Brexit fears mask underlying pressures on investment

• ? Brexit uncertainty is seen as a likely culprit behind weakness in UK business investment. But structural shifts in the economy alongside issues relating to how investment is measured suggest that even without the uncertainty factor, a significant revival in measured investment spending may not materialise.
• ? Movements in relative prices continue to favour expansion by relatively labour‐intensive rather than capital‐intensive sectors. Relatedly, a shift towards investment‐light services activity is persisting, while recent changes in the make‐up of employment are reducing the extent of likely automation.
• ? Moreover, the ongoing pace of technological change and corresponding fears of rapid obsolescence could deter investment. And an increasingly fuzzy division between investment and consumer spending suggests that official data may be increasingly understating investment's true level.

     

The short‐term impact of Brexit

• A scenario run on the Oxford Global Model suggests that Brexit would leave the level of UK GDP 1.3ppt lower by Q2 2018 compared with our baseline forecast that the UK votes to stay in the EU. A vote to leave would mainly shock business confidence but consumers would be adversely affected too. Exporters in price‐sensitive sectors would benefit from a weaker exchange rate.
• Market pricing suggests that sterling could initially fall by around 15% before recovering some of its losses, while the heightened uncertainty would also be expected to drive a sharp drop in equity prices in H2 2016.
• Brexit would present something of a dilemma for policymakers. While a weaker pound would cause inflation to initially spike upwards, we would expect the MPC to look through this and cut Bank Rate in order to support activity. And with the UK likely to retain its reputation as a safe haven, this would also see gilt yields stay lower for longer.
• Weaker growth would also put the Chancellor in breach of the fiscal mandate, though we would expect him to plead extenuating circumstances, rather than tighten policy and potentially exacerbate the slowdown.

     

China‐commodity nexus at the heart of global upturn

• ? The China‐commodity nexus has been at the heart of the global upturn in trade and industry. It could directly and indirectly account for as much as 70% of the recovery since mid‐2016, based on our analysis. We think this nexus will continue to support world growth in the near term, but the global upturn is vulnerable to moderating Chinese growth and slippage in commodity prices.
• ? China has directly accounted for around a third of the upturn in world trade, similar to the contribution of G7 countries. But adding in indirect effects, China's influence is likely to have been much more significant. Stronger Chinese demand has contributed to an improvement in the trade performance of its Asian trading partners, commodity exporters and other advanced economies.
• ? Using a model simulation that introduces positive shocks to imports in “greater China” and to commodity prices (based on the scale we have seen since mid‐2016), our top‐end estimate for China's contribution to the upturn in world trade is around 70%.
• ? The simulation points to especially strong improvements in output and exports for economies such as South Korea, Japan, Malaysia and some commodity exporters. This broadly matches the pattern of performance seen over recent months, though commodity exporters' performance has been quite mixed.
• ? G7 investment growth is likely to have played only a modest role in the recent global upturn. But Japan is an exception, while upgrades to investment forecasts for South Korea, Taiwan and Hong Kong have also been large.
• ? A 1% rise in commodity prices could raise commodity exporters' investment by 0.3–0.6%, based on our analysis. As a result, there could be additional improvement in commodity exporters' investment this year, supporting world growth. However, with our forecasts suggesting that commodity prices are set to slip further over the coming quarters, this boost could prove short‐lived.

     

Tighter labour markets to finally lift global wages

• Wage growth has been relatively slow since 2007 in advanced economies, but an upturn may be in sight. Slow productivity growth remains an issue but tighter labour markets make a positive response by wages to rising inflation more likely and there are signs that compositional and crisis‐related effects that dragged wage growth down are fading – though Japan may be an exception.
• Overall, our forecasts are for a moderate improvement in wage growth in the major economies in 2017–18, with the pace of growth rising by 0.5–1% per year relative to its 2016 level by 2018 – enough to keep consumer spending reasonably solid.
• Few countries have maintained their pre‐crisis pace of wage growth since 2007. In part this reflects a mixture of low inflation and weak productivity growth, but other factors have also been in play: in the US and Japan wage growth has run as much as 0.5–1% per year lower than conventional models would suggest.
• The link with productivity seems to have weakened since 2007 and Phillips curves – which relate wages to unemployment – have become flatter. A notable exception is Germany, where the labour market has behaved in a much more ‘normal’ fashion over recent years with wage growth responding to diminishing slack.
• ‘Compositional’ factors related to shifts in the structure of the workforce may have had an important influence in holding down wage growth, cutting it by as much as 2% per year in the US and 1% per year in the UK. There are some signs that the impact of these effects in the UK and US are fading, but not in Japan.
• The forecast rise in inflation over the next year as energy price base effects turn positive is a potential risk to real wages. But the decline in measures of labour market slack in the US, UK and Germany suggests wages are more likely to move up with inflation than was the case in 2010–11 when oil prices spiked and real wages fell.

