Global Economy Unruffled by Brexit but Threats Loom

Sentiment in financial markets has soured since April, especially after the Brexit referendum. Most analysts have revised down their growth expectations for 2016 and 2017 and cut their inflation forecasts. Monetary policy, accordingly, is now expected to remain accommodative for longer than previously thought.

The odds of a recession in the medium term are now higher, in the eyes of the market, although most analysts do not expect one this year. The experience, however, from previous episodes of volatility post-2008 suggests that the pessimism might be overdone.

Global growth remains fragile, but the fundamentals have not changed significantly over the past three months. The probability of a U.S. recession within the next 24 months, in my view, were high in April, and continue to be high today, but that has nothing to do with Brexit.

The month after the Brexit referendum has confirmed three things. First, the global fallout is not as bad as the headlines in late June suggested – so far. Second, the economic impact looks to be limited to the United Kingdom. Third, the impact was mostly felt through financial markets. Even the swing in investor sentiment was, all things considered, short-lived.

Overall, global equities rallied days after the referendum, as investors focused on the increase in liquidity likely to come from central banks, and the possibility of fiscal stimulus. Volatility has returned more or less to where it was before the referendum, and safe havens such as gold and the yen have given up most of their post-Brexit gains. Two themes, however, have endured.

Bond Market Feels the Impact

The first is the drop in value of sterling. The second is that developed-market bond yields are stuck close to record lows. Around one third of the developed sovereign bond market is trading on a negative yield. The downshift of long-term bond yields can be explained by a mixture of safe-haven demand, lower expected short-term rates, and lower term premia.

There's no economic reason why sovereign yields cannot be negative. If the market views liquid sovereign bonds as a refuge against tail events, then negative yields simply mean that investors are paying an insurance premium for the benefit of protecting their wealth. Sure, in the past the level of sovereign yields was positive, but only because the whole scaffold of financial-asset returns was higher. Negative yields pose a problem if investors don't lower their portfolio return expectations. If investors don't lower their targets enough, they'll be taking too much risk per unit of return. Capital will be invested inefficiently.

The Fallout in Emerging Markets

Emerging markets suffered initial losses following the Brexit vote, but have since recovered. Some markets have reached their highest levels in a year. The biggest effect of Brexit was on Eastern European markets, perhaps because the market expected that region to be most exposed to the real and financial fallout.

In general, however, the impact has been modest on emerging markets. Changes in the monetary policy outlook has in the past has had a significantly larger effect than Brexit. Brexit and its aftermath have distracted the world from one of the significant weaknesses of today’s global economic and financial system: the growth of credit in emerging markets.

As I have pointed out before, credit to the non-financial sector has reached post-2008 maximums in many emerging-market countries, especially commodity-exporting ones. Why is high debt a threat? Because it makes the whole financial system vulnerable to a tightening in credit conditions. Credit terms can get a lot tougher if, for example, the Federal Reserve raises interest rates, or a recession afflicts the U.S. or China, or commodity prices fall. Brexit didn’t cause much trouble, but something else will, eventually.