Macro and Markets

Thursday’s Brexit vote wasn’t a “Lehman moment”, as some have feared. Instead, it was a growth moment. And that may be the greater threat. If policymakers respond effectively, the benefits could be substantial: a stronger global economy, and an ebbing of the political and economic forces now pressuring UK and European policymakers. Conversely, failure to address the growth risks could cause broader and deeper global economic contagion. In the immediate aftermath of Thursday’s vote, there were significant concerns that Brexit would generate a market reaction similar to what we saw following the fall of Lehman Brothers in August 2008. Market moves in the immediate aftermath of the vote wiped around $3 trillion off of global equity markets, mostly in the industrial world. Indeed, foreign exchange markets (and some equity markets) saw larger moves than after Lehman’s collapse, before finding a degree of stability today. Yet, by all accounts, markets moved smoothly and cleared, there were few reports of payment and settlement issues, and little evidence of financial distress affecting counterparties. No doubt, news may emerge in coming days of large loses taken by some over-leveraged investors, and periods of intense volatility are more likely than not. So we should see today’s bounce as a temporary calm, not the end of the storm. But, if we define a Lehman moment as a comprehensive breakdown in trust in markets, a collapse in creditworthiness and confidence that cascades through financial markets as we saw in 2008, then Brexit is a crisis averted. Central banks deserve a great deal of credit on this score.  According to reports, the major central banks, led by the Bank of England, had been war-gaming a Brexit vote for several weeks, talking to market participants, and stress testing banks and markets. BoE head Mark Carney had his version of ‘whatever it takes’ remarks early on Friday, and provided ample liquidity to markets (in both pounds and sterling).  The Federal Reserve, European Central Bank, and other central banks made statements of support. The broader concern for markets, and for policymakers, is growth. For the United Kingdom, which before the vote was expected to grow on the order of 2 percent, the shock will be severe, perhaps on the order of 2-3 percent over the next 18 months. Some market analysts are predicting an outright recession given the substantial political and economic uncertainty that has been created and its likely effect on investment and consumer demand. The exchange rate depreciation will over time provide a powerful offsetting boost, as will expected rate cuts from the Bank of England, but will take time to be felt. First and foremost, this is a UK shock. The more difficult question is the extent of contagion to the rest of the world. The sharp rise in the yen has intensified concerns about Japanese growth, and put pressure both on the Bank of Japan and the government to introduce additional stimulative measures. But looking beyond the immediate cyclical considerations, Europe poses the more significant concern, given the weak state of the region’s economy (and a population increasingly frustrated with their economic prospects). As in the United Kingdom, uncertainty about post-Brexit relations is likely to weigh powerfully on investment. Relatedly, it is not surprising that European bank stocks fell sharply after the vote, given a continental banking system struggling with the legacy of the crisis and weak profitability.  Lower interest rates will not help on that latter score.  The ECB can ensure adequate liquidity to troubled banks, but can’t make them lend. If Europe wants above-trend growth in this environment, fiscal policy will need to do more. My colleague Sebastian Mallaby has a sensible set of recommendations, starting with a German tax cut, but his proposals seem politically quite challenging. Failure to act may not lead to an immediate economic crisis, but a weaker European economy makes the politics of preserving the European Union all the more treacherous. The dog that hasn’t yet barked is the emerging markets, which have held up well in recent days.  In part, this reflects that commodity prices and Chinese growth, the two most important drivers of EM prospects, have strengthened in recent months and, at least compared to the start of the year, there was a buffer to absorb this most recent shock.  Also, many emerging market investors pulled back on risk before the vote.  Tax measures in some countries (e.g., South Korea and Indonesia) have boosted confidence. Perhaps most importantly, the decline in interest rates in the United States, and the associated decline in expectations that the Federal Reserve would hike rates, matters a great deal for these markets. Still, if doubts about any of these supports were to arise, particularly Chinese growth, then a European regional shock could become global quickly. Finally, in the United States, most analysts (and the market more generally) now expect the Fed to delay a tightening till the end of the year, if not cut interest rates. The prospect of a significant strengthening of the dollar will cause a drag on growth, but given normal lags the brunt of any dollar move will not be felt on the economy till 2017. Unfortunately, the political consequences of a dollar spike on the election campaign is far more uncertain, and potentially more immediate. Those who believe that the populist anger we saw in the UK will be mirrored in the U.S. elections will see opportunity here.  This may be the most worrisome source of contagion from Brexit.

Britain’s vote to leave the European Union was fueled by a broad range of social and political concerns, including a fear of immigration, resurgent nationalism, and a populist rejection of UK and European policies, institutions and policymakers. But is also an extraordinary economic experiment. Here are a few things to look for in coming days as the global economy tries to absorb the implications of this leap into the unknown. A sharp market jolt, followed by extreme volatility Pound sterling was in the vanguard of the market reaction. After reaching 1.50 against the dollar yesterday on hopes of a remain vote, the pound fell to 1.33 before rebounding to 1.37. Global equity markets also have fallen sharply this morning, partly a reflection of how unexpected the result was and partly a natural pulling back in risk taking in the face of uncertainty. The biggest falls were outside the UK, in Europe and Asia, and U.S. futures predict a significant decline here. It is often noted that, initially, little changes in the fundamentals of the British economy. It could be several months before Article 50 of the EU treaty is invoked by a new British prime minister, beginning the formal process of withdrawal that would take at least two years, and likely more. For now, the way Britain moves, works and trades will not change. Still, the uncertainty about what follows, and the potentially protracted political debate that follows, is likely to contribute to an elevated level of market volatility. Weaker levels for the pound, and equities, seems more likely than not. Central banks show the flag The Bank of England quickly announced its commitment to “take all necessary steps to meet its responsibilities for monetary and financial stability” and indicated that it had provided significant amounts of dollar and pound liquidity. A number of other central banks have confirmed intervention, and globally this shock likely will be a reason for monetary policies to remain accommodative in coming months. As it has been in this recovery, the burden of driving economic recovery falls fully on central banks. Aggressive central bank action can go a long way to addressing liquidity concerns in markets, but what it can’t do is fix underlying concerns about the health of the European financial system. We should be worried about what a shock to growth, and the asset price moves we are seeing, mean for the longer-term viability of European banks that are already struggling to achieve profitability and deal with the legacy problems from the earlier crisis. Concerns about specific financial institutions in the UK and Europe could emerge in coming days and perhaps represents the bigger threat to market stability. A UK economic stall, which will be felt globally. Market analysts predict a sharp fall in UK growth over the next year, on the order of 1-2 percent lower, with some predicting an outright recession. At the same time, the rating agencies have signaled that they are likely to downgrade the UK. Uncertainty will be felt on investment most importantly, as well as consumer sentiment. Even if you are optimistic about the long-run future of the British economy outside the EU, the cyclical effects appear likely to be significant. The shock will drag European growth lower, adding to political strains on the union. I expect Grexit will again return to the front pages of the newspapers, along with calls for referendum elsewhere. A drag for the Fed The fallout from the Brexit vote in the United States--tighter financial conditions caused by weaker stock markets and reduced risk taking, uncertainty about the future of Europe and global trade, as well as a weaker outlook for growth, strengthens the case for the Fed to put off rate hikes (if they needed any reason beforehand). Many issues that have come to the fore in our election campaign, including anxiety about the economic future of the country and globalization, will get a new look today. Together, there are many reasons to believe the economic consequences for the United States could be significant. Again, Britain punches above its weight.