Hazy Outlook and Rising Global Risks
The UK referendum and the probable slowdown of the UK economy increased the downside risks for other European economies. We expect global monetary policy to shift further in a dovish direction, which will limit the Fed's ability to raise its policy rate, despite robust US macro data.
After the UK referendum on EU membership, the short to medium-term outlook for the UK itself, and for many European economies but also some important ones outside Europe, has become significantly more uncertain. Growth expectations needed to be lowered, which also dampens the outlook for (core) inflation, and shifts monetary policy biases further into a dovish direction.
UK Economy to Face Sharp Slowdown
We expect a significant slowdown in the UK, though uncertainty about the precise impact is substantial. Also, depending on the speed and severity at which UK economic data deteriorates, the Bank of England is likely to loosen monetary policy again, through rate cuts and potentially a reactivation of asset purchases, after being on hold for almost four years.
The Impact on Eurozone
For the Eurozone, the referendum and slowdown in the UK mean higher downside risks for the economic outlook, but we still expect growth rates above 1 percent in both 2016 and 2017. The European Central Bank is now more likely to extend its asset purchase program by at least six months in September, which may also require the adjustment of some important program parameters to gain the necessary flexibility. The next phase of political uncertainty may already be approaching, with the constitutional referendum due to be held in Italy in October. If the changes to the constitution are rejected – in which case Prime Minister Mario Renzi has said he would step down and call new elections – the euro and EU-skeptic "Five Star" movement is on track to become the largest party in parliament, as indicated by current polls.
The Fed Put on Hold
For the US Federal Reserve, the implication of weaker growth in Europe and further monetary policy easing is that it will likely have to remain in wait-and-see mode, even though downside risks to US growth and inflation seem significantly less pronounced than for the Eurozone; the recent June payroll report has confirmed the robustness of the US economy. We have shifted the probable timing of the next rate hike to December 2016, but acknowledge that substantial uncertainty remains around this new base case.
Global Economy Still in Vulnerable State, Risk of Further Slowdown
Advanced economies once again face a potential economic shock and rising uncertainty, at a time when growth generally is still low. Global business activity, as measured by the Purchasing Managers' Indices (PMI), continued to expand only at subdued rates in June, even before the UK referendum decision. A significant setback in July cannot be excluded. We therefore expect the global economy to continue to grow sluggishly in the second half of 2016, with risks tilted to the downside. This is particularly true for large economies such as China, where we expect a renewed slowdown after the recent rebound.
US Recession – Is It Likely?
A recurrent issue in an environment of subdued growth is the risk of an US recession – both whether it has already begun or what the probability of a recession is over the coming quarters. Recent US economic data shows a decline in industrial production that by historical comparison usually occurs during times of recession. However, manufacturing production has not yet shown a similar decline, and retail sales as well as employment continue to rise. This suggests that the US economy is, at least currently, still quite a way from recession.
Regarding the likelihood of a recession over the coming quarters, Glenn D. Rudebusch (2016) from the Federal Reserve Bank of San Francisco has shown that there is little evidence for the often cited assertion that recoveries inevitably "die of old age." With the current expansion that began in July 2009 being 85 months old, his model suggests that the probability of it ending in the next month is approximately 2.6 percent, which – when cumulated – gives a probability of just over 25 percent that the US economy may fall into recession over the next 12 months.
Financial Markets Seem Concerned
A model developed by the Federal Reserve Bank of New York that takes the yield curve as a recession indicator, currently indicates a risk of recession over the next 12 months of around 8 percent. This is significantly higher than the 2.2 percent indicated by the model just a year ago. However, 12 months ahead of the Great Recession that began in December 2007, the model was already flagging a 20 percent probability of recession within the next year. As such, the risk of a recession has increased compared to a year ago, but still remains comparatively low.
In this context, it is also important to keep in mind that low longer-term interest rates are a stimulus to the economy, thus providing the seeds for a continuation of the expansion. In addition, with energy prices apparently having stabilized, the largest negative impact emanating from the energy sector on US manufacturing activity may already have passed. Other components of domestic demand look relatively robust, especially private consumption and residential investment. We therefore continue to expect the US economy to grow by about 1.8 percent year-on-year in 2016, and 2 percent year-on-year in 2017.