International Economic Week In Review: Brexit Takes Center Stage

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by: Hale Stewart

While traders and investment have known about the UK "Brexit" vote for some time, this week the markets finally grasped the idea that the UK could potentially leave the EU. As a result, the pound dropped, equities stalled and more government bond yields went into negative territory:

The global rally in government bonds broke records on Friday while equities buckled as a combination of anxiety over the world economy and Britain's referendum on EU membership sent investors racing to safety.

Bears took charge of financial markets already grappling with the effects of negative interest rates in the eurozone and Japan as European equities suffered their worst day since the market meltdown at the start of the year.

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German, UK and Japanese sovereign bond yields all reached historic lows with the yield on the 10-year Bund - a benchmark for the eurozone - falling as low as 0.01 per cent. Gold also rallied as deeper risk aversion dashed any hopes that US stocks would reach a new high this week.

Arguments regarding the potential impact of the UK"s withdrawal from the EU vary. The most balanced view comes from Professor Krugman, whose analysis is at this link. Personally, I'm less sanguine should the UK vote to leave.

This week, the Chinese Statistics Bureau issued three statistics: retail sales increased 9.7%, industrial production rose 6% and investment in fixed assets expanded 3.9% (all 3 are Y/Y). The first two releases were in line with the each series' latest 12-month results. However, the investment figure has dropped sharply over the last 4 months, potentially indicating a problem:

And the industrial production report contained the following data on utilities' growth:

The BOJ maintained their current interest rate and asset purchasing policy. In their announcement, they offered the following assessment of the Japanese economy:

Japan's economy has continued its moderate recovery trend, although exports and production have been sluggish due mainly to the effects of the slowdown in emerging economies. Overseas economies have continued to grow at a moderate pace, but the pace of growth has somewhat decelerated mainly in emerging economies. In this situation, the pick-up in exports has paused. On the domestic demand side, business fixed investment has been on a moderate increasing trend as corporate profits have been at high levels. Against the background of steady improvement in the employment and income situation, private consumption has been resilient, although relatively weak developments have been seen in some indicators. Housing investment has resumed its pick-up, and the pace of decline in public investment has been slowing. Reflecting these developments in demand both at home and abroad and the effects of the Kumamoto Earthquake, industrial production has continued to be more or less flat. Financial conditions are highly accommodative. On the price front, the year-on-year rate of change in the consumer price index (CPI, all items less fresh food) is about 0 percent. Although inflation expectations appear to be rising on the whole from a somewhat longer-term perspective, they have recently weakened

It's difficult to align the above statement with available data. The GDP capital formation account has slightly declined in the last 2 quarters, returning to levels seen at the beginning of 2015 in the latest reading. Industrial production, which, on a Y/Y basis, has only increased in 2 of the last 12 months, declined again, this time by 3.3%. On a Y/Y basis, retail sales declined in 5 of the last 6 quarters; on an M/M basis, they are down in 4 of the last 5. The only good news on is the alternate growth calculation, GDI, which increased 2.5% Y/Y in the latest GDP report.

On Thursday, the Bank of England maintained their current interest rate policy. Their statement contained the following paragraph:

While consumer spending has been solid, there is growing evidence that uncertainty about the referendum is leading to delays to major economic decisions that are costly to reverse, including commercial and residential real estate transactions, car purchases, and business investment. As the Committee has previously noted, potential referendum effects are making economic data releases more difficult to interpret, and the Committee is being more cautious in drawing inferences from them than would normally be the case.

Markit Economics' recent UK reports on manufacturing, services and construction all confirm the BOE's observation. The Bank's characterization of the decision-making slowdown as "costly to reverse" is interesting and concerning, for obvious reasons. This week's other releases were positive: retail sales increased 6% Y/Y and .9% M/M, while the unemployment rate was 5%. However, the economy is waiting for the Brexit vote with bated breath.

This week's European news was mixed. The 1.1% Y/Y increase in industrial production was by far the strongest report. The employment report was encouraging, because it showed a 1.4% increase between 1Q15 and 1Q16. But EU unemployment is still far too high. The -.1% increase in annual inflation was the week's worst news, because it indicates the region's pricing pressures are still far too weak.

Clearly, the markets are on hold until the Brexit vote is over. The polls are all over the place, so any type of prognostication is pointless. Should the UK vote to leave, it will probably only be the tip of the iceberg as other countries - Spain and Greece, to start with - consider the possibility of leaving as well. And if that happens, the potential repercussions could be very widely felt.

Hale Stewart, XE.com