From Brexit to Stagflation?

From Brexit to Stagflation?

Many of those who voted “Leave” on Thursday reportedly already regret it, either because they didn’t really expect to prevail and merely wanted to register a protest vote, or because of the sharp sell-off in financial markets and the mushrooming forecasts of recession, or be it because, judged by the initial reactions in Scotland and Northern Ireland (which both voted “Remain”), Brexit could well turn the United Kingdom into the Kingdom of England and Wales – quite the opposite of making Britain great again.

Now the big question: What is the likely economic fallout from the Brexit vote on the rest of the world over both the cyclical (six-to-12-month) and the secular (three-to-five-year) horizons?

As we see it, the impact on global growth and inflation on the cyclical horizon is likely to be relatively small – and almost certainly not large enough to push the global economy into recession. Even if the UK fell into a recession, which is a distinct possibility, the direct knock-on effect on global GDP through lower UK import demand would be minimal as the UK accounts for only 3.6% of global imports of merchandize goods and 4.1% of global imports of commercial services. In addition to the direct trade effect, business investment around the globe is likely to be dampened somewhat due to the heightened uncertainty about the global implications of Brexit and the tightening of financial conditions. If in doubt, companies will delay investment projects to assess how Brexit could affect them. The trade and investment effects combined could lower the trajectory for global growth slightly in the next couple of quarters but not by enough to cause a recession. For the eurozone, which would obviously be most affected by Brexit after the UK, Nicola Mai estimates a negative impact on GDP of around 0.3% here. The effect on the U.S. and other regions would likely be smaller.

However, we are closely watching three related swing factors that could lead to a larger negative impact on the global economy over the next six to 12 months: the dollar, China and central bank action. First, a significant further strengthening of the dollar in response to global risk aversion would be a problem not only for U.S. growth prospects but also for all the dollar debtors in emerging markets, and could also push commodity prices lower – we all watched that movie last year. Second, China might react yet again to dollar strength by allowing a more rapid depreciation of its currency against the greenback, which could intensify global growth and deflation concerns.

Third, an important reason why we expect the short-term hit to global confidence and growth from Brexit to be limited is that we anticipate further action by virtually all major central banks to limit the potential damage. We expect the Bank of England to cut its official interest rate from 0.5% to zero relatively soon and, if more is needed, to restart quantitative easing (see Mike Amey’s analysis here). Our European team already put a 50:50 chance on additional European Central Bank easing before Brexit, and the probability has certainly not decreased with the vote. Our Tokyo team expects more Bank of Japan easing at the next policy meeting on 29 July and sees a high probability of currency intervention to weaken the yen in the near future. And in the U.S., a July hike is now completely off the table, September is not impossible but a low probability because the dust from Brexit may not have settled yet and the U.S. presidential race will be in full swing, and even a December hike looks increasingly questionable at this stage.

Finally, what about the longer-term implications of the Brexit vote? Does a British vote to withdraw from the EU inform us about the willingness of electorates in other countries, including the U.S., to be lured by populist promises? True, there is the chance (or hope) that a bad experience in Britain with Brexit might make voters elsewhere think twice. However, as I see it, the vote in the UK is part of a wider, more global, backlash against the establishment, rising inequality and globalization. Even if populist, separatist and nationalist parties don’t come to power, the Brexit shock is likely to intensify the pressure on current and future mainstream governments to address inequality, become more protectionist and limit migration. This underlines our secular theme of rising political risks and “insecure stability” – see our Secular Outlook here.

What could this mean for the longer-term global economic outlook? Most importantly, investors will have to factor in a higher chance of a stagflationary outcome over the next three to five years: even lower growth or near-stagnation coupled with a significant rise in inflation. This would likely come to pass if current or future governments turn more protectionist by erecting barriers to trade and migration, and take up or intensify the battle against inequality by redistributing income (through taxation and regulation) from capital to labor. This could lower potential growth even further and would likely lead to higher wage and inflation pressures. If this scenario came to pass, both risk assets and nominal bonds would fare badly – remember the 1970s?  However, in contrast to the ‘70s, investors now have an instrument at their disposal that didn’t exist back then: inflation-linked securities, which would benefit both from lower real interest rates resulting from lower economic growth and from rising inflation.



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