The Outlook: May 2019 economic commentary 

 


How has the Brexit vote affected the UK economy?

With Brexit still not having taken place, there has not yet been any changes to the UK’s external trading arrangements. Rather, the impact on the economy has come via two main channels: first, the marked depreciation of sterling in the immediate wake of the referendum, and second, the impact that Brexit uncertainty has had on the spending decisions of businesses and consumers.

Less investment

The most recent manifestation of Brexit uncertainty has come in the form of a sharp rise in stockbuilding - companies accumulating extra supplies in anticipation of Brexit-related disruption. Survey data for the first quarter of this year indicates that companies built up inventories as part of their contingency planning ahead of a possible no-deal Brexit.  This had the effect of boosting production – factory output rose 2.2% quarter on quarter in Q1, its strongest gain since 1988 – as well as lifting imports of anything from medicines to auto components.

As a result, rising inventories were a key factor in driving a solid 0.5% quarter-on-quarter gain in GDP growth during Q1. However, as the boost from stockpiling will be temporary, the Bank of England (BoE) expects growth to slow 0.2% quarter on quarter in Q2.

UK business investment NPEL

A more worrying impact of Brexit uncertainty has been seen in the weakness of business investment since the referendum. After four consecutive quarterly declines, business investment showed an encouraging 0.5% quarter on quarter during Q1. However, as the chart above shows, capital expenditure by businesses has been more or less flat since the referendum, following steady gains during 2010-15. As a result, the share of business investment in GDP has fallen.

Factors other than Brexit might be deterring UK companies from investing. The ongoing US-China trade war dented business confidence around the globe last year. However, since the referendum, UK investment has been far weaker than in any other G7 economy and survey data suggests Brexit uncertainty has been a key factor holding back spending. Indeed, a recent International Monetary Fund (IMF) analysis concluded that since the referendum, business capital expenditure had grown by 5.5 percentage points less than would be expected given the otherwise investment-friendly environment of low interest rates and a competitive exchange rate.

As well as the immediate impact on demand, the stagnation in investment seen since the referendum threatens to further weaken the UK’s already poor rate of productivity growth, as workers have less ‘kit’ to assist them in improving efficiency. A recent study by economists at Stanford and Nottingham universities suggests that Brexit-related effects have reduced annual productivity growth to 0.5% from an already lacklustre post-crisis average of around 1.0%. In combination with lower immigration in the wake of the Brexit vote, weaker productivity growth could reduce the economy’s potential growth rates. The Bank of England estimates the UK’s potential growth rate at around 1.5%. However, private sector estimates suggest it could be as low as 1%. 

More hiring

Rather than commit to long-term investment projects at a time when the outlook is so uncertain, it would appear that UK businesses have opted to hire more workers instead. Since the June 2016 referendum, the number of people in employment has risen by more than one million, and the unemployment rate has fallen to 3.8% - its lowest level since 1974.

A tightening labour market has ushered in faster wage growth, with growth in average weekly earnings excluding bonuses rising to a post-crisis high of 3.7% year on year in January, before easing back to 2.9% in March. An acceleration in inflation following the post-referendum depreciation in sterling – which lifted the cost of imported goods – ate into household’s real incomes.

However, with inflation falling back to below 2% from the post-referendum high of 3.1% in November 2017, wages are now rising around 1.5% in real terms. In turn, falling unemployment and increased purchasing power has helped fuel household consumption, which rose a solid 0.7% quarter on quarter during Q1.

Stretched consumers

However, the legacy of negative/weak real wage growth during 2017 and much of 2018 has been lower saving and increased borrowing. The household saving ratio (gross saving as a percentage of gross disposable income) fell sharply since the referendum and stood at just 4.5% at the end of 2018, down from 7.8% at the beginning of 2016.

When borrowing is taken in to consideration, the post-referendum squeeze on incomes has seen UK households move to a position where their outgoings outstripped their income for the first time since 1988. At the beginning of 2016, UK households were net lenders (saving more than they were borrowing) to the tune of nearly £8 billion, but they turned net borrowers during Q4 of 2016 and have been so ever since, with net borrowing at £4.4 billion in Q4 of last year.

Low interest rates and bond yields

Of course, one of the reasons why consumers have reduced saving and increased borrowing is because interest rates are so low.

Anticipating a sharp downturn in the economy in the wake of the referendum, the Bank of England (BoE) cut interest rates to 0.25% in August 2016, and raised them in November 2017 and August 2018 back to 0.75% as the economy stabilised. However, the risk of a disruptive, no-deal Brexit has worked against a further hike in rates, while also depressing market expectations for the future path of interest rates.

In its May Inflation Report, the BoE revised up its growth forecasts (to 1.5% in 2019 and 1.6% in 2020) and projected inflation above its 2% target and rising at the end of its 3-year forecast period. In the press conference following the publication of the report, BoE Governor Mark Carney warned investors that “there are insufficient hikes in the current market curve to be consistent with our remit” - in other words, rates would have to rise further than markets currently expect if the BoE is to stop inflation rising above the 2% target.

JP Morgan estimate that, based on the BoE’s assumptions for growth and the amount of slack within the economy, policymakers would need to raise interest rates to 2% by 2021 to keep inflation sustainably at the 2% target. However, investors remain fearful of a disruptive Brexit and are sceptical that growth and inflation will pick up as the BoE expects. Even after Carney’s warning, markets still anticipated just one 25bp hike by 2021, which would leave the policy rate at just 1%.

In turn, the shallow path of rate hikes expected by the market has the effect of depressing longer-term interest rates and the yields on UK government bonds (known as gilts). Uncertainty over Brexit, and the ongoing risk of a disorderly departure, is also likely to have fostered ‘safe haven’ flows into gilts, pulling down yields. It is interesting to note that prior to the Brexit vote, 10-year gilt yields traded much in line with their US counterparts. In May 2016, for example, the US 10-year yield of 1.85% was just 42bps above the UK equivalent of 1.43%. However, fast forward to May 2019 and the yield gap has widened to 130bps, with the US 10-year yield rising to 2.41% and the UK gilt yield falling to 1.11%.

Brexit is clearly not the only factor weighing on gilt yields. Ultra-low rates in the eurozone, along with strong demand from UK pension funds, and the BoE’s bond holdings, have kept a lid on yields. However, Brexit uncertainty and the associated weakness of future growth expectations have undoubtedly played a part.

The cost of uncertainty

Nearly three years on from the Brexit vote, the dire projections of ‘Project Fear’ have clearly proved overly pessimistic. The economy has avoided recession, real GDP is around 5% higher than at the time of the referendum and unemployment has fallen to its lowest level since 1975.

However, the referendum result has undoubtedly left its mark. The pound, in trade-weighted terms, is still down around 10% from pre-referendum levels. Higher prices for imported goods have squeezed real wages and taken their toll on household finances. Despite hopes for a boom in exports, the annual trade deficit was wider in 2018 than it was in 2015. Uncertainty has held back business investment, threatening to further jeopardise the country’s already lacklustre rate of productivity growth. Interest rates and gilt yields are probably lower than they would have been in the absence of the leave vote – good news for homeowners with mortgages, but bad news for savers seeking low-risk, inflation-beating returns.

What if we hadn’t voted to leave? Counterfactual growth estimates should, of course, be taken with a pinch of salt. However, separate studies from both the Centre for Economic Reform and Goldman Sachs suggest the UK economy is currently around 2.5% smaller than it would have been in the absence of the Brexit vote.

The hope is that, if and when the Brexit situation is clarified, business investment will rebound and the growth shortfall will be made up. The risk is that failure to reach an agreement will prolong the uncertainty.

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.

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