     

World Economic Prospects

Overview: 2016 – unhappy New Year?

• 2016 has got off to a shaky start, with sharp declines in global equity markets and renewed jitters about China and its currency. Recent asset market trends have prompted some observers to suggest a high risk of a global recession this year.
• A glance back at recent history suggests why. Since last May, global stocks and non‐fuel commodity prices have both dropped by 12–13%. Over the last forty years, such a combination in a similar time frame has usually been associated with recession.
• There have been exceptions to this pattern; there were similar sell‐offs in stocks and commodities in 2011, 1998 and 1984 without associated recessions. Notably though, in at least two of these cases, expansionary US policy helped reverse market movements – but US policy is now headed in the opposite direction.
• More heart can be taken from the relative resilience of real economy developments in many of the advanced economies over recent months. There are few signs, for instance of sharp declines in consumer or business confidence, or in property prices.
• Policy settings also remain expansionary in the Eurozone, Japan and China – where broad money and growth has moved higher in recent months.
• Industry remains the problem area, both for commodity price‐sensitive extractive sectors and manufacturing. The global manufacturing PMI continues to suggest very subdued output growth.
• Services output remains more robust, and should be supported during 2016 by tightening labour markets – December's strong US payrolls release was encouraging in this regard.
• But there are downside risks to services, too, should stock price declines hit consumer spending. Our Global Economic Model suggests a 15% fall in world stocks may cut global GDP by 0.4–0.7%.
• As a result, there is a real danger that our global growth forecast of 2.6% for 2016 proves too optimistic with growth instead slipping below last year's already‐modest 2.5% reading.

     

The Brexit Controversy; what light does evidence shed?

• ? There has been widespread misinformation in and outside Parliament about the economic case for Brexit. Outside Parliament, the rival groups – those with a negative assessment of Brexit and those with a positive one – have set out their arguments but these have huge differences in the factual and intellectual support they each bring to the debate. The group predicting a negative effect have published a wide set of empirical appraisals from academic and related research teams of the case for leaving and that against it. This, largely rigorous statistical analysis, finds strong and clear evidence of the large costs to leaving. The camp predicting a positive result for Brexit, in contrast, relies on one academic source for its case; the Cardiff University Macroeconomic Institute led by Patrick Minford. This has reported its predictions of the effects of Brexit which in contrast to the other camp, show large positive effects to growth and other key parts of the UK economy.
• ? We assess the empirical quality of these two cases and conclude that the economic modelling of the Cardiff group is insufficient for them to give an adequate empirical estimate of the costs and benefits of Brexit; the Liverpool model it uses has a sparse overseas sector and does not differentiate between EU and non‐EU trade for example, so is unsuited to analyse the effects of changes in these. Our verdict is that, based on the evidence, Brexit in almost any form would be damaging to the UK. ¹ 1 The views expressed in this article are those of the authors and may or may not be those of Oxford Economics
  

     

