Weekly Economic Commentary by Scott J. Brown, Ph.D.
Anarchy in the U.K. / I’m so bored with the U.S.A.
June 27 – July 1, 2016
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 Lehman-type 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.
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’.”
June 20 – 24, 2016
On June 23, the United Kingdom will vote on whether to remain in the European Union. The vast majority of economists are projecting dire consequences for the U.K. economy if voters decide to leave, with some likely spillover to the rest of the world. Until a few weeks ago, polls had pointed to an easy victory for the “remain” campaign. However, many polls now show the “leave” side ahead. Polls are widely regarded as unreliable, following the inaccuracies ahead of last year’s general election. Betting odds (to date) still favor “remain,” but it may be a photo finish.
The European Union allows for the free flow (or mostly free flow) of goods, services, capital, and people across the borders of member countries. Hence, in leaving the EU, the U.K. would face restraints in foreign trade, global finance, and immigration. The vast majority of economists believe that leaving the EU will have a significant negative impact on the U.K. economy. HM Treasury estimates that a Brexit will shave 3.6% from the country’s Gross Domestic Product over two years, and the hit could be a lot more.
In its recent policy statement, the Bank of England’s Monetary Policy Committee noted that the outcome of the referendum is “the largest immediate risk facing U.K. financial markets, and possibly also the global financial markets.” Brexit would weaken the currency (10-20% by some estimates) and present a major challenge for the central bank. Facing a lower growth path and a higher inflation path, the BoE would have to weigh stabilizing prices against stabilizing output and jobs, and it’s unclear currently which would require the greater response.
The uncertainty of a Brexit has already had on impact on the U.K. economy by paralyzing capital investment. The BoE sited evidence of delays to major economic decisions that are hard to reverse, such as commercial and residential real estate transactions, car purchases, and business investment. That comes on top of a scenario of capital spending in the global economy in general.
Some analysts are minimizing the likely risks for the markets. After all, a “leave” victory would set in motion negotiations with the rest of the EU, which could take up to three years. However, an exit from the EU is analogous to a divorce and every other country would be expected to ask for some form of alimony. The uncertainty of a long, a competitive negotiation process by itself would be a negative for economic growth.
Why then, would U.K. voters want to leave? Some want more autonomy, to be free of European regulations no matter what the cost to the economy (and many “leave” voters recognize that there will be a large negative impact on growth). It also turns out that a significant portion of U.K. voters distrust the government, dislike immigrants, and are dismissive of expert opinion (it’s a good thing that we don’t have any of that in the U.S.).
The U.K. is very much integrated with the rest of Europe and a Brexit would also have significant impacts on other European countries. Consider Ireland and Northern Ireland (which is part of the U.K.). Movement between the two would become a little more difficult and trade would likely be whipsawed. Many U.K. retirees have settled in Spain, Italy, and Southern France. Who will cover their healthcare? Will they have to move home? Following a Brexit, who might be next? Will nationalistic tendencies spread, leading to a broader collapse of the EU?
London is a major financial hub. Some big global banks have already begun to retreat. Presumably, Frankfurt would gain a stronger foothold in global finance, or Dublin could become a financial center, or some business would likely go to New York. However, that’s one more negative for the U.K. economy.
Those arguing for an exit have suggested that the U.K. shouldn’t really care about losing trade with the rest of Europe. Global growth is going to come mostly from China and the other emerging economies. However, the U.K.’s trade with all the BRIC countries is currently less than its trade with Ireland.
A couple of weeks ago, many polls began to show the “leave” vote in the lead, but betting odds (Ladbrokes, for example) show a comfortable lead for “remain.” The horrific murder of Jo Cox, an MP and “remain” proponent, has led to some speculation (by the markets) that the “remain” vote will benefit from a sympathy vote. That’s speculation. However, the campaign has been contentious and should heat up significantly in the next few days.
On Thursday, polls will close at 10 p.m. local time (5 p.m. EDT) with results anticipated four to seven hours later (9 p.m. to midnight EDT). A “remain” victory would likely be well received by global stock markets and we should see some unwinding of the flight to safety (that is higher bond yields). A “leave” victory would not be taken well (weaker stock market, weaker sterling, and lower bond yields).
A slowdown in job growth
June 6 – 17, 2016
“The data in today's labor market report on balance suggest that the labor market has slowed. Nonfarm payroll employment increased at an average monthly pace of 116,000 over the last three months--well below the 220,000 per month average pace over the preceding twelve months. The unemployment rate moved lower, reaching 4.7%, a new low in the current recovery, but involuntary part-time employment increased and the labor force participation rate declined. Even so, there are reasons to expect that the labor supply still has room to respond if labor demand increases.”
– Fed Governor Lael Brainard, June 3, 2016
The economy added nearly 697,000 private-sector jobs in May. That’s before seasonal adjustment (in comparison, we added 996,000 in May 2015). One month does not necessarily make a trend, but figures from March and April were revised lower, reinforcing the view that (seasonally adjusted) job growth has slowed. The question, for the Fed and for investors, is why.
Mild winter weather may have pulled forward seasonal job gains into the spring. Prior to seasonal adjustment, the economy added 2.91 million jobs from January to May, vs. 3.19 million over the same period last year. That’s not a huge difference.
There is a fair amount of statistical noise in the payroll data. Figures are reported accurate to ±115,000. We can be 90% certain that the true monthly change in payrolls was between
-77,000 and +153,000. We can reduce the impact of statistical noise by looking at the three-month average: private-sector payrolls at +107,000, vs. a +214,000 average over the 12 previous months. So yes, job growth appears to have slowed significantly.
In its sampling, the Bureau of Labor Statistics misses new firms and firms going out of business. The birth/death model corrects for this. The birth/death model correction (to unadjusted payrolls) was +224,000 in May, vs. +217,000 a year ago. The birth/death model does well under normal conditions, but misses turning points. If wrong, the May figure would be even worse.
Surveys have shown an elevated level of business caution. Worries about global growth, the June 23 Brexit vote, possible Fed policy actions, and the presidential election have led firms to delay capital spending projects (even though they have the means to finance expansions). There are signs that some firms pared inventories in anticipation of weaker demand, only to struggle a bit to restock as demand ended up stronger than expected. Until recently, there weren’t many signs that firms had curtailed hiring (if the economy were to slow more significantly, you can always lay off workers, but if you make capital expenditures, you may be stuck with idle plant and equipment).
Job growth was strong in the last two years, but the pace was naturally expected to slow this year as the job market tightened. Anecdotally, many firms report difficulty in finding qualified workers. Perhaps more precisely, firms are having trouble hiring workers for the wages that they are willing to pay. There’s still a strong emphasis on cost containment. The job market has tightened, but average hourly earnings are still up only 2.5% y/y.
The unemployment rate fell to 4.7% in May, the lowest since before the recession. However, that’s still a bit misleading, as labor force participation is well below the pre-recession level. The employment/population ratio for the key age cohort (those between 24 and 55) has been trending higher, but the level still suggests that there is plenty of slack in the job market. Perceptions of labor market slack have been the key factor in competing policy views at the Fed. The more hawkish Fed district bank presidents often get more press than they deserve.
One opinion matters more than others, that of Fed Chair Yellen. Yellen will speak on the economy and monetary policy in different contexts over the next three weeks. Financial market participants might want to pay attention. The Fed remains in tightening mode, looking to resume the normalization of monetary policy. However, given the recent data, officials should be in no particular hurry to raise rates.
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