Australia On Credit Downgrade Watch – S&P

There is a one in three chance of Australia receiving a sovereign ratings down grade, according to S&P.

From Business Insider.

Credit rating agency Standard and Poor’s (S&P) has placed Australia’s AAA rating on credit watch negative from its previously stable outlook.

While S&P also said it had “affirmed our ‘AAA’ long-term and ‘A-1+’ short-term unsolicited sovereign credit ratings on Australia” the move to a negative outlook does imply Australia is now at a heightened risk of losing its AAA rating.

Worth noting too that S&P indicate that states and major banks are also on watch, which is logical considering that these entities rely directly or indirectly on Federal Government support, and a reduction in the rating of the “peak” body would flow through, leading to potentially higher funding costs. “The negative outlooks on these banks (Commonwealth, Westpac, ANZ and NAB) reflect our view that the ratings benefit from government support and that we would expect to downgrade these entities if we lower the long-term local currency sovereign credit rating on Australia,” S&P said.

S&P said in a statement accompanying the announcement that:

The negative outlook on Australia reflects our view that without the implementation of more forceful fiscal policy decisions, material government budget deficits may persist for several years with little improvement. Ongoing budget deficits may become incompatible with Australia’s high level of external indebtedness and therefore inconsistent with a ‘AAA’ rating.

Crucially S&P says it is “more pessimistic about the central government’s revenue outlook than the government was in its latest budget projections”.

In a strong message to both side of the political fence S&P said that because Australia carries a high level of net external debt “Australia’s general government sector fiscal outcomes need to be stronger than its peers’, and net debt needs to remain lower, to remain consistent with the current ‘AAA’ rating”.

That’s sounds ominous and S&P notes that “Australia’s external debt net of public and financial sector assets (our preferred stock measure) is over three times current account receipts (CARs)”. They also highlight that the current account deficit of 5% of GDP this year will “only moderate slightly during the forecast horizon to just over 3%”.

As a result “Australia’s 2016 gross external financing requirement of US$630 billion is over half of GDP,” S&P said.

That sounds ominous but S&P expects “Australia’s external borrowers to maintain easy access to foreign funding”.

Summing up what all of the above and the change to negative outlook means S&P said (our emphasis):

There is a one-in-three chance that we could lower the rating within the next two years if we believe that parliament is unlikely to legislate savings or revenue measures sufficient for the general government sector budget deficit to narrow materially and to be in a balanced position by the early 2020s.

The dollar reacted to the announcement, but has recovered somewhat since.

Household Debt Up Again

The latest RBA chart pack, released today includes data on household debt. Debt a a percentage of disposable income is up again, to an all time high. This is driven by flat income growth, and ever more home loan borrowing. Even after the May interest rate cut,  interest paid as a proportion of disposable income has risen.

household-finances(1)This is of course an average, and segmented data contains considerable variation.

Low Inflation – A Result Of Globalisation?

As discussed, low inflation is a phenomenon exhibited in many developed economies around the world, and this is driving central banks to cut core cash rates, in an attempt to move inflation into a policy band which is typically 2-3%.

Yet, inflation seems to be staying lower for longer. A new working paper from the IMF “What is Keeping U.S. Core Inflation Low” uses bottom-up analysis to try and identify the underlying causes of low inflation. They conclude that sizable elements which drive inflation outcomes are related to the international price of goods, and that this global linkage has been one of the major factors in driving inflation lower. In other words, globalisation explains much of the current lower inflation. Therefore we, perhaps, need to question underlying assumptions about what the right inflation target should be.  2-3% may not be relevant any more, and monetary policy needs to be reviewed.

Over and above the potential non-linearity of the Phillips curve, another key element of the current conjuncture is global concerns about low inflation. One way of seeing how this may be impacting the U.S. is to look at the very different trends in core PCE goods and services inflation.