Brexit and FDI

• The potential for a departure from the EU to undermine the UK's attractiveness as a location for Foreign Direct Investment (FDI) is often cited as one of the key risks were the UK to leave the EU. In weighing up the threat to FDI posed by ‘Brexit’ we assess the net gain from inward investment and the role played by EU membership in attracting FDI.
• In theory, FDI benefits the economy via lower interest rates, higher wages for workers and ‘spillover’ benefits boosting economy‐wide productivity. But the evidence for these benefits is ambiguous. And FDI has potential drawbacks. These include an adverse effect on the tradeable sector, reflected in a wider current account deficit, the potential to ‘crowd out’ investment by domestic firms and the fiscal cost of subsidies paid to inward investors.
• That almost half of FDI in the UK comes from other EU countries suggests that EU membership is not the only driver of foreign investment in the UK. Other factors include the UK's business friendly environment, as reflected in global competitiveness surveys, and a relatively deregulated labour market. Of perhaps most importance is the lure provided by the UK's large domestic economy. 80% of FDI in the UK is in sectors where sales to the EU account for less than 10% of total demand.
• However, FDI in manufacturing does look vulnerable to Brexit, given the importance of the EU market. Granted, manufacturing accounts for a modest share of UK FDI. But to the extent that FDI boosts productivity, a loss of inward investment in this sector is likely to come at a disproportionate cost.
• Our modelling suggests that in a worst case Brexit scenario, the stock of FDI could ultimately be 7% lower relative to the UK remaining in the EU, potentially knocking around ½% off the level of GDP.

     

Will the Bank of England turn dovish?

• ? Short of a sharp slowdown in the economy and/or inflation expectations, or a no‐deal Brexit, we think that the Bank of England is unlikely to follow recent moves by the Fed and ECB in signalling cuts to interest rates.
• ? Admittedly, the BoE's guidance on rate rises has gone awry before. And the UK has some commonalities with the US and eurozone, including declining core inflation and continued job creation without inflationary consequences.
• ? But growth projections paint the UK in a relatively favourable light, while stable inflation expectations and a relaxation of fiscal austerity offer two more reasons for the BoE to plough its own, more hawkish, furrow.

     

Global wages: we don't (yet) have lift‐off

• ? Policymakers, most notably in the US, have been expecting wage growth to pick up for some time as job markets tighten. But the data over the last six months have shown few indications of wage lift‐off. Our review of the latest evidence suggests that although labour markets are, on the whole, still tightening, we see increased downside risks to our forecasts for faster global wage growth in 2018–19.
• ? Rates of “churn” in labour markets – a possible precursor to faster wage growth – have continued to rise in the US and parts of Europe.
• ? But other structural factors may still be holding wages down. A recovery in prime‐age participation in the US may be helping to cap wage rises, as may a pool of “underemployed” workers in the US and UK (though this pool is shrinking fast).
• ? Productivity growth also remains weak, running at a 0.5%–1% annual pace in Q1 2017 across the US, UK, Germany and Japan. This compares with a G7 average pace of 1.5% per year in 1985–2006.
• ? Overall, the risks to our baseline forecast of faster wage growth in the major economies in 2018 look skewed to the downside. We expect wage growth to firm in 2018 by 0.5–1 percentage points in the US, UK, Germany and Japan. We would give this modal forecast a probability of around 60%, but with a 25% chance that wage growth is somewhat slower than this and only a 15% chance that it is higher.

     

Brexit adds to gloom over long‐term growth prospects

• The prospect of continued weak productivity growth and less support from rising labour supply means we are relatively gloomy about medium‐term growth prospects. Our forecasts show potential output growth of just 1.6% a year from 2017–2030. This would be well below the average of the decade prior to the financial crisis (2.7%) and in line with our estimate for the 2007 and 2016 period which included the global financial crisis.
• We have become more pessimistic about the extent to which growth in total factor productivity is likely to accelerate. This is partly due to a judgement call that more of the weakness since the financial crisis reflects structural factors. Brexit is also likely to weigh on long‐term prospects, resulting in a degree of trade destruction and lower FDI inflows than would be the case were the UK to remain in the EU. Brexit is also likely to result in less capital deepening.
• Demographic factors also point to weak potential output growth moving forwards. High levels of inward migration have mitigated the impact of an ageing population recently. However, immigration is likely to fall sharply over the next decade, as first an improving European labour market reduces incentives to migrate and then the UK Government adopts more restrictive immigration policy. We are also coming into a period where there will be fewer increases in state pension age than of late.
• Since the mid‐1990s there has been a surge in the number of people going to university, resulting in strong contributions from human capital. But this will be less important moving forwards as university admissions reach a ceiling.
• Stronger growth in potential output would be possible if Brexit results in trading arrangements which are closer to the status quo, or if policy is more ‘liberal’, than our baseline assumptions.

