Major Economies Economic Outlook August 2016

Brexit casts long shadow on the global economy

Major Economies: Brexit casts long shadow on the global economy

July 27, 2016

While most stock markets and currencies have recovered from the post-Brexit turmoil, multiple uncertainties are still casting a long shadow on the global economy. In the aftermath of the vote, FocusEconomics panelists cut the economic outlook for some countries in order to reflect both the short-term consequences of the vote and ultimately the UK’s expected exit. While revisions to many 2016 forecasts were small as they mostly reflected the turbulence associated with the referendum, adjustments to the 2017 projections are gradually becoming more pronounced

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Country-wise, growth prospects for the United Kingdom suffered the most, followed by the rest of the Euro area. In particular, Germany’s forecast was revised down as Brexit could hurt Germany’s healthy trade surplus with the UK. The impact to the rest of the world has been more limited due to the UK’s weaker economic links with most non-EU countries. That said, analysts believe that shockwaves will reverberate mainly via secondary channels.

The most direct contagion channel will be through trade linkages. The UK is the Eurozone’s largest trading partner and the common-currency block enjoys a healthy trade surplus with the island. Although the full impact on trade will largely depend on the outcome of the negotiations, it will certainly reduce trade between the two economies to some extent. Beyond the Eurozone, the impact will be felt particularly in some Nordic economies, including Norway, and in Central and Eastern Europe. Regarding the rest of the world, the impact via the direct trade channel will be more limited. Nevertheless, the most important knock-on effect will be weaker growth in the Euro area and, consequently, lower demand from the world’s second-largest economy. A slowdown in demand from the Eurozone will have a broader impact, particularly in export-driven economies with close ties with the Continent.

Rising economic and political uncertainty, along with the expected slowdown in Europe, will heighten volatility in financial markets worldwide. In a context of increased risk aversion, investors will rush to safe-haven assets. This move will add pressure on some currencies and domestic financial markets, particularly in emerging-market economies, which could translate into sharp currency depreciations and, potentially, balance of payments crises. Capital flight into high-quality holdings will strengthen some currencies such as the Japanese yen and the U.S. dollar, prop up gold prices and lower the yield of sovereign bonds in some countries including Germany, Japan and the United States.

Other threats stemming from mounting uncertainty are a decline in business confidence and stock exchange losses. While lower levels of business sentiment could delay investment projects, a fall in the stock markets could impact consumer confidence via a negative wealth effect.

On the flip side, global uncertainty and the expected slowdown in the Eurozone and the United Kingdom will likely force the United States Federal Reserve to postpone its tightening cycle. In turn, this decision will allow central banks across the globe to adopt a more accommodative monetary policy stance. Moreover, some countries could benefit from better trade deals with the UK as the British government seeks to diversify markets.

The effects of the Brexit vote will be mostly negative for the global economy, but the impact will be uneven. While most countries in Europe, particularly in the Eurozone, and economies with acute macroeconomic imbalances will be the hardest hit, economies more reliant on domestic demand will be able to weather the storm. The key element is how the negotiation process between the two parties will evolve and what the final terms of the agreement will be. Chancellor Angela Merkel’s backing of new Prime Minister Theresa May’s plan not to trigger Article 50 this year in order to clarify the UK’s negotiating stance has at least alleviated fears of a quick and disorderly leaving process. Despite Merkel’s conciliatory tone, she nevertheless stated that, “nobody wants things to be up in the air.”

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Sailing into troubled waters

Global financial jitters have eased recently following the turmoil in the aftermath of the unexpected Brexit vote. While it is still difficult to fully assess the impact of the United Kingdom’s decision as it will largely depend on the outcome of UK-EU negotiations, analysts believe that the shockwaves will reach the global economy mainly via secondary channels such as the expected slowdown in the Eurozone, the financial sector and business sentiment. Chancellor Angela Merkel’s backing of new Prime Minister Theresa May’s plan not to trigger the Brexit this year has at least alleviated fears of a quick and disorderly exit. Despite Merkel’s conciliatory tone, she nevertheless signaled that it is necessary to establish a clear timeline.

While trade links between the United Kingdom and the rest of the world are relatively small, weaker growth in the Euro area—one of the world’s largest importer and exporter—will reverberate across the globe, particularly among export-driven nations. Uncertainty during the negotiation process will also fan market volatility worldwide. Countries that rely strongly on external financing and suffer from acute macroeconomic imbalances will feel the brunt of the pain due to further pressure on their financial and exchange rate markets. In other developments, investors seeking refuge in safe-haven assets will add upward pressure on the U.S. dollar and the Japanese yen, thereby eroding their terms of trade and hurting their respective external sectors. Financial volatility and a poor performance in equity markets could also dampen consumer spending via a negative wealth effect. Another spillover could stem from weaker business sentiment as a result of rising uncertainty and weak growth in the Euro area.