IMF-Inflation---Root1 Core services inflation declined through the 1990s from close to 5 percent to 2 percent, climbed again in the 2000s to reach 3.4 percent on the eve of the Great Recession, but then fell significantly during the Great Recession. It has recovered since then, but at around 2 percent remains significantly below levels seen earlier. Core goods inflation, on the other hand, has often been negative over the last twenty years, likely reflecting the impact of global pressures

IMF-Inflation---Root2Indeed, core goods inflation seems to react to nonpetroleum import prices with a lag, and the latter have been on a downward trend since late-2011.

Aggregate analysis only allows a limited understanding of the channels by which global pressures are impacting U.S. inflation. Moreover, it does not really facilitate the analysis of sector-specific factors such as the impact of the Affordable Care Act (ACA) on healthcare inflation. To really understand how external, domestic, and idiosyncratic factors drive the different components of inflation, one needs to develop a structural or “bottom-up” model, which is the goal of this paper. Specifically, we develop models of inflation for import prices, core goods, healthcare services, housing services, and core services excluding healthcare and housing. We then combine these models into one for aggregate PCE inflation. The overall findings of the paper are:

  • Core goods inflation is driven mainly by global price pressures and dollar movements. Domestic factors (e.g. the unemployment gap) help explain core services inflation, and it is important to separately model housing and healthcare
    sub-components of services inflation.
  • The aggregate inflation forecasts from this “bottom-up” approach have small root mean square errors (RMSEs), although the RMSEs using an aggregate Phillips curve equation are also small. The former, however, is more informative in tracing the effects of shocks and understanding the exact channels through which they affect overall inflation.
  • When we use the bottom up model for forecasting inflation in 2016 and beyond, our benchmark scenario has inflation gradually rising towards but not reaching 2 percent by 2020, given the headwinds caused by global price pressures. This benchmark scenario uses the Congressional Budget Office’s (CBO) forecast for the unemployment gap (which troughs at around -0.4 percent in 2017 before starting to increase and turning positive in 2019), assumes the dollar remains constant in nominal effective terms, house price inflation remains around levels of late 2015, and the impact of the public spending cuts on health care inflation gradually declines.
  • Core PCE inflation could, however, reach as high as 2.4 percent by 2018 if the dollar were to depreciate, the unemployment rate goes well below the natural rate, house price inflation climbs, and there is a more temporary impact of public spending cuts on health services inflation.
  • These forecasts assume inflation expectations stay well anchored. If inflation expectations do become unanchored, then of course inflation could rise more rapidly and reach a higher level. This, however, seems a very unlikely scenario. The forecasts also assume the absence of non-linearities in the Phillips curve, which is empirically supported by our recursive analysis and direct tests.

Price changes in PCE core goods and core services have evolved differently over the past few decades. This motivated us to look deeper into inflation dynamics and investigate whether the underlying determinants of core goods and core services inflation also differ.

Our empirical work indicated that that this is indeed the case. In particular, we found that foreign rather than domestic factors drive core goods inflation, with a specific channel operating through import prices. The latter were, in turn, found to be primarily determined by the strength of the dollar as well as inflation in countries that are major non-oil commodity exporters of to the U.S.—most notably, China, Canada, the Euro area, and Mexico.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate.The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, itsExecutive Board, or IMF management


How Are Employment and Inflation Connected?

Inflation dynamics and its interaction with unemployment seem to be behaving differently since the Global Financial Crisis (GFC). Are external factors such as low interest rates and credit availability and other external variables influencing the current apparent dislocation of the assumed relationship between inflation and unemployment? Or is the underlying relationship, as described in the so called Phillips curve at fault? Perhaps we cannot assume, all else being equal, that in the current economic climate, lower levels of unemployment will necessarily translate to higher inflation.

The Phillips curve is a single-equation empirical model, named after A. W. Phillips, describing a historical inverse relationship between rates of unemployment and corresponding rates of inflation that result within an economy. Stated simply, decreased unemployment, (i.e., increased levels of employment) in an economy will correlate with higher rates of inflation. (Wikipedia).

