A mid-year update on the global economy
- We had hoped to move into the second half of 2016 with uncertainties around the UK's relationship with Europe removed. Instead, they have intensified, with the Brexit vote bringing volatility to markets, a sharp fall in the pound and a new British Prime Minister by the autumn. We expect the Brexit decision to cut UK growth, push up inflation and leave a cloud of uncertainty hanging over the country for years. But now more than ever, European investors need to take a global view.
- Looking beyond the immediate market reaction, the broad global environment sketched out in our last outlook paper remains broadly in place. The eurozone recovery has been slightly stronger than expected and there is less fear than there was then that financial instability in China is about to spread to the rest of the world. But concerns about the strength of the US recovery remain, along with longer-term worries about central bank potency and the continued slump in productivity in the developed economies.
- This underscores our message from January: investors should have modest expectations for developed market (DM) equity returns from here and explore alternate asset classes to diversify and - potentially - raise their risk-adjusted returns.
- The key points of focus for the rest of the year will be politics, the US Federal Reserve (the Fed) and the strength of recovery in the eurozone and the US. Though the dollar has risen recently, the weakening of the US currency, coupled with a stronger oil price, were striking and welcome developments in the first part of 2016. It would be costly for the global economy and especially for emerging markets if the dollar rose markedly in the second half of the year. But the most important focus will be growth in US productivity and profits. Both of these need to strengthen in the second half of 2016 for fears of recession to subside.
Overview: Key themes for 2016
The EU referendum result is a political earthquake for the UK, with important economic consequences that will hang over the country for years. But the impact for other countries and markets will depend on how close they are to the epicentre. Below we lay out what we see as the key trends shaping the global economic landscape for investors in 2016, before drawing out the key implications for investors. We end with a focus on the key risks hanging over markets - and the judgments we will be monitoring most closely as we look to the rest of 2016 and beyond.
1. Brexit will dent Europe, but the global productivity slump poses a larger threat
In the short term, we expect Brexit-related uncertainty to take at least 1 percentage point from UK growth over the next year, while the fall in the pound should add 1-2 percentage points to inflation. The eurozone economy is also likely to be negatively affected, both by the hit to business confidence and investment and a reduction in exports to the UK, which in the case of Belgium, the Netherlands and Ireland represent a significant chunk of their GDP (see Exhibit 1).
Belgium, the Netherlands and Ireland will feel the effects of any slowdown in exports to the UK
Exhibit 1: EXPORTS TO THE UK