Fear and uncertainty gripped global markets on Friday following the UK referendum vote to leave the European Union. The political turmoil in the UK and the initial uncertain response by EU leaders over the weekend were felt on Monday as sterling plummeted and international markets took a hit. But on Tuesday, Wall St rallied, leaving some to wonder whether the worst of the Brexit might be over, at least in the near term.
The Cipher Brief asked Ryan Sweet, the Director of Real-Time Economics at Moody’s Analytics for his view on the impact of Brexit on U.S. economic stability.
The Cipher Brief: Do the U.S. Markets Tuesday show that volatility over Brexit is subsiding?
Ryan Sweet: It is too early to tell. The most optimistic scenario is that markets have realized that the outcome of the U.K. referendum will have isolated economic consequences. The U.K. economy will experience a moderate recession and growth in Europe will be weaker now than if the U.K. remained in the European Union. The impact on the U.S. economy will be small, assuming financial market conditions don’t tighten significantly.
However, investors are a fickle bunch and will sell for lots of reasons that may or may not be linked to what is going on in the broader economy. Therefore, time will tell if Tuesday’s calm in markets is the beginning of the end of the angst following the U.K. referendum or just a reprieve.
So far, the tightening of financial conditions has been orderly, with few signs that market functioning has deteriorated or that financial intermediaries are significantly strained. Conditions can change quickly. For now, the economy is dodging a bullet, but we would have to revisit our forecast if financial conditions tighten significantly, or there is evidence of systemic risk.
The economy already has weathered a number of bouts of sudden tightening in financial market conditions during the current expansion. Each round of financial market angst differs from others because of its catalyst and each occurred at a different point in the economic expansion. Still, the economy’s ability to weather past tightening in financial markets should boost confidence that the current strains need not do significant harm.
TCB: What does it mean for the U.S. dollar and U.S. trade?
RS: The U.S. dollar will likely appreciate vis-à-vis the pound and euro given the flight to safety. The longer the angst in financial markets lasts, the larger the appreciation in the dollar. Further appreciation in the dollar will weigh on net U.S. exports and manufacturing, and is disinflationary because of reduced import prices and lower global oil prices. The disinflationary effects could have implications for the Fed, since a persistent and noticeable appreciation in the dollar will slow inflation’s return to policymakers' two percent target.
In our baseline, we assumed the pound would depreciate vis-à-vis the dollar this year while appreciating in the low single digits in 2017, 2018 ,and 2019. Under all three of our Brexit scenarios, the pound depreciates noticeably vis-à-vis the dollar, but the biggest declines occur once the U.K. actually separates from the EU, which could take a couple of years.
The direct impact on trade should be modest. The U.K. accounts for only four percent of total U.S. goods exports, and net exports are only 13 percent of U.S. GDP. The British pound will depreciate vis-à-vis the U.S. dollar, making our goods and services more expensive. However, the hit to our goods exports shouldn’t have a significant effect on U.S. GDP. For perspective, if U.S. exports to the U.K. were cut in half, it would shave only 0.1 of a percentage point off GDP growth.
TCB: In the run-up to the vote, Moody’s found through its weekly business survey that confidence has been trending lower. Is that uncertainty increasing now that the referendum has produced a result? What might alleviate that uncertainty?
RS: Our weekly business confidence survey improved a bit last week but largely does not reflect the U.K vote to leave the EU, which occurred on the last day of the survey. Global business sentiment has been unusually volatile in recent weeks and appears fragile. South American businesses are especially dour, reflective of a struggling economy. U.S. businesses are the most upbeat, although they aren’t nearly as optimistic as they were a year earlier.
The referendum has increased economic uncertainty globally, and this will weigh on business sentiment. Uncertainty also constrains business investment, especially on R&D, and reduces hiring and slows GDP growth. We believe the heightened uncertainty following the referendum will fade, but it will remain higher than it was prior to the vote. There will be more bouts of uncertainty this year, particularly as the U.S. election approaches. Also, the U.K. is unlikely to officially break from the EU for a couple of years, and this long process will likely increase economic uncertainty from time-to-time. Though uncertainty can affect businesses willingness to hire and invest, the economy can weather it. For one, uncertainty has been elevated for most of this economic expansion, and U.S. businesses have shown an ability to adjust.
TCB: Are concerns greater or lower than they were last Friday following the Brexit result?
RS: About the same. Financial markets remain a wildcard. Other threats haven’t subsided. For example, there is a threat the Brexit will empower Euro-skeptic political parties that have gained significant support in most European countries. These include the National Front in France, the Alternative for Germany party, Podemos in Spain, and Five Star in Italy. Their skepticism of immigration, trade, and just being part of a larger Europe runs deep. The EU could splinter, perhaps not this year or next, but when the European economy weakens again, which it will, and nativist sentiments are inflamed even more. A fractured Europe will result in much diminished European and global economies.
Ryan Sweet is the Director of Real-Time Economics at Moody’s Analytics.
