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The burden of Brexit

The result of the British EU referendum has raised uncertainty in Europe. The pace of growth in the UK and Europe is likely to slow down.

In his book “Risk, Uncertainty and Profit”, published in 1921, U.S. economist and pioneer of risk research Frank Hyneman Knight distinguishes between risks for which probabilities can be assessed with some confidence and uncertainties which are hard to objectively quantify. The Brexit vote shows that Knight’s ideas continue to be relevant.

A number of opinion polls and other indicators appeared to suggest that the probability of Brexit was relatively low. The actual result came as a big surprise. An even bigger surprise, however, was that political leaders in Westminster were caught off guard. It is still unclear when and how exactly the United Kingdom (UK) might leave the European Union (EU). The UK now faces a plethora of uncertainties the probabilities of which are difficult to assign.

The new prime minister Theresa May has not yet triggered Article 50. The new British government declared instead that the nature of the UK/EU relationship after an exit needed to be clarified first. But EU representatives do not want to start negotiations before the UK formally applies to leave the EU. So it is not even clear whether the exit will take place. What remains clear is uncertainty. And this uncertainty is likely to burden economic development and may lead investors and consumers to spend less. This cut can only be measured approximately, not exactly. We expect a deceleration of economic growth in the UK to 0.8% next year. This should lead to declining imports. As the most important trading partner, the Eurozone is likely to be hit hardest. Although there are first signs of recovery, for example in credit demand, Eurozone growth should – compared with our forecasts shortly before the referendum – weaken by 0.3 percentage points to 1.2% in 2017 in the wake of the Brexit vote. Countries with less tight trading links to the UK should be hardly touched. Our U.S. growth forecast of two percent for 2017 remains unchanged as do our mid-June growth estimates for Japan and emerging markets (EM).

Central banks clearly regard the Brexit vote as a burden, requiring them to cushion the economic repercussions of the referendum. The U.S. Federal Reserve (Fed) is likely to raise official rates only moderately. At most, we would expect two rises of 25 basis points each by mid-2017. And discussions whether the European Central Bank (ECB) will start tapering quantitative easing (QE) in spring 2017 have been temporarily muted. Accommodative monetary policies should also contribute to calming capital markets.

In order to cushion major economic setbacks in the UK, the Bank of England (BoE) might once again join the club of central banks pursuing QE policies. In this case, it might additionally cut its official rate by 25 basis points. Over twelve months we expect another rate cut, eventually leading to an official bank rate of 0.1%. The BoE ended its first asset-purchase program in October 2012 after buying assets worth 375bn pound sterling. The Bank of Japan (BOJ) is likely to extend its asset-purchase program and to cut rates further, but the Brexit vote is not to blame. Rather Japan’s central bank may be worried about meager economic growth and near-zero inflation rates.

Emerging markets might be beneficiaries of current developments, as EM governments and corporations have used the low-interest-rate environment and significantly extended their debt since 2007. Rising debt has increased the dependency on the monetary policies of advanced economies, particularly the United States. The postponement of U.S. rate hikes has therefore alleviated their situation. Commodity-exporting emerging countries such as Brazil and Russia additionally benefit from rising commodity prices. Both countries should grow by one percent in 2017 after a phase of recession.

In the last few years, China’s political leadership has focused on credit-financed investment to stimulate the economy. Several sectors therefore experienced over-capacities and rising non-performing loans. This increases the pressure on the government in Beijing to launch structural reforms. The example of India shows that economic restructuring and market-economy reforms can be worthwhile. For 2017, we expect an acceleration of growth by 0.3 percentage points to 7.8%, and for China a deceleration by 0.3 percentage points to six percent.

Economic downturn after Brexit vote

Investment should curb growth in the UK by 0.5 percentage points.

Growth and growth factors in the United Kingdom

Sources: Bloomberg Finance L.P., Deutsche Asset Management Investment GmbH; as of 07/2016; E = expected; year-on-year gross-domestic-product (GDP) growth

First signs of recovery

Credit demand continues to be low. But the era of receding corporate loans is coming to an end.