Is the Phillips curve broken? This question is a central topic in macroeconomics as modified forms of the Phillips Curve that take inflationary expectations into account remain influential. Modern Phillips curve models include both a short-run Phillips Curve and a long-run Phillips Curve. This is because in the short run, there is generally an inverse relationship between inflation and the unemployment rate; as illustrated in the downward sloping short-run Phillips curve. In the long run, that relationship breaks down and the economy eventually returns to the natural rate of unemployment regardless of the inflation rate.

The key question is – how does unemployment affect inflation? Since the Great Financial Crisis (GFC) of 2008-2009, while inflation has declined, it has fallen less than was anticipated (an outcome referred to as the “missing disinflation”). More recently the currently low unemployment rates should have pushed the inflation rate closer to the Federal Open Market Committee’s longer-run inflation goal, but inflation has been running below the 2 percent target for an extended period.

IMF-PhilllipsSo an IMF working paper “Did the global financial crisis break the US Phillips Curve?” is worth looking at.

Clearly, if confirmed, a changing or non-linear, relation between inflation and unemployment would have significant implications for monetary policy. While a linear Phillips curve warrants a symmetric monetary policy response with respect to business cycle conditions, a nonlinear Phillips curve, where inflation increases rapidly when unemployment rate declines below the natural rate may imply preemptive measures are needed to counter inflation when the economy is closer to potential. If, on the other hand, the Phillips curve is very flat monetary policy should react more strongly to unemployment movements, relative to inflation.

In this paper, we shed light on the forces and, possibly changing, dynamics between inflation and activity since the GFC. In other words, did the GFC break the U.S. Phillips curve? Moreover, we investigate three hypotheses which have recently been put forward as factors which could explain why inflation is currently low:

(a) Financial frictions, and shocks could imply slow recoveries and persistently low inflation.

(b) Globalization has increased the role of international factors and decreased the role of domestic factors in the inflation process in industrial economies. These hypotheses originated from the concerns of some monetary policymakers of an increasing disconnect between monetary policy on one side and domestic inflation and long-term interest rates on the other.

(c) the last hypothesis pertains to the inability of stabilization policy – due to the effective lower bound on policy rates – to lower real interest rates enough to bring the economy back to long-run sustainable levels and to achieve long-run inflation goals. Policymakers have emphasized how persistently low inflation poses substantial risks if monetary policy is constrained by the zero bound, and could derail the economic recovery .

Using extensive modelling they examine a series of “(possibly) nonlinear vector stochastic dynamic process(es)”. They took account of the Federal Reserve lowered the federal funds rate to the zero lower bound (ZLB) where it remained until December 2015. “Once the ZLB, or a negative Shadow Funds rate, is obtained, the perception, if applicable, that the funds rate reacts differently e.g. can fall no further, would be captured by switching in coefficients plus switching in shock variances such that adverse shocks to the Shadow funds rate are obtained. Second, there could be a change in the relationship between the federal funds rate and the term spread either directly because of the negative Shadow rates, or because of nonstandard monetary policy measures that stand in for conventional monetary policy. This is the main reason why the term spread is included as a variable in the model”. They conclude:

We use large BVAR’s, DFM’s and MS-VAR models to investigate the possibility of non-linearity in the recent post-crisis dynamic of inflation and unemployment rate in U.S. data. In other words, did the GFC break the U.S. Phillips curve? We also study what conditioning information set is informative for inflation and unemployment. We find that changes in shocks is a more salient feature of the data than changes in coefficients and a model with time-varying coefficients in the policy rule fits better than all other models that allow a change in coefficients. The model with coefficient switching in the simple instrument rule with variance switching in all equations attain the highest marginal data density.

Moreover, conditional forecasts which condition on external variables and financial risk variables seems to come closest to describing the dynamics of inflation while credit variables are the most important conditioning variables of the post-GFC unemployment rate.

We show that financial and external variables have the highest forecasting power for inflation and unemployment, post-GFC.

In other words, the Phillips curve is not broken, but is swamped by external factors, which makes it a less useful and authoritative tool. We cannot assume, all else being equal, that in the current economic climate, lower levels of unemployment will necessarily translate to higher inflation. We think the missing and critical factor is low, or falling real wages.

Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

UK Banking Risks Escalate

The Bank of England has released the latest edition of The Systemic Risk Survey, which is conducted by the Bank of England on a biannual basis, to quantify and track market participants’ views of risks to, and their confidence in, the stability of the UK financial system. This report presents the results of the 2016 H1 survey which was conducted between 11 April and 29 April.

UK-RisksProbability of a high-impact event and confidence in the UK financial system

  • The perceived probability of a high-impact event in the UK financial system over the short term has risen considerably. The
    perceived probability of such an event over the medium term has increased slightly. 56% (+46 percentage points since the
    2015 H2 survey) of respondents now consider the probability of a high-impact event as high or very high over the next year;
    37% (+6 percentage points) between one and three years ahead.
  • Confidence in the stability of the UK financial system has fallen since the 2015 H2 survey. Respondents are less likely to judge themselves as very or completely confident (14%, -15 percentage points since the 2015 H2 survey) and more likely as not very confident (10%, +4 percentage points).

Sources of risk to the UK financial system

  • The two risks to the UK financial system most cited by respondents were those of an economic downturn (mentioned by 73% of respondents, +1 percentage point since 2015 H2) and UK political risk, which increased significantly (+46 percentage points to 72%). UK political risk was also identified as the number one source of risk (+61 percentage points to 65%). In the history of this survey only one other risk has ever been identified by a larger proportion of respondents as their number one source of risk.
  • Around half of respondents citing an economic downturn specifically referenced a slowdown in global economic growth,
    rather than a UK-specific slowdown.
  • Almost all respondents that mentioned UK political risk explicitly referenced the possibility of the United Kingdom leaving the European Union.
  • The perceived risk of a cyber attack increased, albeit marginally, for the third consecutive survey to a new survey high
    (+2 percentage points to 48%). The proportion of respondents citing risk of financial market disruption/dislocation fell
    slightly (-7 percentage points to 37%). Perceived risks surrounding the low interest rate environment rose (+13 percentage
    points to 34%). Respondents perceived geopolitical risks to have fallen noticeably (-14 percentage points to 32%). The risks
    around regulation and taxes have increased (+9 percentage points to 28%), driven by concerns over regulation rather than

Risks most challenging to manage as a firm

  • UK political risk was most commonly cited as the risk most challenging to manage. The percentage of respondents
    mentioning this risk increased by 39 percentage points (14% to 53%). Only sovereign risk, in the period between 2011 and
    2013, has ever been perceived as a more challenging risk to manage since this survey began in July 2008.

Retail Turnover Rose 0.2% in May

Australian retail turnover rose 0.2 per cent in May 2016, seasonally adjusted, according to the latest Australian Bureau of Statistics (ABS) Retail Trade figures.

This follows a rise of 0.1 per cent in April 2016.

In seasonally adjusted terms, there were rises in food retailing (0.7 per cent), other retailing (1.4 per cent) and cafes, restaurants and takeaway food services (0.3 per cent). Department stores (0.0 per cent) was relatively unchanged. There were falls in household goods retailing (-1.1 per cent) and clothing, footwear and personal accessory retailing (-1.2 per cent) in May 2016.

In seasonally adjusted terms there were rises in New South Wales (0.7 per cent), Victoria (0.6 per cent) and South Australia (0.3 per cent). Tasmania (0.0 per cent) was relatively unchanged. There were falls in Western Australia (-0.7 per cent), Queensland (-0.4 per cent), the Northern Territory (-0.6 per cent) and the Australian Capital Territory (-0.3 per cent) in May 2016.

The trend estimate for Australian retail turnover rose 0.2 per cent in May 2016 following a 0.2 per cent rise in April 2016. Compared to May 2015, the trend estimate rose 3.3 per cent.

May-2016-Trend-RetailOnline retail turnover contributed 3.2 per cent to total retail turnover in original terms.