On the flip side, central banks are expected to adopt a more accommodative monetary policy stance, which will shore up economic growth. The United States Federal Reserve will likely postpone its tightening cycle, while the Bank of Japan is expected to announce an expansion of its "Quantitative and Qualitative Monetary Easing with a Negative Interest Rate" program. 

With the impact of the Brexit vote yet to hit the real economy, preliminary data suggest that global growth has remained stable so far. The world’s economy expanded 2.6% annually in Q2, which matched the result tallied in the previous two quarters. Policy support shored up economic activity in China, while growth in the United States remained robust in the April-to-June period due to vigorous private consumption. Despite losing some steam, dynamics in the Eurozone were also strong in the same period.

Going forward, headlines will be dominated by Brexit-related developments. While other mounting risks in some countries are not expected to dramatically hit global growth, they could nevertheless destabilize economic dynamics in their respective regions. Analysts will therefore remain tuned in how developments unfold in Brazil, Nigeria and Turkey. Despite the announcement of reforms in Brazil, the materialization has yet to be seen, while the sharp depreciation of the naira and attacks on oil facilities are clouding Nigeria’s economic outlook. The failed military coup and the subsequent purge by President Recep Tayyip Erdogan promise to fuel political unrest in Turkey. FocusEconomics Consensus Forecast panelists expect the global economy to expand 2.6% in Q3.

Brexit spillovers likely to be felt in 2017

The UK vote to leave the European Union unnerved markets worldwide and hit business sentiment in the immediate aftermath of the referendum. While volatility has eased somewhat in recent weeks and the consequences in the short-run appear to be limited, analysts believe that Brexit will have an impact on the global economy next year via renewed economic uncertainty and weaker global demand, though panelists are still tentative in revising their forecasts and further downgrades are still on the cards. The economic analysts we surveyed for this month’s Consensus Forecast cut their growth estimates for 2017 by 0.1 percentage points to 2.9%. For this year, the panel sees growth stable at 2.6%.

This month’s stable global outlook for 2016 mainly reflected unrevised projections for the Euro area, the United Kingdom and the United States. Forecasts for the Euro area and United Kingdom were left unchanged this month as our panelists had already taken into account the consequences of the Brexit vote in the previous month’s publication. A strengthening yen and concerns about the state of the economy prompted panelists to downgrade their view on the Japanese economy.

Among developing economies, the economic outlook for Asia ex-Japan was unchanged due to stronger-than-expected Q2 growth in China, which offset global headwinds. While panelists are becoming less pessimistic about the outlook for Brazil due to reduced political uncertainty, heightened financial volatility and Venezuela’s deep economic crisis led this month’s deterioration in Latin America. In Eastern Europe, while a less negative outlook for Russia is supporting growth prospects in the region, spillovers from the Brexit vote will hit some countries in Central Europe going forward. Finally, despite the gradual increase in commodity prices, the outlook for the Middle East and North Africa and Sub-Saharan Africa regions continues to be threatened by volatility in the financial markets, severe security threats and mounting economic imbalances.

UNITED KINGDOM | Impact of Brexit vote already visible in early data

The UK’s decision to exit the EU has fueled economic and political uncertainty in the country. The few official data sources available covering the period after the referendum suggest that the economy is suffering the consequences. According to a flash estimate, the Manufacturing PMI index dropped to a three-year low in July, thus signaling deteriorating business conditions in the sector due to a decline in both output and new orders. The disappointing PMI figure caused the pound to plunge against the U.S dollar. In the political arena, all eyes are now on the timeline of the formal exit process. The first step is for new Prime Minister Theresa May to invoke Article 50, which will give the country two years to negotiate its trade, business and political links with the EU. Adding to the myriad problems the UK is facing, Scotland is considering seeking a second independence referendum as early as next year if the UK’s new government begins the formal withdrawal process without Scotland’s consent. 

The Brexit vote threatens to rattle the country’s strong macroeconomic fundamentals, even though the full impact of the exit will take years to quantify. The panelists we surveyed this month expect that GDP growth will slow this year amid low business sentiment, a significantly weaker currency and a gloomier outlook for the labor market. Our panel expects the economy to grow 1.4% in 2016, which is unchanged from last month’s estimate. For 2017, the panel projects that the economy will grow 0.3%. 