     

World Economic Prospects Monthly

Overview: Coronavirus variants raise near‐term concerns

• ? While vaccination roll‐outs will pick up speed in the coming months, high global Covid‐19 case numbers and the threat from the spread of more transmissible variants of the virus have prompted us to lower our 2021 world GDP growth forecast for 2021 slightly from 5.2% to 5.0% after an estimated 3.9% fall in 2020 .
• ? The start of Covid‐19 vaccination programmes has provided light at the end of the tunnel with respect to the prospect of controlling the pandemic. But hopes that the start of inoculations will lead to an imminent relaxation of restrictions has been dampened somewhat.
• ? While the slow pace of vaccinations to date has disappointed some, we do not think this is grounds for panic. Initially slow progress is to a large extent down to teething problems and near‐term constraints which should ease, particularly if other vaccines are licensed in the coming weeks and months.
• ? The bigger risk is the possibility of tighter restrictions to contain the UK and South African coronavirus variants that spread far more easily. The former mutation has now spread to around 50 economies and around a third have reported community transmission.
• ? Our global GDP growth forecast downgrade for 2021 largely reflects a more cautious assessment of the outlook for H1, particularly in Europe and other advanced economies where restrictions looks set to be extended or increased.
• ? But while the recovery path for the global economy is likely to be bumpy and risks remain elevated, we still think this year will see strong growth, by pre‐ as well as post‐ GFC standards. Some emergency fiscal support measures will end, but policy will remain supportive. Indeed, by taking control of the Senate, US President Biden may be able to pass more ambitious fiscal plans.

     

How likely is a UK recession after Brexit?

• In the wake of the UK Brexit vote, forecasters have rushed to downgrade their growth forecasts for the UK, with some now expecting a recession. Using the Oxford Economics' Global Economic Model, we examine how likely a recession is by looking at the shocks the UK economy faces and the policy responses. We conclude that while a sharp slowdown is likely – in line with our own new forecasts – a recession is unlikely.
• Many UK forecasters are now predicting a recession in 2017, even though ‘stand‐alone’ recessions in industrial countries are rare. Our forecast is less downbeat. The UK faces a series of negative shocks including to consumers and business confidence, but growth will be supported by the weaker sterling and likely policy responses.
• Using the Oxford Economics' Global Economic Model, we show that to shift our baseline forecast of growth of 1.1% next year to zero would require a very severe negative confidence shock. Our new baseline already assumes a shock equivalent to one‐third of that seen in the global financial crisis (GFC). All else being equal, the shock would have to be around two‐thirds of that in the GFC to cut GDP growth to zero in 2017.
• Our new baseline also does not incorporate all the possible policy levers the UK can employ. We currently assume the Bank Rate drops to zero, but if a ‘rescue package’ of £75 billion of QE and a fiscal stimulus equal to 1% of GDP was also added, then the shock to confidence needed to get zero GDP growth would have to be similar to that seen in the GFC. We do not consider this likely given the scale of financial stress and credit restriction that occurred globally at the time of the GFC.

     

Looser financial conditions carry a sting in the tail

• ? Against a long list of headwinds facing the economy, one apparent saving grace has been a relaxation in financial conditions since the start of 2019. Our UK Financial Conditions Index presently sits at its loosest in 18 months.
• ? Some of the lowest real interest rates in the world and a currency trading close to the weakest on record represent, all else equal, are powerful reflationary forces for the UK. But the fundamental cause of loose conditions ‐ the rising no‐deal Brexit odds ‐ mean they carry a sting in the tail.
• ? Conversely, the likely rise in market interest rates and sterling that would follow our expectation of a Brexit deal implies an overall positive for the economy could be dampened by tighter financial conditions.

     

Why the UK saving ratio is unlikely to flip anytime soon

• ? With inflation down and wages rising, the outlook for consumer spending in the UK is brightening. But should households opt to boost savings, the mood could darken.
• ? We think a meaningful rise in the saving ratio from its recent record lows is unlikely, though. Austerity may be easing, but the drag from fiscal policy is still set to limit households’ savings resources, while the durability of the current expansion may reduce the motivation for precautionary saving.
• ? What's more, any rise in interest rates on savings accounts will probably be even slower than the modest pace we expect for Bank Rate. And with the demographic shift toward an older, less thrifty, population, the appetite of households to save looks set to remain subdued.