Dwelling approvals continue to rise in trend terms

The number of dwellings approved rose 0.9 per cent in May 2016, in trend terms, and has risen for six months, according to data released by the Australian Bureau of Statistics (ABS) today.

Dwelling approvals increased in May in the Northern Territory (18.7 per cent), Australian Capital Territory (8.2 per cent), New South Wales (2.0 per cent), South Australia (1.9 per cent) and Victoria (1.8 per cent), but decreased in Western Australia (2.6 per cent), Queensland (1.8 per cent) and Tasmania (1.2 per cent) in trend terms.

In trend terms, approvals for private sector houses rose 0.2 per cent in May. Private sector house approvals rose in South Australia (1.9 per cent), New South Wales (1.5 per cent) and Victoria (0.2 per cent), but fell in Western Australia (2.2 per cent) and Queensland (0.5 per cent).

In seasonally adjusted terms, dwelling approvals decreased 5.2 per cent, driven by private sector dwellings excluding houses, which fell 11.3 per cent. Private sector house approvals rose 0.1 per cent in seasonally adjusted terms.

HIA-July-1The value of total building approved rose 1.0 per cent in May, in trend terms, and has risen for five months. The value of residential building rose 1.5 per cent while non-residential building fell 0.2 per cent.

Commenting on the results, HIA Senior Economist, Shane Garrett said

Multi-unit approvals tend to bounce around a lot from one month to the next, but it’s been clear for some time that activity on this side of the market has peaked. Interestingly, the RBA cut interest rates during May and today’s result indicate that this move may have helped contribute to steadier conditions for detached house approvals. The decline in approvals during May was quite widespread in geographic terms, with Victoria being the only major state to experience an increase during the month. Today’s figures fit closely with our view that new home building activity is in the process of declining from last year’s record peak to more modest levels as the end of the decade approaches. The contraction in activity is predicted to be concentrated on the multi-unit side, with a more measured reduction in detached house building.

An uncertain election result may lead to stagnant financial markets

From The Conversation.

For the second time in the space of ten days, it appears that betting markets and pollsters have got it wrong. First, despite odds showing a 90% likelihood of “Remain” winning, the UK voted to “Leave” the European Union in its June 23 referendum.

Now, a mammoth federal election campaign has resulted in political stalemate in Australia, and the result will not be known until Tuesday at the earliest.

Clearly, the repercussions of a hung parliament are not as wide-ranging as “Brexit” and we are unlikely to see Canberra’s streets flooded with protesters. However, when Australian markets open on Monday they will still be faced with a high degree of political uncertainty. Investors do not tend to react favourably to such ambiguity.

Investors reduce risk under political uncertainty

Investors tend to respond in one of two ways. The most-common situation is for the political uncertainty to manifest in higher levels of market volatility and a flight to quality as investors try to reduce their exposure to risk.

This was what we witnessed post-Brexit: Australian stockmarkets and the dollar fell by more than 3%, while “safe” government bond yields hit an all-time low.

An alternative is for markets to become locked in stasis – where investors sit on their hands, unsure as to whether they should buy or sell. Market liquidity falls and asset prices become resistant to change.

This is effectively what happened following the hung parliament of August 2010. In the aftermath of that election, stock prices remained within a tight trading range and the dollar hardly budged over the course of the following week.

When the result of the 2016 election is finally known, it appears that the outcome will be either a minority Coalition government or a hung parliament. The Senate is likely to be more fractious than prior to the election.

Talk has already started about potential unrest among the conservative faction of the Liberal Party who supported former prime minister Tony Abbott. There is even discussion of an election re-run if the parliament proves ungovernable. Clearly, this uncertainty could linger for months.

Concerns for jobs and growth

The likelihood of a lengthy period of uncertainty is important. It means it will be difficult to pass any economic or budgetary reforms. Without such reforms, it is unlikely the budget will return to surplus in the near future (if ever) and it becomes more likely that the AAA credit rating will be lost.

