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posted on 03 July 2016

A Sober Economy Can Handle The Brexit Hit

from Lakshman Achuthan, Co-Founder and Chief Operations Officer of ECRI

One of the main signs of the health of the global and U.S. economies is its ability to absorb a blow, and shake it off. At least that's how Lakshman Achuthan of the Economic Cycle Research Institute sees it. That's something to consider in light of all the fretting and hang-wringing after the U.K. vote last week to exit the European Union.

ECRI is best known for analyzing business cycles using a variety of data points. The firm uses its proprietary Weekly Leading Index as part of a broader approach to forecasting recession probabilities based on the universe of expansions, plateaus and contractions over time. It is less focused on any single economic data point, and instead uses the idea of long cycles to determine what is most likely to come next.

Achuthan's description of what actually causes a recession is pretty compelling. The context he uses is a cyclical approach that focuses less on the shock and more on the state of the economy. In other words, look at cyclical vulnerability as a precondition for any shock to become recessionary.

Here's a good metaphor: Imagine a person who has had a glass of wine at dinner at a restaurant. As this person returns home and walks down the street they encounter a few obstacles: Items strewn in their path, a dog running by, a crowd of pedestrians jostling them as they pass. This person is likely to remain upright and continue on their way, more or less unimpeded.

Contrast that with the imbiber who has had a few too many: Whether this person falls over is less a function of what bumps into them or is in the way, and more determined by what has impaired their balance. Even a modest bump might leave them sprawled on the ground.

So it isn't necessarily so much the qualities of an economic shock that cause a recession, but rather the state of the economy itself when that shock occurs. In theory, it doesn't take much to tip an economy into a recession when it has weak job gains, subpar retail sales, low wage growth, high inflation, declining housing values, falling durable goods sales and low consumer confidence. Now imagine an economy with steady job gains, rising retail sales, consistent wage growth, modest inflation, rising housing values, gains in durable goods and high consumer confidence. An economy like this can absorb a body blow and continue expanding.

The reaction of the economy to the Brexit shock is worth considering.

Based on the data, the U.S. economy is neither weak nor robust. (My view has been that it's stronger than many give it credit for.) The unemployment rate has improved a lot, and the economy has added about 14 million jobs since 2010; pay raises, however, have been disappointing; retail sales have been mixed, with much of the gain coming from automobiles. Inflation is contained; housing values have risen, consumer confidence has increased. Although the U.S. economy is far from perfect, it can take a hit and maintain its modest expansion.

There have been plenty of forecasts of recession by a number of bearish economists and fund managers for years -- and even new predictions of another financial crisis. So far, the global economy and the U.S. economy have managed to endure a number of blows. Those anticipating a Brexit-driven recession may be disappointed.

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