Brexit: Not that Bad for the Economy After All?

Before the referendum the International Monetary Fund suggested that a vote for Brexit would mean a recession in 2017 - but now it is predicting growth

Robert Johnson, CFA 26 July, 2016 | 3:18PM
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The IMF was one of the most vocal critics of the UK referendum to leave the EU. The IMF went so far as to suggest that the UK could drop into a recession in 2017. However, new forecasting last week did not look quite as dire as some of the earlier rhetoric suggested.

Specifically, the vote would have little result on 2016 with the growth forecast for the UK dropping from 1.9% to 1.7%. The IMF forecasters took a bigger hatchet to the 2017 forecast, dropping the growth rate from 2.1% to 1.3%. Given the UK's relatively small size, the changes barely budged world forecasts, which dropped from 3.5% to 3.4% for 2017. In fact, a drop in the U.S. forecast due to a slow start in 2016 was probably a bigger contributor to the drop than Brexit.

A strong yen hit the Japanese forecast too, and ongoing investment issues in India also weighed on the world growth rate. However, higher commodity prices generally boosted GDP forecasts for commodity producers, including Russia and Brazil.

Brexit-Related Risks and Uncertainties Remain

The baseline IMF forecast for 2017 was moved around by many other factors than Brexit itself. However, the baseline case does assume a relatively smooth transition process and limited impacts beyond Europe. It also constructed two additional scenarios that showed a modestly worse economy and a severely worse economy based on a breakdown in trade negotiations between the UK and the EU that results in higher tariffs, bigger trade effects, more corporate relocation, and badly damaged sentiment. Those would also result in more worldwide contagion. The IMF hastened to point out that the quick bounce back in financial markets diminishes the possibility of these more severe scenarios.

Interestingly, the IMF report seemed the most worried about financial market reactions to Brexit along with sentiment indicators. Secondarily, it worried that market turmoil would tighten credit conditions, potentially worsening the outlook for already-troubled European banks. It also expressed some concerns about relocating corporations, though that might end up benefiting non-UK economies.

Here is a direct quote from the IMF report:

"The direct spillover effects from the contraction of U.K. imports are negligible for global trade. However, spillover effects to the rest of the European Union and other countries emanating from an increase in global risk aversion and tighter financial conditions play a more dominant role."

We take a rather dim view of economic forecasts based on sentiment. Sentiment is volatile, not very predictive, and often doesn't turn up in real-world actions that matter.

Europe Manufacturing: Still in Positive Territory

Turning to that real world, data from European purchasing managers suggested that things were not falling apart in Europe. Although the index for Europe did drop from 52.8 in June to 51.9 in the July flash report, it is still the second-best reading since February. And the reading is above the critical 50% level, suggesting that more businesses were seeing growth than shrinkage

Data from France and Germany, the two largest countries in the European survey, showed month-to-month improvement despite the various terrorism attacks in addition to Brexit. Employment growth throughout the region continued to improve, with Germany reporting the biggest leap in survey employment data in five years. This would seem to us to be a lot more important than opinions expressed in business confidence polls.

Even more so than in the U.S., hiring requires a lot of corporate thought as decisions are difficult to reverse quickly. Better employment levels also likely mean more consumer spending and total domestic demand.

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Robert Johnson, CFA  is director of economic analysis with Morningstar.

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