Loans to corporations (non-financial)

Source: Thomson Reuters Datastream; as of 07/2016

India in the fast lane

China cushions structural change with short-term impetus. India focuses on deregulation

GDP growth in China and India

Sources: Thomson Reuters Datastream, International Monetary Fund, Deutsche Asset Management Investment GmbH; as of 07/2016; E = expected

Our forecasts

The world economy is advancing on a solid growth track. After a weak start to 2016 the U.S. economy is gaining momentum.

2016 has already seen an abundance of political turmoil. British voters decided in favor of leaving the EU. Forming a government remains difficult in Spain. Moreover, a new U.S. President will be elected November 8th. We expect a stable development of the global economy despite the political uncertainties. Our global growth forecast was however, cut by 0.2 percentage points to 3.4%, primarily due to developments in Europe. Apart from politics, the Eurozone is also negatively affected by the insufficient capital base of Italian banks. It is still open whether private creditors will be asked to pay up. Rising TARGET2 balances remain an indication of continuing uncertainties within the Eurozone.

GDP growth rate (in %)1

F refers to our forecasts as of 7/7/16.

GDP growth in % (year-on-year)

  Region 2016F 2017F

United States

1.8

2.0

Eurozone

1.4

1.2

United Kingdom

1.3

0.8

Japan

0.5

0.7

China

6.3

6.0

World

3.3

3.4

Fiscal deficit (in % of GDP)1

F refers to our forecasts as of 7/7/16.

Fiscal balance (in % of GDP)

  Region 2016F 2017F

United States

-3.0

-3.2

Eurozone

-1.9

-1.9

United Kingdom

-3.3

-3.3

Japan

-6.0

-5.2

China

-2.4

-2.5

Consumer price inflation (in %)1

F refers to our forecasts as of 7/7/16.

Consumer price inflation (in %)

  Region 2016F 2017F

United States2

1.6

1.8

Eurozone

0.3

1.6

United Kingdom

0.7

2.6

Japan

-0.2

0.2

China

2.0

1.5

Current-account balance (in % of GDP)1

F refers to our forecasts as of 7/7/16.

Current-account balance (in % of GDP)

  Region 2016F 2017F

United States

-2.7

-2.8

Eurozone

2.9

2.7

United Kingdom

-3.9

-3.5

Japan

2.8

2.5

China

2.5

2.5

Benchmark rates 1

F refers to our forecasts as of 7/7/16.

Benchmark rates

  Region Current3 2017F

United States

0.25-0.50

0.75-1.00

Eurozone

0.0

0.0

United Kingdom

0.5

0.1

Japan

0.0

0.0

Commodities

The downhill slide of commodity prices, which began in mid-2014, ended in January 2016. The commodity market had been boosted by energy resources and precious metals. Oil prices (West Texas Intermediate, WTI) climbed by roughly 85% since their lows on January 20th (as of 6/29/16). Reasons are the large fall in U.S. oil production and a growing global demand. Price gains were reined in, however, by extended production in Iran. By mid-2017, we expect oil prices to rise only moderately. In the first half of 2016, gold was in heavy demand, the result of growing political uncertainty and receiving a further boost by the Brexit vote. Investors reacted to the expected postponement of Fed rate hikes and the continuation of the ECB’s ultra-expansive monetary stance.

Commodities1

WTI = West Texas Intermediate; LME = London Metal Exchange; F refers to our forecasts as of 7/7/16.

Commodities

  Commodities in U.S. dollars Current3 2017F

Crude oil (WTI)

44

55

Gold

1,320

1,390

Silver

20

20

Copper (LME)

4,930

4,600

Aluminum (LME)

1,592

1,500

ref-2

1 Source: Deutsche Asset Management Investment GmbH; as of 7/26/16

ref-3

2core rate, personal consumption expenditure Dec/Dec in %

ref-4

3Source: Bloomberg Finance L.P.; as of 7/26/16

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