     

World trade recovering but still reasons for caution

• ? World trade has picked up in recent months, expanding at the fastest pace in six years in the first quarter, with the rise fairly evenly split between advanced and emerging markets. Stronger activity in China and a broader upturn in global investment have been key factors. But there are still reasons for caution. Although the ‘cyclical’ element in world trade is improving, the ‘trend’ element is not thanks to changes in supply chains and a lack of trade liberalisation.
• ? World trade growth looks set to reach about a 4% annual rate in Q1 2017, the fastest pace since 2011. Alternative freight‐based indicators confirm the upturn. This suggests some modest near‐term upside risk to our world growth forecasts.
• ? Recent growth has been evenly split between advanced countries and emerging markets (EM). In EM, the end of deep recessions in Russia and Brazil and an upturn in China have been key factors. China directly added 0.5 percentage points to annual world trade growth over recent months and firmer growth there has also pushed up commodity prices and the spending power and imports of commodity exporters.
• ? Another important positive factor is an improvement in investment, which is a trade‐intensive element of world GDP. Rising capital goods imports across a range of countries suggest the drag on world trade from weak investment is fading.
• ? The decline in the ratio of world trade growth to world GDP growth over recent years has both cyclical and structural elements. But while the cyclical component now seems to be improving, there is little evidence that the structural part – responsible for between a half and two‐thirds of the recent decline – is doing likewise.
• ? Key factors behind the structural decline in world trade growth are changes in supply chains and a lack of trade liberalisation/protectionism. Both are likely to remain a drag over the coming years. Meanwhile, a levelling‐off of growth in China and drop back in commodity prices could curb the recent cyclical uptick.

     

An investment‐led expansion is no pipe dream

• Contrary to some perceptions, the UK's economic recovery has not been a disproportionately consumer‐led one. In fact, business investment has punched well above its weight in supporting growth. And the conditions look good for this outsized contribution to continue.
• Consequently, we think that the threat of ‘secular stagnation’, reflecting a lack of appetite to spend on the part of firms, is one that the UK should avoid. Moreover, strong investment growth should have desirable by‐products in the form of more accommodative monetary and fiscal policy.

     

World Economic Prospects Monthly

Overview: Growth resilient to protectionist concerns

• ? Despite the mounting threat of more protectionist trade measures, we expect the impact on global growth and trade to be mild. Given this, and the still fairly solid underlying economic picture, we have left our global GDP growth forecasts for 2018 and 2019 unchanged at 3.2% and 3.0% respectively.
• ? Although economic data in Q1 painted a pretty solid picture, there are signs that the global expansion may lose momentum in Q2. Most notably, the global PMI fell sharply in March, more than offsetting the gains of the previous three quarters or so. Some of the decline may reflect an over‐reaction to recent trade threats and could be reversed in April and despite the drop, the surveys still point to strong growth. But the fall highlights the risk that lingering trade tensions could damage confidence and prompt firms and consumers to delay investment and major spending plans.
• ? On a more positive note, China's economic growth picked up markedly in early 2018, which could provide a fillip to global trade growth in the near term. Given the betterthan‐expected start to the year, we have made no change to our 2018 China GDP growth forecast (of 6.4%) despite the probable negative effects of trade measures.
• ? Meanwhile, most advanced economies remain in the late expansionary stage of the cycle. And those that show signs of slowing, such as the Eurozone, are doing so from multi‐year highs. While we have nudged down our 2018 Eurozone GDP growth forecast slightly to 2.2%, the pace is expected to remain well above trend. We judge the impact of US tariffs and counter‐measures on the US economy to be subdued and have lowered our GDP growth forecasts for 2018 and 2019 by just 0.1pp.
• ? For now, we see further solid growth for the world economy this year even in the environment of rising protectionism. While there is a risk that a further escalation of trade tensions could trigger a sharper slowdown in global GDP growth, we still see the risks of a full‐blown and damaging trade war as limited and the chances of protectionism leading to recessions as smaller still.

