Two key events internationally over the next 10 days are impacting financial market sentiment around the world. The first event is the US Federal Reserve’s policy meeting on Tuesday and Wednesday this week. The second is the British referendum on Thursday 23rd June determining whether Britain should remain in the European Union (Brexit). Both of these events have the capacity to alter the outlook for global economic growth, which is why they are influencing financial market trading. Another reason why financial markets are concerned is that both events elevate uncertainty about future economic prospects.
Taking first the US Fed’s policy meeting this week, if the decision is to lift the funds rate by 25bps – a second step towards gradually normalising interest rates as the US economy continues its long and slow recovery from the global financial crisis – that would seem to be an innocuous move on the face of it. A problem arises, however, as it is not entirely clear whether the US economic recovery is continuing or starting to show early signs of faltering.
US indicators of new housing activity are strong as too are recent readings of consumer sentiment and retail spending. Regional surveys of business activity, however, have mostly taken a softer turn of late. Importantly, nonfarm payrolls have taken a noticeably softer turn in April and May too. Also, what is happening outside the US is important too and international economic agencies have mostly been downgrading their view of global economic growth prospects. Brexit also looms as a potentially destabilising influence for financial markets and a negative influence on global growth prospects.
If the Fed decides to lift the funds rate this week there is a significant risk it will be doing so when the US economy is already taking a softer turn. An unwarranted rate hike, unless quickly reversed, could materially raise the risk of recession developing in the US later this year. We believe the key decision makers in the Fed are aware of the risks surrounding this week’s rate decision and will view the line of least regret as leaving the funds rate unchanged until it becomes clearer how well or not US economic growth is holding up.
While a decision to hike the US funds rate this week would likely promote more selling pressure in risk assets, a decision leaving the funds rate unchanged may lead to only limited relief from selling pressure with the Brexit vote due only just over a week later.
In essence, the Brexit vote marks the difference between staying inside a much bigger region that trades relatively freely inside its common boundary and with comparatively free migration of resources, capital and labour, within its common boundary to the area where the return is greatest. In basic economic terms, freer trade and use of resources generates higher economic growth than when trade and movement of resources are restricted. Often the underlying benefit of stronger growth is either not recognized or ignored by voters when they are asked whether they favour freer trade or freer flow of resources. The desire to protect against foreigners is a powerful one often overriding the benefits from not protecting local interests.
The Brexit vote is hard to call. Recent newspaper opinion polls seem to suggest that more than 50% of British voters are now in favour of Brexit. As always, the only vote that counts is the one on Thursday week.
If the vote is to leave the EU, a significant part of the EU’s relatively free trading arrangement starts to break down. That alone is sufficient to dent global economic growth prospects. If other EU members decide to follow the British precedent, the EU may slowly crumble representing a longer-term depressing influence on global economic growth.
What happens to the British pound’s exchange rate will also play a part in the economic impact of Brexit. It is conceivable that the British pound depreciates sharply enough to lend a temporary boost to British exports and growth. More likely the pound and the euro will both deteriorate against the US dollar but any brief lift in European growth as a result will probably be outweighed by damage to US economic growth prospects from a stronger US dollar. China would also need to reevaluate its currency policy to avoid untoward renminbi appreciation that could depress its growth prospects.
A British vote to stay inside the EU would probably promote a relief rally in risk assets, partly because a major area of uncertainty has been removed, but also because global economic growth prospects are not compromised.
The worst outcome for investors in risk assets would be if the Fed tightens this week combined with a British vote next week to exit the EU. Such an outcome would also see interest rates fall much lower. The RBA would be likely to push the cash rate down to below 1.0% over time.
The best outcome for investors in risk assets, in our view, would be a pass by the Fed this week and a British no vote to exiting the EU. Global economic growth prospects would still not be unduly strong, but at least they would not be compromised.