely to permit the formation of a new government – a welcome contrast to the country’s state of limbo since its last election six months ago.
• The centre-right PP managed to win the election with more votes than expected and the centre-left PSOE met expectations. Far left Podemos, an upstart anti-establishment party, underperformed expectations and landed in third place. A minority centre-right/centre-left government is thus likely and should prove a reasonably steady hand.
• Other political risks beckon, including an Italian referendum on Senate reform in October that is viewed by some as a proxy vote on the country’s centrist government, the U.S. presidential election, and French and German elections in 2017.

 ISM Manufacturing preview:

• The U.S. ISM Manufacturing index is always closely watched given its status as among the more timely and useful leading indicators in the world.
• Our forecasting model takes inspiration from a handful of improved regional PMIs to project a 52.3 reading in June – a one point improvement from May.
• This would be a welcome development after the grim Brexit news, though we remain underwhelmed by the broader economic environment and continue to fret about such indicators as declining corporate earnings, shrinking global trade, a fall in the level of temporary employment, a lack of significant remaining economic slack and the advanced age of the current expansion.

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