This creates multiple concerns for Australian financial markets, and the broader economy. A credit rating downgrade will likely increase the cost of funding for Australia’s banks.

The Big Four banks will be particularly impacted given the significant role that offshore funding plays in their balance sheet management. This will mean higher interest rates for borrowers – which would not be beneficial for the housing market.

A prolonged period of uncertainty will make it difficult for firms to finalise investment decisions. At a time when the economy is still attempting to transition away from the boom in mining investment this will dent economic growth and employment. So much for “jobs and growth”.

Essentially, this is a recipe for a “risk-off” environment of declining stockmarkets and a depreciating Australian dollar. It is also likely that the market will price a higher likelihood of a reduction in the RBA target rate at the July or August meeting. This will further aid a continued rally in relatively safe government bonds (bond prices rise as yields fall).

If you consider the ongoing political uncertainty resulting from Brexit and the forthcoming US presidential elections in addition to the federal election, then months of nervous markets may lay ahead.

Author: Lee Smales, Senior Lecturer, Finance, Curtin University

Black market jobs cost Australia billions and youth are at the coalface

From The Conversation.

Young people, job creation and taxation have all been at the centre of the federal election campaign; yet almost nothing has been said about one of the sleeper issues these have in common – the cash-in-hand economy.

Youth unemployment is typically twice the national unemployment rate. Millennials are finding it harder to secure full-time work after leaving university. Shockingly, Australians aged 15-24 are at the highest risk of hospitalisation following a workplace accident.

However, there is another risk young people face that we know surprisingly little about.

A rose by any other name?

“Cash-in-hand” is a familiar phrase in our economy. Like most shady dealings, it goes by many names: unreported employment, the informal economy, or a grey labour market. Whatever we call it, it is used to circumvent Australian workplace and taxation legislation.

This should not be confused with being paid in cash. For example, let’s say an employer wanted to reduce their expenditure on transaction fees. They could add up an employee’s hours, calculate wages for the week minus tax, superannuation and other deductions. The adjusted wages could then be paid straight from the till, accompanied by a payslip.

The tell tale signs of a “cash-in-hand” job are a lack of formal employment paperwork, such as signed contracts, weekly payslips or a group certificate at tax time.

There are obvious downsides. These jobs are unlikely to pay the correct minimum wage, penalty rates, or super contributions. A greater concern is these jobs aren’t covered by workers compensation. Considering the previously mentioned risk of hospitalisation, cash-in-hand jobs become a serious concern.

Who, what and why?

The most concerning aspect is that so little data is being collected about these jobs.

A 2012 survey found that one in four young workers had recently done cash-in-hand work. While no concrete data exists on where these jobs are being offered, we can make some educated guesses.

Part-TimeThe figure above was created by selecting the top five jobs where the average age of employees was between 15-21. This gives us the most common industries for young Australians: fast food, hospitality, and retail.

Figure 2 ‘Participation in education and/or employment among young people aged 15 to 24, by age group, 2005 and 2014’ Australian Institute of Health and Welfare analysis of ABS 2015

If we look at the orange portion of Figure 2, we can see that 29% of young Australians are combining work and study. This is especially relevant when we consider Student Visas, Youth Allowance and Austudy payments.

We know that approximately 899,000 young people are both working and studying. However, 229,900 are receiving study payments, at a maximum rate of $216.60 per week with the ability to earn an additional $216.50. This puts the maximum payment as $433.10 – just over $30 above the poverty line. Let’s use some hypothetical examples, and say that “Julie” and “Ravi” are two of these student workers.

Julie is 18 and works casually at a local cafe in Brunswick while studying at the University of Melbourne. To maximise her earnings, she works 13 hours during the week at $16.61 an hour. This gives her $215.80, combined with her Austudy payments for a total of $432.40 per week.

She shares a three bedroom house in Brunswick and pays $200 a week in rent. Her average weekly expenses are $104 on food, $10 for her mobile phone, $19.50 on her public transport, and $34 a week on utilities. This leaves her $64 per week for other expenses.

