Will the UK Cause a US Recession?
- Author Eugene Vollucci
- Published August 13, 2016
- Word count 634
Palos Verdes, CA. When a majority of the UK population decided to leave the European Union (EU), their decision unleashed uncertainty on real estate markets and revealed the perplexity on both sides of the Channel about how to deal with this problem.
No doubt, real estate has started to re-price reflecting heightened doubt, the threat of slower growth in Europe, and the potential for deeper contagion to our economy.
However, it has become exceedingly hard to forecast the investment outlook from here. This is now an enormously complicated situation for which no one has shown a workable solution. Will other member countries follow the example of the UK? We simply do not know, and it seems safe to say that something deeply fundamental has changed.
Frank Knight, the famous US economist, taught us to distinguish between risk and uncertainty. Situations with risk were those where the outcomes were unknown but governed by probability distributions known at the outset. Knight argued that these situations, where decision-making rules such as maximizing expected profit can be applied, differ in a deep way from "uncertain" ones, in which not only the outcomes, but even the probability models that govern them, are unknown. This is a perfect description of the current situation in which we have to assess the impact of elevated uncertainty on economic growth, expected earnings and returns on real estate investments.
The world-renowned UK economist John Maynard Keynes showed how uncertainty influences the decision-making process of households, the investors in his famous treatise "The General Theory of Employment, Interest and Money" from 1936. If the outcome of a situation such as the current one in the UK is assessed as uncertain with respect to jobs, future demand, future access to markets, future costs and the free movement of labor determining the future supply of labor, it is rational for households to increase their savings as an insurance against potential future unemployment, as it is rational to cut investment spending. As a result, demand declines and economic growth weakens.
In anticipation of lower or even shrinking economic growth, investors sell real estate, as they expect values to fall. Slower growth confirms the first assessment of households, prompting more savings and even further cuts in investment spending. This process is well known as a self-fulfilling prophecy and might lead to a deep recession. We do not yet predict one, but based on our reasoning, we come to the conclusion that a longer period of uncertainty will dampen economic activity. How deep the cut in growth will be depends on the length of the period of uncertainty and expected outcomes, which also depend on each other. Given the heightened level of uncertainty, we are unable to pencil in exact numbers, but we feel that the current conditions will weigh strongly on our economic growth.
This has created increasing concerns about the amount of bad loans in the balance sheets of the financial sector, especially in the shadow banks, and the ability of the domestic financial industry to deal with a rising magnitude of credit defaults.
The decision of the UK to leave the EU and the associated negative impact on growth should not come as a surprise. We would expect the first interest rate hike to be delayed by about two years to mid-2019 and are forecasting a rate cut next summer.
The outlook for higher rates in the US has changed, in our view. Drag may now stem from heightened uncertainty due to the economic developments, especially from the fallout from the EU referendum vote and the US elections. With these and other influences, the Feds will delay interest rate normalization at least until December, but possibly later, depending on the impact of potentially stronger growths and the unforeseen effects of slower growth in Europe on the US economy.
ABOUT THE AUTHOR: Eugene E. Vollucci, is the Director of The Center for Real Estate Studies, a real estate research center He is author of four best selling books and many articles on rental income investing, apartment investing, real estate and taxation. To purchase a subscription to Market Cycles and to learn more about the Center for Real Estate Studies,Article source: http://articlebiz.com
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