Emerging Risks in the International Economy
The international economy will likely continue to pose risks to the U.S. economy in 2016. Weaknesses globally are broad‐based and include challenges in many emerging market economies in addition to Japan and Europe. Canada has begun a domestic led recovery, but U.S. economic growth has been well below consensus forecasts recently, growing at an annual rate of 1.4% in the fourth quarter 2015 followed by only 0.9% growth in the first quarter 2016. Brazil is mired in a political as well as economic crisis. Russia continues in a deep recession resulting from low energy prices and sanctions, while continued war in Ukraine poses risks to Eastern and Central Europe. Venezuela and other emerging market economies reliant on energy and commodities will likely undergo a highly challenging period until producer prices begin to lift sufficiently to reduce debt risks. The IMF and other organizations maintain a relatively sanguine base forecast of gradual acceleration in economic growth from +3.1% in 2015 to +3.2% in 2016 and +3.5% in 2017, but recent revisions have been downward and their forecast risks also remain weighted to the downside. According to the IMF World Economic Outlook issued in January 2016:
“Risks to the global outlook remain tilted to the downside and relate to ongoing adjustments in the global economy: a generalized slowdown in emerging market economies, China’s rebalancing, lower commodity prices, and the gradual exit from extraordinarily accommodative monetary conditions in the United States. If these key challenges are not successfully managed, global growth could be derailed.“
In the context of this weak economic backdrop, unexpected events could trigger risks to the world, domestic and even our regional economies.
Another of these risks is the potential for Brexit. Regardless of one’s views on whether the United Kingdom should stay in the European Union (EU) when its citizens go to the polls on June 23rd, there is probably little disagreement that a decision to leave would likely significantly increase near term economic uncertainty, and represent an economic shock to the world economy at a time that it is already incurring unusually slow growth.
The United Kingdom’s strong economic recovery from recession brought its unemployment rate down dramatically from 8.4% in the fall of 2011 to 5.1% in March. This dramatic decline was achieved at least in part by the benefits of free trade in the European Union, which allowed both its manufacturers and large services sector to have full preferential access to markets in the entire European Union, now at 28 countries across the continent and representing the largest free trade zone in the world. Exit from the EU would not only end this preferential treatment, but it would also require the United Kingdom to obtain new access to other markets around the globe – a daunting task when protectionism has returned into vogue even in relatively pro free trade countries such as the United States. Those for “Brexit” argue that benefits such as the elimination of excessive EU regulations and greater independence from the EU in general will lead to higher economic growth. However, estimates for long‐term GDP losses have been massive. For example, the U.K’s Treasury estimates 6% lower real GDP in 2030 if the U.K. leaves the E.U. As more of these reports are released in the coming weeks, the likelihood of a June 23 decision to leave the E.U. should become less.
Yet, let’s presume the scenario of the U.K. voting out of the EU. The initial impact would likely be a sharp drop in the pound and probably the euro against the dollar, and increased financial volatility comparable to the turbulence early in the year. A third of U.K. exports go to the European Union, with the rules of trade likely to change almost immediately as the countries preferred status for trade ends. The chief of the London Stock Exchange Xavier Rolet estimates 100,000 jobs in London’s financial district would be lost if the U.K. left the EU, with another 185,000 jobs ultimately lost because of indirect demand created by the impacted financial services. (Source: Financial Times)
Many of these jobs are high paying by world standards, and their loss would reduce average household incomes significantly. The Bank of England predicts a technical recession would result in the United Kingdom, with stagflation a possibility as inflation rises with productivity growth declines and currency declines. However, even as large as these potential shocks are to the United Kingdom economy, the political and economic damage to the European Union would likely be even greater, hitting at the core of the EU’s ability to manage the sovereign debt loads in its weakest economies. The U.K. exit, should it occur, would likely trigger the exits of other relatively strong economies in the EU that have serious disagreements regarding sovereign debt relief, fiscal policy, immigration, security, defense and regulations viewed as dictated from Brussels. Germany and other countries recently supported a plan to assist Greece’s sovereign debt repayment this year, but the beginnings of a possible downsizing of the EU would likely harden positions and possibly raise future default risks in Greece or other EU countries with high debt levels. This potential cascade of economic shocks could ultimately contribute to a wider world economic slowdown with outright recessions in both advanced and developing economies. Europe would likely enter a continental recession initially. The rising international debt of developing countries would facilitate the weakness in Europe to spread to financial markets and economies virtually worldwide.
The discussion above is a ‘worst case scenario’ and certainly not our forecast. However, one cannot underestimate the complexity of international connectivity and the potential for shocks to be transmitted via financial markets. To assist in the monitoring of these potential global financial stresses on the U.S., the Federal Reserve Bank of Cleveland produces an index to measure the general state of financial markets. The chart of the index is above. The Cleveland Fed Financial Stress Index (CFSI) is a comprehensive index that has equity, credit market, commercial and residential real estate, securitization, and interbank market subcomponents, many of which have been on a rising trend. There are 4 Risk categories for the CFSI: Grade 1 Low Stress Period, Grade 2 Normal Stress Period, Grade 3 Moderate Stress Period, and Grade 4 Significant Stress Period. The indicator is currently in the upper zone of the Grade 3 Moderate risk period category. We will be monitoring this and other high quality indicators of financial and economic functioning in the coming weeks and months, especially if world economic events enter the realm of the “unexpected.”