UNITED STATES | Robust private consumption drives growth in Q2

The U.S. economy firmed up in Q2 after having slowed in Q1. Data for June show that retail sales increased for a third consecutive monthconsumer confidence jumped to an eight-month high and the employment report was outstanding, which alleviated concerns about the strength of the labor market. This suggests that consumer spending—the backbone of the economy—remained rock-solid in the second quarter. Meanwhile, business activity among U.S. manufacturers was resilient in Q2: the ISM manufacturing index increased again in June, signaling that growth in the sector had gained momentum. Moreover, an increase in global oil prices in Q2 likely stemmed the decline in business investment in the U.S. oil sector. The outcome of the UK referendum will put Europe at the top of President Barack Obama’s agenda in his final few months in office. Although a short-term impact from Brexit on the U.S. is unlikely, the U.S. can no longer count on its long-standing special relationship with the UK to sway other EU members on policy matters. With the UK’s influence in Europe diminished, the U.S. will likely seek closer ties with Germany and France, but will have less leverage over the region than before.

The process of the UK leaving the EU will likely involve a protracted period of negotiations that could affect investor sentiment globally and impact investment and trade within Europe. This could strengthen the U.S. dollar and have knock-on effects in the economy by restraining growth in export-oriented industries. FocusEconomics panelists expect GDP to increase 1.9% in 2016, which is unchanged from last month’s forecast. For 2017, the panel sees GDP growth at 2.1%. 

EURO AREA | Brexit fuels downside risks

The Eurozone economy showed resilience in Q1 and growth picked up to a one-year high despite external headwinds, yet data for Q2 suggests that the economy has lost some steam: industrial production contracted in May and economic sentiment decreased in June. Most importantly, the UK’s vote to leave the EU has dramatically increased downside risks for the Eurozone economy. The vote will have ramifications for the bloc’s trading patterns, financials and political stability. While some of the economic consequences were immediate—financial markets have experienced heightened volatility—how negotiations between EU and UK officials play out will be key to determining the full economic impact. The first available data since the vote suggest that activity has slumped: the Composite PMI fell in July, yet the indicator still beat market analysts’ bleak post-Brexit expectations, offering a glimmer of hope that the Eurozone economy could prove resilient despite heightened risks. 

The brunt of the impact of Brexit is not expected to be felt this year, as negotiations will likely drag out and European rules set a two-year period for negotiating an exit, subject to possible extension. Our panel sees the Eurozone economy expanding 1.5% in 2016, which is unchanged from last month’s forecast. For next year, our panel sees the economy decelerating slightly to 1.3% growth as the impact from Brexit starts to kick in.

JAPAN | Yen strengthens following Brexit vote, while markets anticipate stimuli

GDP rebounded in Q1, preventing the economy from falling into recession, yet uncertainty about the health of the Japanese economy persists. The all-important manufacturing sector shows no sign of recovery, while external demand remains grim amid a soaring yen. In this regard, the UK’s vote to leave the European Union prompted investors to flee to safe-haven assets such as the yen, driving the Japanese currency to strengthen to levels last seen in 2013. Although trade ties between the UK and Japan are relatively small, the Japanese economy will feel the impact of Brexit mainly via heightened volatility in the financial markets, which will add upward pressure on the yen, and also through weaker growth in the Euro area. The coalition government increased its majority in the upper house of the National Diet in the 10 July election and is now putting the final touches to a new fiscal stimulus plan of around JPY 10 trillion.

While a strong yen is weighing on Japan’s economy, the possibility that the authorities will unveil massive fiscal and monetary stimuli are bolstering market sentiment. The absence of deep structural reforms will nevertheless continue constraining Japan’s long-term growth. Analysts see the economy growing 0.5% this year, which is down 0.1 percentage points from last month's projection. Next year, they see growth at 0.7%. 

INFLATION | Global inflation inches up in June

Global inflation in June accelerated slightly from May’s 2.9% to 3.0% according to preliminary data. The print marked the fastest rate since October 2014. Commodity prices are gradually recovering, which is adding upward pressure on global inflation. That said, weak global growth in most of the world’s key economies and mounting economic uncertainty following the Brexit vote promise to limit gains in inflation going forward and pave the way for central banks to further ease their monetary policies. Along with the aforementioned rise in prices for raw materials, analysts believe that heightened volatility in the financial markets, coupled with domestic developments, will fuel inflationary pressures in some emerging-market countries such as BrazilNigeria and Venezuela.

Taking these developments into account, our panel of analysts expects that global inflation will be 3.4% in 2016, which is up 0.1 percentage points from last month's estimate. Panelists participating in our survey see inflation rising slightly to 3.6% in 2017.

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Written by: Ricard Torné, Senior Economist

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