Economic Commentary July 2016

Posted on Tuesday, July 12, 2016

Bookies Proven Wrong!

By Mel Miller, CFA  | Chief Economist

View as PDF

British bookies have historically achieved an enviable record of predicting the winning outcome of political races. They accurately predicted a "No" vote on the Scottish referendum when the polls suggested a "Yes" outcome. Also in the 2015 general election, the bookies had the Tories winning, while the polls indicated a Labour victory-the bookies were right again.

But, they called it WRONG on the Brexit vote!

The markets were shocked because the polls were predicting a dead heat and in the days leading up to the vote, the bookies odds were 90%+ in favor of "Remain" (Remain in the European Union). I too was shocked by the outcome of the Brexit vote!

The United Kingdom referendum was the biggest financial and economic event of the second quarter of calendar year 2016. While technically not a " black swan" event, the repercussions of the UK leaving the EU will be felt around the world; and I am concerned about a copycat movement by other EU countries.

Over the last couple of years, I have had the privilege of visiting the Czech Republic, Hungary, Italy, Austria, and Germany. All of these countries are members of the European Union, but the Czech Republic and Hungary, along with seven other countries, are not members of the Eurozone. The nine have maintained their own financial independence and have not adopted the Euro as their currency.

Even while on pleasure trips, I am an economist with a tendency to ask probing questions of the "locals." I learned that Hungary and the Czech Republic are not looking to become full-fledged members of the EU and they do not want to adopt the Euro. They see neighboring countries that are full-fledged Eurozone members struggling with weak economies and concerned about the weak southern members (e.g. Greece and Italy). As one Czech executive said, "why should the Czech Republic bail out Greece because Greece doesn't have financial discipline?"

I am on record having predicted that eventually there will be a northern Euro alliance and a southern Euro alliance.

The fear of a financial contagion following the Brexit vote caused world markets to decline. As of the end of June, the markets have regained much of the initial loss as the prospect additional countries exiting the EU have waned.

EC- Dollar Index ChartWhile the expected economic slowdown in the UK will take months to develop, the direct impact of the Brexit vote on the economy of the United States is likely to be minimal. The U.S. is the largest exporter in the world; yet exports to United Kingdom only represent less than 0.7% of U.S. GDP. Given the decline in the British Pound and the Euro as compared to the U.S. dollar, exports from the U.S. to countries where the common currency is the Pound or Euro are now more expensive.

EC- Durable Goods ChartDurable goods orders point to a continuing trend of slow business investment. Business has remained on the sidelines for over a year, reluctant to invest in new equipment. This lack of commitment has a negative impact on worker productivity as many workers are in need of higher efficiency equipment. Overall, U.S.-based businesses remain cautious.

The consumer is the driving force of the economy. So, how are consumers feeling and behaving these days? Analyzing retail sales, excluding the volatile gas component, clearly shows that the U.S. consumer is highly cautious. Same store sales through May have increased by just 0.8% over the last year.EC- Retail Sales Chart
The increase is lower than inflation, and that was before the Brexit vote!

Federal Reserve Chair, Janet Yellen, has shared the fact that her favorite measure of economic vitality is U.S. Final Sales to Private Domestic Purchasers Less Government Expenditures and Gross Investment Savings. She favors this measure because it excludes all governmental spending and private savings.

This true indication of demand does not paint a strong picture. It was no surprise that the Fed did not see the EC- Final Sales Chartneed to raise interest rates at their last meeting in June.

As I stated last November in my 2016 forecast, I do not see the Fed increasing interest rates this year. At the time I was afraid that I was going to look like the London bookies on the Brexit vote as the general consensus forecast at the time called for two or three increases in 2016. But my original forecast is now the consensus among economists.

Does the Brexit vote plus the current state of the U.S. economy warrant a modification of my 2016 GDP forecast?

Yes, indeed. The odds of a recession in Great Britain in 2017 have increased dramatically and the impacts may have some spillover effect on the U.S. I am therefore lowering my GDP growth forecast for 2016 to 1.3% to 1.7% from the original 1.8% to 2.2%.

Just as the London bookies were wrong on the Brexit vote, my revised forecast could be wrong. Actually, I want to be wrong! I would love to see the economy grow faster in the second half of the year.

In summary, the second quarter economic climate was dominated by the Brexit vote. I wonder what event will take center stage in the third quarter. The Republican and Democratic conventions take place during the third quarter. Just say'n…