Download Anarchy in the UK / I`m So Bored with the USA

Anarchy in the U.K. / I'm So Bored with the
U.S.A.
June 27, 2016
by Scott Brown
of Raymond James
Caught leaning the wrong way, the financial markets were hit hard by the outcome of the U.K.’s
referendum on EU membership. However, the decision to leave the European Union is not a Lehmantype event. A full-blown panic is unlikely and we should see the U.S. market settle down early this
week. The outlook for the U.K. economy is not good. Meanwhile, back at home, investors will look to
the calendar and collectively yawn. While a number of data releases have market-moving potential,
none is going to alter the underlying picture of the economy – that is, until the June employment report
arrives on July 8.
What were they thinking? The majority of economic studies on the EU exit impact pointed to severe
consequences for the U.K. economy. Some voters recognized this and still wanted to leave. The desire
for self-rule was a motivating force. As in the U.S., the economic recovery in the U.K. had passed
many individuals by. The “elites” in London were seen doing well, but the “common people” struggled
simply to maintain their living standards. Throughout the campaign, many felt that they were being
talked down to by the powers that be. Much of the push for “leave” came from anti-immigrant feelings.
The “leave” campaign misled on the impact of immigrants, suggesting that they were a drain on the
National Health Service. UKIP leader and Brexit supporter Nigel Farage said that the “leave” campaign
was “scaremongering” and described some of the advertisements (not his, of course) as “a mistake.”
There were significant differences in votes by educational attainment, with those with degrees most
likely to vote “remain” and those with less education more likely to choose “leave.” Scotland voted
strongly for “remain.” Scottish First Minister Nicola Sturgeon said that a second referendum for
independence (from the U.K.) was “highly likely.” Northern Ireland may also move to leave the U.K. and
rejoin the EU.
The key factor here is uncertainty. Prime Minister David Cameron has resigned (effective October),
and his successor will face a lengthy negotiation (two years) with the EU on exit terms. This isn’t going
to be pretty. It’s effectively a divorce with 27 wives all wanting some sort of alimony. Uncertainty is the
enemy of business fixed investment. Even prior to the vote, there was evidence of firms pulling back on
capital spending plans. Residential and commercial real estate transactions were being postponed.
Consumers delayed big-ticket purchases. Economic growth in the U.K. will take a hit and there is a
good chance of an outright recession.
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The Bank of England has some room to cut rates, but the proper policy response isn’t clear. The
weaker pound will boost inflation. The central bank will have to decide which problem, slower growth or
higher inflation, is the greater.
The direct impact on the U.S. economy may be small. The U.K. accounts for less than 4% of U.S.
exports and less than 3% of U.S. imports. Still, many U.S. firms do business in the U.K., so slower
U.K. growth isn’t going to help (especially on top of sluggish global growth in general).
The referendum result sent global equity markets reeling. The pound fell sharply (to a 30-year low). A
flight to safety pushed bond yields down. The 10-year Treasury note yield sank from 1.74% to 1.41%
(briefly), before bouncing about halfway back. This seemed to be largely a knee-jerk reaction to a
surprise, rather than an outright panic. Stock markets, bond yields, and the pound rose off their lows.
The U.S. markets have had plenty at home to deal with in recent weeks, including three appearances
by Fed Chair Yellen and a host of economic data reports. However, all of that was dominated by Brexit
concerns.
The U.S. economic outlook should not change much following the Brexit vote. The U.S. economy was
already not getting much help from the rest of the world, but domestic demand should remain
moderately strong. Housing is in good shape. Consumer fundamentals remain sound, although low
gasoline prices will provide less support for spending over time. Business fixed investment has been
weak, but much of that has been tied to the contraction in energy exploration. Ex-energy, capital
spending appears soft, but this is more consistent with a slow patch than an outright recession. Still, as
Fed Chair Yellen noted in her Congressional testimony, “considerable uncertainty in the economic
outlook remains.”
The pace of job growth is a key concern for the Fed. Job growth slowed into 2Q16. The May payroll
figure was restrained by the strike at Verizon, but these workers will come back in June. Accounting for
the strike, job growth was still lower than in the early part of the year, but it’s unclear why. Statistical
noise may have been a factor. Firms may have reduced hiring in the face of uncertainty. Firms may
have had a tougher time finding qualified workers (willing to work for what the firm is going to pay). The
June employment report, due July 8, should help to answer many of these questions. Between now
and then, the economic calendar is not very eventful.
With the Brexit vote out of the way, attention may return to previous worries, such as China and
Greece. Financial market volatility may die down somewhat, but it’s not going to go away.
The bigger concerns are longer term in nature. In her testimony, Fed Chair Yellen said that “although I
am optimistic about the longer-run prospects for the U.S. economy, we cannot rule out the possibility
expressed by some prominent economists that the slow productivity growth seen in recent years will
continue into the future.” Quoting one famous philosopher, “it just goes to show ya, it’s always
somethin’.”
© Raymond James
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