     

A ‘lost decade’ for pay may be a taste of things to come

• ? The failure of pay growth to respond to falling unemployment is less of a puzzle when allowance is made for structural changes in the jobs market. But the same developments make it hard to see where a pay revival will come from.
• ? In real terms, the average weekly wage in the UK is below the level of 10 years ago, an unprecedentedly poor performance. This is despite joblessness dropping to a 42‐year low and employment at a record high.
• ? The responsiveness of pay to falling unemployment has dwindled. A shift towards less secure forms of employment, the tightening up of eligibility for benefits and the consequences of globalisation have all made workers more compliant and less willing and able to push for higher wages.
• ? The result has been a decline in the ‘equilibrium’ rate of unemployment. The Bank of England currently judges this rate to be around 4.5%. But that earnings growth is so subdued despite unemployment being in line the Bank's estimate suggests that the sustainable rate of joblessness may well be much lower.
• ? With unemployment forecast to plateau at current levels, the odds of a revival in pay growth look slim, despite possible upsides from strong corporate profitability and rises in the National Living Wage. This would not be a new development – a secular decline in earnings growth has been apparent over the last 30 years in both nominal and real terms, with pay growth in successive periods of economic expansion failing to return to pre‐recession norms.
• ? This suggests that a serious revival in pay growth is unlikely to happen without the economy operating at significantly higher pressure and with a substantially lower unemployment rate. But this would require a recognition of, and a more accommodative policy response to, the historically weak economic expansion since the financial crisis. Neither seems likely.

     

Over the cliff edge and on to the rocks below

• ? If Brexit negotiations were to break down, the UK would face a significant increase in trade disruption from March 2019, even if it were able to put some basic trading arrangements in place. In a scenario where key sectors face extra friction, we find that the level of UK GDP would be 2.0% – or £16bn in cash terms – lower at the end of 2020 compared with our baseline. The impact on the remaining EU countries, including Ireland, would be much smaller .
• ? This article focuses on what a cliff‐edge Brexit means for trade costs and prices. This is only part of the equation – such a scenario would also influence supply chains and migration, while there is also potential for policymakers to mitigate some of the negative effects via looser policy.
• ? The notion that the UK could simply walk away from Brexit negotiations and rely on WTO rules to trade with the world is deeply flawed. The UK would need to re‐establish more than 750 very complex international arrangements just to maintain the status quo. We expect only the most critical issues – such as air travel – to be resolved by March 2019. Exporters also face a substantial increase in non‐tariff barriers.
• ? A breakdown in talks would also see both sides levying tariffs on imports from each other from March 2019, raising the cost of importing UK goods into the EU by 3.5% and by 3.1% for goods imported into the UK from the EU. For the UK, this will apply to roughly 60% of its goods exports and imports, but for all EU countries except Ireland the share would be less than 10%.
• ? The additional trade frictions would knock around 1pp a year off UK GDP growth in 2019 and 2020, resulting in a period of very weak growth. And the risks to this scenario are skewed to the downside – a slump in confidence or failure to establish the necessary customs infrastructure in time could easily generate a worse outcome

     

Will Brexit speed a seismic shift in UK trade patterns?

• The UK's trade pattern has shifted significantly away from the EU since the 1990s. Our analysis suggests that this shift will continue in the decades to come, with the EU share in UK goods exports potentially slipping to around 35% by 2035. Shifts in relative prices from moves in tariff and especially non‐tariff barriers could lower the share further.
• Over 60% of UK goods exports went to the EU in the late 1990s but this has fallen to around 45%. Slow EU growth is partly to blame, with UK exports to the EU barely expanding since 2007. But our analysis also shows that a 1% rise in EU GDP leads to only around half the rise in UK exports to the EU that a 1% rise in GDP in the rest of the world induces in UK exports to non‐EU countries.
• Based on our findings and OE forecasts of long‐term growth in the EU and the world, the EU share of UK goods exports could fall to 37% by 2035 and around 30% by 2050 – back to its 1960 level. The share of services exports to the EU has held up better but is lower than for goods, at around 40%.
• Weakening growth of UK exports to the EU has taken place despite the development of the EU single market since the early 1990s. Indeed, based on our projections UK goods exports to the single market could drop below 5% of UK GDP by 2050. These projections make no allowance for Brexit effects, but the declining importance of exports to the EU single market could colour prospective Brexit negotiations.
• Simple income‐based projections of potential country shares in future UK exports suggest a further swing towards emerging countries (EM) in the decades ahead, especially China and India. Exports to EM could approach 40% of the total by 2035. A shift in the pattern of trade preferences and restrictions faced by the UK post‐Brexit could spark even larger shifts in the structure of UK exports.