How the US economy is affected by Brexit comes down to one thing
The US economy and stock market have very little direct exposure to the UK economy. However, they do have one very significant indirect exposure.
In the wake of the UK's decision to leave the European Union, Americans can't help but wonder what this means for them.
The US's direct exposure to the UK is actually rather limited. According to data cited by Wells Fargo, the UK accounts for just under 4% of US exports, which represents about 0.4% of US GDP. American bank exposure to British entities totals nearly $500 billion, which is just 3% of total US bank assets. Americans own $1.3 trillion worth of British securities, which is just a tiny fraction of the $70 trillion worth of US household financial assets. And according to data from FactSet, "the aggregate revenue exposure of the S&P 500 to the United Kingdom is 2.9%."
Despite those small direct exposures, the UK still has the potential to do significant damage to the US economy.
The Brexit could hit the US economy via tight financial conditions
While most economists acknowledge the minimal direct exposure, they warn that the uncertainty ignited by the Brexit vote could seep into the US economy in one important way: tighter financial conditions.
Simply put, tighter financial conditions means that it is harder and more expensive for businesses and consumers to get money. That in turn leads to less borrowing, less investing, and ultimately less economic activity. Tighter financial conditions manifest in several ways including volatile stock and bond markets, which is what the world has been experiencing since the Brexit votes were counted late Thursday.
This is a big deal because it's not about whether a business or consumer is exposed to the UK. Rather, it's about whether a business or consumer borrows money or requires investment capital, regardless of exposure to the UK.
"The repercussions will depend crucially on the magnitude of the fall-out in global financial markets," Capital Economics' chief US economist Paul Ashworth said in a note published right after the vote.
"There is a risk that financial turbulence has a real economy impact," Credit Suisse's Ric Deverell warned.
"For most countries outside the EU the bigger impact will most likely be felt on the real economy via financial markets," HSBC's Janet Henry said on Friday. "Volatility and heightened uncertainty will likely be the order of the days and weeks ahead."
Critically, this all has implications for monetary policy. Last week, Federal Reserve Chair Janet Yellen warned of potential fallout from a Brexit scenario.
"One development that could shift investor sentiment is the upcoming referendum in the United Kingdom," Yellen told Congress in her Semiannual Monetary Policy Report. "A UK vote to exit the European Union could have significant economic repercussions. For all of these reasons, the Committee is closely monitoring global economic and financial developments and their implications for domestic economic activity, labor markets, and inflation."
The good news: financial conditions have tightened, but they're still pretty loose
The current level of financial market volatility we've experienced, while scary, doesn't appear to signal real trouble quite yet.
"The tightening of financial conditions implied by the drop in US stock prices is unlikely to be enough to push a fundamentally strong economy into recession," Pantheon Macroeconomics' Ian Shepherdson said.
Even with the current market volatility, overall financial conditions remain loose in the context of recent history. This is largely due to easy monetary policy and historically low interest rates.
"Significant declines in Treasury yields should offset, to some degree, the tightening of other aspects of financial conditions," Nomura's Lewis Alexander said.
But all eyes will remain on financial conditions
Financial conditions are worth monitoring carefully.
Goldman Sachs' proprietary Financial Conditions Index (FCI) is one of the more popular indicators of financial conditions, and it has been ticking up reflecting tighter conditions.
"If these changes were to prove persistent, the tightening of financial conditions could subtract about 25bp from GDP growth over the next year," Goldman Sachs' Zach Pandl warned. "We nudged our forecasts in this direction last week, but the risks will look skewed to the downside unless market conditions recover. Additionally, at this point the tightening of financial conditions has been orderly, with few signs that market functioning has deteriorated or that financial intermediaries are under stress."
"A further tightening in financial conditions or evidence of systemic risk could warrant another downgrade to our growth forecasts," Pandl added.
And we're not just talking about an economic slowdown. Rather, we could see the US economy go into outright recession.
"Our US economists see a 33% probability of a US recession over the coming 12 months, given elevated levels of inventories and weak corporate profitability (due to high real unit labour cost growth)," Deutsche Bank's Torsten Slok said on Wednesday. "These weak fundamentals make the US economy more vulnerable to a Brexit-related tightening of US financial conditions."
For more on the Brexit:
These 4 charts show what the US's exposure to the UK actually looks like
What the Brexit vote means for the US economy
Currency expert warns the British pound faces a 'grave danger' in the weeks ahead
The UK may have committed 'an act of economic self-harm with global ramifications'
One chart captures the night of insanity as the Brexit vote counts trickled in
