The Outlook: September 2018 economic commentary

Commentary

Colin Warren, chief economist at AFH Wealth Management, weighs in on market moves and investment challenges.


Warnings of the negative consequences of a no-deal Brexit carry greater legitimacy than the pre-referendum “Project fear” campaign, but talk of a 35% fall in house prices looks overdone. 

The economic forecasting community has not exactly covered itself in glory in recent years. Most forecasters failed to predict the 2007-08 global financial crisis and, in the UK, warnings from the Treasury and others, that the economy would immediately slide in to recession if the country voted to leave the EU proved overly pessimistic. Economic forecasting is an imprecise science at the best of times, and when it comes to the divisive issue of Brexit, there is the added complication of political bias clouding objective judgement.

Against this backdrop, it’s not surprising that some Brexiteers have dismissed recent forecasts of dire consequences for the economy in the event of a no-deal Brexit as “Project Fear 2.0”. However, with hindsight, there are good reasons why the near-term risks that the UK economy currently faces are greater than those in June 2016.

The doom-mongers were wrong

So, why did a post-referendum recession fail to materialise as many had predicted? In short, there had been an assumption that increased uncertainty would, in itself, result in a sharp fall in both investment and consumer spending. This proved ill-founded. Although consumer and business confidence did fall after the referendum, nothing of substance actually changed to constrain activity, at least not initially. Banks kept lending, and borrowing costs fell as the Bank of England cut interest rates and restarted its quantitative easing programme. With the UK still in the EU single market and customs union, exports and imports continued to flow freely. Indeed, UK exporters got a boost from the fall in sterling that had occurred in the wake of the referendum, and a pick-up in global growth was also supportive.

Nevertheless, even though recession was avoided, the vote to leave the EU has probably resulted in real GDP growth coming in weaker than it otherwise would have done. Within a two-year period, the UK has gone from being one of the fastest growing economies in the G7 prior to the 2016 referendum to one of the slowest. During the year to the second quarter of 2018, GDP rose just 1.3%, compared to annual average growth in excess of 2.5% during 2014-15.

From a demand perspective, the slowdown has primarily been the result of weaker household spending, which accounts for around 63% of GDP. Although consumer demand held up immediately after the referendum, it began to slow as the depreciation of the pound ushered in a rise in inflation which ate in to household incomes. Annual growth in real household spending was just 1.1% in the second quarter of 2018 - its weakest pace in over six years.

Despite hopes that sterling weakness would provide a big boost from the external sector, net exports have failed to compensate for weaker domestic demand. This has been in part because exporters have used sterling weakness to boost profit margins rather than to expand sales volumes. Moreover, many UK exports compete on quality, not price. In addition, it has been difficult for businesses and consumers to switch away from more expensive imports due to the lack of domestically produced alternatives.

Disruption under no-deal

Going forward, the hit to economic activity in the wake of a no-deal Brexit would be of a different kind to that seen after the referendum. Recent press reports, along with government’s no-deal preparation papers, have outlined the scale of the potential disruption. The prospect of customs checks, tariffs and safety inspections is likely to hamper trade and disrupt supply chains. Several high-profile companies, including Jaguar Land Rover, have warned of the risks to investment and employment if a good deal isn’t secured.

The absence of any deal would not only jeopardise UK trade with the EU, but it could also see a deterioration in the trading environment with the countries with which the EU has third-party trade agreements. These countries, including those of the EU, account for around 54% of UK exports. Recent reports have indicated that UK exporters are already losing orders due to uncertainties over Brexit, with the August purchasing manager index showing manufacturing export orders reducing for the first time since April 2016.

A no-deal Brexit would also usher in a further fall in sterling. In turn, this is likely to hit consumer spending again, just as the inflationary impact of the post-referendum depreciation is waning and real wages are starting to pick up. The imposition of tariffs on EU imports is likely to give prices an additional boost. Moreover, whereas consumers ran down savings in the wake of the referendum in order to support expenditure, this buffer is now considerably smaller. The household savings ratio (i.e. household saving divided by disposable income) currently stands near historic lows at around 4%, roughly half the level that existed prior to the referendum.

With business confidence likely to fall in the event of a no-deal Brexit, capital expenditure could also weaken. Less favourable trading terms with the EU are likely to make the UK a less attractive destination for foreign direct investment. And if exports and consumer demand weaken, businesses will have less incentive to expand capacity.

House price crash?

Even with these headwinds, press reports that Bank of England governor Mark Carney has warned cabinet ministers that a no-deal Brexit could see house prices fall 35% look overdone. Carney has been at pains to point out that this was not a prediction, but rather a worst-case scenario used in the Bank of England’s bank stress tests. For house prices to fall this far over three years, there would probably have to be widespread ‘distress selling,’ which, in turn, is likely to require much higher interest rates. Under the stress test Carney was referencing, interest rates are seen rising to 4% from the current 0.75%.

However, in reality, the Bank of England’s policy rate is more likely to fall in the event of a no-deal Brexit, and the authorities are likely to provide liquidity to the banking sector to avoid a credit crunch. Brexit is likely to reduce the economy’s capacity to grow without generating inflationary pressures via the impact on immigration and investment, and the expected fall in sterling following a no-deal Brexit would raise inflation through higher import costs. However, the Bank seems likely to look through a temporary rise in inflation and focus on stabilising the real economy in the near term, as was the case after the 2016 referendum.  

"Not the end of the world"

Although the risk of a no-deal Brexit has risen somewhat in recent weeks, the negative consequences for both the UK and the EU suggest some kind of deal will ultimately be done. Recent warnings are, of course, in large part designed to focus minds and pressure the government to negotiate a deal with Brussels and then secure parliamentary approval. The head of the World Trade Organisation, Roberto Azevedo, recently opined that a no-deal Brexit would ‘not be the end of the world.’ But as someone Twitter noted in response, this is a low bar for evaluating the impact of a no-deal Brexit. Both sides should take note.

In the coming months we will look in more detail at the potential ramifications of different Brexit scenarios on UK financial markets.

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.