UK: How strong is the Brexit impact?
A deeply-divided UK has made its choice; 51.9% of the electorate voted to leave the EU in a referendum held on 23 June. The vote will have both short- and long-term economic consequences. Investors will move swiftly to price uncertainty. The shock to equity and currency markets (GBP is expected to lose at least -10% this year) will impact private consumption and investment in Q3 and Q4. The risk of recession in H2 2016 is high. We expect GDP growth will slow more sharply in 2016, to +1% from +2.3% in 2015. In the longer term, economic activity will be impacted in a more profound way. A series of indicators, including GDP growth, exports and foreign investment may narrow, given uncertainties related to the outcome of negotiations with the EU. Company turnover and margins will also reflect the new reality, with an associated hike in the number of insolvencies (from 1,500 to 1,700 cases between 2017 and 2019). The official exit may occur in early 2019 but an extension of the two-year European procedure is not excluded. In a soft leave scenario, in which the UK signs a Free Trade Agreement (FTA) with the EU, real GDP growth could fall by -2.8pps between 2017 and 2019. In a hard leave scenario (no FTA) a -4.3pps cumulative shock could occur (see also our Economic Insight).
Global Economy: Market surprise, Central Bank support
The Brexit surprised financial markets and its initial impact was strong. The peak depreciation of the GBP was -10% (now -6.5%) and many financial stocks decreased by -20%. However, Central Bank support reassured somewhat. The BoE pledged to “provide more than GBP250bn of additional funds through its normal facilities” to the financial sector, if needed. Moreover, key world Central Banks (including the ECB and the BoJ) stand ready to activate their currency swap-lines and support liquidity, again where needed. The aggregate impact of the shock and policy support includes: (i) safe havens benefited strongly. The USD appreciated by +2% in effective terms, the JPY/USD appreciated by +3% and 10-year bond yields hit new lows in the U.S. (1.5%), Germany (-0.05%) and…in the UK (1.1%, -30 bps) and (ii) 10-year yields increased in “riskier” economies in the Euro Area, with Portugal (+30bps), Spain (+12bps) and Italy (+10bps), but these yields still remain below levels at end-2015.
U.S.: Fed on hold, manufacturing weak
At its June meeting, the Federal Reserve left the target range for its federal funds rate unchanged at 0.25% to 0.5%. Much of the accompanying information was dovish. In April only one Fed member forecast just one interest rate hike in 2016 and now six do. The lone dissenter - who wanted to raise rates in March and April - now agrees that conditions are too soft to do so. The official GDP forecast for 2016 was marked down to +2% from +2.2%, partly reflecting a slowing labour market and soft business investment. EH expects only one rate hike in 2016, at most. Manufacturing industrial production fell -0.4% m/m in May (-0.1% y/y), as 12 of 20 industries are now in contraction. Capacity utilisation fell -0.4pps to 74.8%, the lowest since February 2014. Meanwhile, inflation remains quiet, with CPI running at 1.1% y/y, while core CPI is at 2.2% and has been range bound between 2.1% and 2.3% for six months. PPI and core PPI are currently 0.0% and 1.2%, respectively. Housing starts fell -0.3% m/m in May (+9.5% y/y) while permits increased by +0.7% m/m (-10.1% y/y).
Brazil: Olympic shames?
With fewer than 50 days before the Olympic Games, host city Rio de Janeiro declared a “state of financial emergency”. According to Governor Francisco Dornelles, commitments have not been met because of the fall in tax revenues linked to the weaknesses in the oil sector. In recent months, the state has been unable to deliver some basic services, has delayed pensions and salary payments and closed some schools and hospitals. Moreover, a total of USD8.4mn in interest payments due to multilateral banks in May was missed. The Federal government authorised an emergency financial support of BRL2.9bn (USD850mn) for the city to finance latest infrastructure projects and security needs of the Olympics. The economy is in a poor state, with GDP contracting by -3.8% y/y in 2015 and -3.5% forecast for 2016, so this latest episode is a further dent in investor confidence. Moreover, political Telenovela continues, with major political scandals including Dilma Rousseff’s impeachment and numerous corruption investigations that Temer’s interim government is currently facing.