Ravi is a 21 year old international student. He is studying for his Masters at Deakin University and works at a supermarket in Burwood, near the house he and his brother share. His rent and expenses are comparable, but he cannot receive Austudy. His Visa states that he can only work 20 hrs a week, giving him a maximum income of $459.64 after tax. After accounting for expenditure, Ravi is a little better off with $92.13 to cover other expenses.

Neither example accounts for business cycle/seasonal demands, parental income affecting payments, unexpected expenses, legal fees, health costs, or textbooks. Basic living costs account for 80-87% of their entire wage.

If either student faces costs that can’t be met by their usual wages, they may consider “cash-in-hand” work the only viable alternative. Julie will still get her Centrelink payments, and Ravi won’t breach his visa requirements.

What we don’t know could hurt us

The risks of this informal economy extend well beyond young workers. Professor Christopher Bajada estimates that cash-in-hand jobs make up a informal economy equivalent to 15% of Australia’s GDP. Similarly, in 2004 the government estimated the informal economy between 3-15%.

Even if we take the lowest estimate of 3% of GDP, that’s approximately AUD$48.6 billion outside our economy. A 2012 comprehensive report produced by The Australia Institute estimates a staggering $3.3 billion of revenue is being lost to cash-in-hand working arrangements. Given that taxation, debt and public spending have become key election battlegrounds, this lost revenue is potentially game changing.

Author: Shirley Jackson, PhD Candidate in Political Economy, University of Melbourne

UK Will See Large Investment Shock Post-Brexit – Fitch

Fitch Ratings says that there is little doubt that the UK referendum vote in favour of leaving the EU will take a significant toll on the economy.

Businesses are facing a surge in uncertainty on three separate fronts – the future of the UK’s trading relationship with the EU, the shape of the regulatory framework, and domestic political uncertainty, including the future status of Scotland. This uncertainty will prompt firms to delay investment and hiring decisions, while elevated financial market volatility will further damage business confidence.

We expect investment to fall by 5% in 2017 and by 2018 for it to be 15% lower than previously expected in Fitch’s May 2016 Global Economic Outlook (GEO). Consumption will not be immune to this shock and overall spending by UK residents will see a mild decline in 2017. The sharp fall in the value of sterling will provide some offset to the demand shock, with exports likely to benefit somewhat in the near term. Imports look likely to decline as investment contracts and foreign products become more expensive, resulting in expenditure switching to domestically produced goods and services and higher inflation. UK GDP growth is expected to fall to around 1% in both 2017 and 2018. This is a downward revision of 1 percentage point in each year from the May 2016 GEO.

The long-term impacts of Brexit on the economy are harder to estimate with great precision. However, in addition to less favourable access to the European Single Market, reductions in trade openness and inward FDI could harm productivity performance, while reduced immigration would slow labour supply and potential GDP. These negatives will likely outweigh any GDP gains from deregulation outside the EU or the redirection of EU budget transfers.

Brexit hits the world economy at a fragile juncture, with US growth recently weighed down by external shocks, but the direct near-term impact on the global economy is likely to be manageable. The trade exposures of US and Asian economies to the UK economy are small. The eurozone will suffer a larger shock from weaker UK demand and the depreciation of the pound, but for the block as a whole, growth adjustments will likely be significantly smaller than for the UK. Global financial market contagion beyond the UK has not been particularly severe since the vote, although European bank shares have fallen sharply as concerns about profitability have risen. Liquidity provision and monetary policy adjustments by global central banks should be able to contain the risk of a significant and widespread tightening in global credit conditions, although a further strengthening of the dollar – with implications for emerging market currencies and debt service – cannot be ruled out. Further Fed tightening is now likely to be delayed until December 2016 and the ECB is expected to persist with asset purchases beyond March 2017. The Bank of England is likely to lower interest rates to 25 bps later this year.

Nevertheless, medium to long-term risks to the global economy from the Brexit vote would rise in the event of increased political fragmentation pressures in the rest of the EU or a reversal of globalisation that culminated in rising trade protectionism.