Macro View: The belief that everything is back to normal is wishful thinking

AFTER the initial shock reaction to Britain’s Brexit decision, the stock markets staged an impressive rally. The US S&P 500, the UK FTSE 100 and Japan’s Nikkei 225 are now well above their pre-referendum levels. The German and French main indices are still marginally lower than on 23 June, but have also recorded strong gains in recent weeks.

Superficially, the global economy and the financial markets have returned to normality. A major blow that many have feared may prove irreparable, and may even trigger a new recession, has so far left very few permanent scars. But the abrupt swing – from gloom and despondency after the Brexit result became known, to a mood of complacency now – is premature and deceptive. Risks of an imminent recession have lessened; but growth forecasts have been downgraded, both in the UK and globally. The belief that everything is back to normal is wishful thinking.

The markets are still addicted to ultra low interest rates and to injections of huge quantities of cheap money by the central banks. In many important respects, the markets’ dependence on life support provided by the central bank has increased further since the referendum. Deposit rates and short term bond yields are still in negative territory in the eurozone and Japan, even though negative interest rates weaken the banking sector and threaten economic recoveries. There has also been talk of “helicopter money”, although this has not yet been tried. The UK and Japan will ease policy further in the next few months. In the US, in spite of improved economic data, the Federal Reserve is likely to delay any tightening at least until the final months of 2016.

Risk of a downturn

In Britain, sterling stabilised at a level more than 10% lower against the US dollar than on 23 June. But there is too much gloom about the real UK economy; this is often fuelled by “remain” supporters that are keen to justify their dire predictions before the vote. Governor Mark Carney’s pessimism about the economy was not shared by the regular report of the Bank of England’s own agents, which showed surprising resilience among UK businesses. New labour market figures, with multi-year records of high employment and low unemployment, indicate that the UK economy was stronger before the referendum than was previously thought.

The evidence is contradictory. Initial findings show a steep fall in the purchasing managers’ index for July, but anecdotal evidence from retailers show a more positive picture. The situation will remain unsettled for some time. The risk of a downturn cannot be shrugged off, but a new recession is unlikely. The most plausible scenario is a period of weak, below-par UK growth, until the implications of Brexit become clearer. Contrary to expectations that were fuelled by Carney’s comments, which signalled a cut in rates, the Monetary Policy Committee left rates unchanged at its July meeting. However, the markets believe that a base rate cut of at least 25 basis points is likely after the August MPC meeting, when the Bank of England will publish its Quarterly Inflation Report with a new comprehensive economic forecast.

The most dramatic and significant consequences of the Brexit vote have been on the UK political front. The departure of David Cameron and his replacement by Theresa May has been swifter than anybody imagined. The new prime minister has displayed political ruthlessness. Senior ministers such as George Osborne and Michel Gove were sacked. The new government is made up of many new ministers known for their loyalty to Mrs. May, and a few senior leaders of the Leave campaign (David Davis, Boris Johnson & Liam Fox). Formulating an agreed strategy in the forthcoming Brexit negotiations will be a test of Mrs. May’s political skills. She will have to bridge tensions between “hard Brexiteers”, who refuse to concede any element of post-Brexit free movement, and those willing to make compromises in this area, so as to gain greater access to the single market.

Active fiscal policy

Phillip Hammond, the new chancellor, confirmed that he is no longer committed to achieving a budgetary surplus by 2020, although moving to a surplus remains a longer term aim. Mr Hammond left open the option resetting fiscal policy in his next Autumn Statement. This implies that, if growth prospects worsen markedly, the government will try to sustain activity by adopting a more active fiscal policy, with a combination of spending increases and tax cuts.

Our full-year UK GDP forecasts are 1.5%t for 2016 & 1.3% for 2017; these figures are lower than before the Brexit vote, particularly for next year; but the downgrading is less severe than was feared. We expect zero GDP growth in the third quarter of 2016, as the Brexit vote increases uncertainty; but positive growth will then return, though the pace of expansion will initially be weak and below trend. We expect the MPC to cut base rate to zero before the end of 2016, and then to start edging rates up gently in the middle of 2017. UK fiscal policy will become a little more accommodating, but there will be no spending splurge. The UK cannot afford to take too many risks with its credit rating.

Eurozone growth prospects

In the eurozone, growth prospects have also worsened since the Brexit referendum. The immediate impact was less severe than in the UK, but the pace of eurozone expansion is still likely to be slightly weaker than in the UK next year: in full-year terms, we expect GDP growth of 1.5% in 2016 and 1.2% in 2017.  Although eurozone inflation is only 0.1%, well below the official target, the European Central Bank decided not to inject additional stimulus at its July meeting. The ECB held its main interest rate at 0.0% and its deposit facility rate at -0.4%.

However, ECB president Mario Draghi made it clear that the European Central Bank was ready to take additional measures, should it become clear that extra support is required to raise inflation towards its target of “just under 2%”. In Japan, with inflation likely to remain well below target, and with hopes of faster growth fading, there are widespread expectations that the central bank will expand its already huge monetary stimulus programme, in a further effort to hit its 2 percent price objective.

Stronger tone, new uncertainties

The US economy continues to outperform Europe and Japan, and the dollar rose to a four-month high on a trade-weighted basis. The “flash” survey of purchasing managers rose to its highest level in a year, exceeding expectations. The US labour market created 287,000 jobs in June, rebounding strongly from disappointing figures in April and May. The unemployment rate, which is derived from a different data set, rose from 4.7% to 4.9%; this was mainly due to an increase in the number of people looking for work, due to greater confidence that job prospects may be improving.

The stronger tone of the US economic data has generated new uncertainties about the timing of the next move by the Fed. Heightened global turmoil after the Brexit vote led many to believe that the Fed may delay any tightening until 2017. But the more recent recovery in share prices, and stronger US economic data, has prompted a shift in opinion. It now seems more likely that the Fed will raise rates once before the end of 2016.

David Kern of Kern Consulting was chief economist at the British Chambers of Commerce between 2002 and 2016. He was group chief economist at NatWest between 1983 and 2000.