The UK has not yet left the EU and the outlook for its future relationship with the bloc is uncertain. More obvious is the effect that continued uncertainty has had on the UK economy. While temporary stockpiling before the old 29 March exit date boosted output in the first quarter, GDP contracted by 0.2% in Q2 and growth is expected to slow in the coming months.
Surveys also paint a gloomy picture. The Purchasing Managers’ Index hit a post-referendum low of 49.3 in September, which suggests that underlying growth is near zero. The economy is expected to expand by 1.1%-1.2% this year, well below the 1.8% recorded in 2016. Forecasts suggest that growth could fall below 1% in 2020.
A tale of two economies
Lying behind the headlines is the dichotomy between weak business investment and resilient consumer activity. This is a trend common across most developed countries over the last 18 months, but particularly in the UK.
Persistent uncertainty has clearly weighed on business investment, which contracted by 3.5% last year (see chart 1). The culprit is clearly Brexit: the Bank of England (BoE) reckons that the prospect of leaving the EU reduced business investment by about 11% in the three years after the referendum.
Chart 1: A sorry sight
Source: Refinitiv, Office for National Statistics, Bank of England, Lloyds, as at September 2019.
Although business investment only accounts for a tenth of GDP, it can have a knock-on effect by affecting productivity growth. Indeed, the BoE thinks that Brexit probably reduced UK productivity by 2%-5% since the referendum.
The rise of protectionism has exacerbated the situation by reducing external demand: the contribution of net trade to GDP turned negative in 2018, shaving off about 0.5 percentage-points of output (see chart 2). The eurozone has been particularly affected by the US-China spat and given that 45% of UK exports head to the continent, this has had a detrimental effect on the UK economy.
Chart 2: Export exodus
Source: Refinitiv, Office for National Statistics, as at September 2019.
But in the face of this, consumption – the largest component of UK GDP – has held up remarkably well, mainly boosted by a strong labour market (see chart 3). While employment growth has softened recently, the labour market remains in good health overall. The unemployment rate, at 3.8%-3.9%, is the lowest since 1974, while wage inflation has picked up to 3.8%-3.9% – the highest since 2008.
Chart 3: Keeping a brave face
Source: Refinitiv, Office for National Statistics, GfK, as at October 2019.
Muted inflation has also supported real disposable incomes. The oil price has fallen, while the boost from sterling’s depreciation after the referendum has faded. While trade tensions could boost prices temporarily, it seems more likely that inflationary pressures will remain contained.
The UK consumer also seems in a better position than before to weather any economic shock. Household debt as a share of disposable income has declined since the financial crisis (see chart 4), while rock-bottom interest rates mean the cost of servicing debt is low. Finally, a higher savings rate means that consumers have a last-measure buffer to resort to.
Chart 4: In rude health
Source: Refinitiv, Office for National Statistics, as at October 2019.
But how long will this divergence be sustained? The fortunes of the labour market will be crucial. Currently, it appears vulnerable to poor business sentiment and could easily transmit stress to consumers. Moreover, the focus of policymakers on Brexit means that other pressing issues like low productivity and inequality have fallen by the wayside.
Brexit has not yet happened, but it has already taken its toll on the economy (we discussed the effect of Brexit-related uncertainty in our edition of Ahead of the curve last October). The BoE reckons that UK GDP is 1.5%-2% lower than it would have been in a no-referendum scenario, due to ‘income effects’ – or sterling’s plunge which boosted inflation and squeezed real incomes – and deterred business investment.
A no-deal exit looks unlikely in the short term, but even if a withdrawal agreement is approved it is unlikely to be plain sailing going forward. The withdrawal bill will only address the divorce aspect of Brexit, and the future relationship with the EU – including trade and security arrangements – could take years to negotiate.
Moreover, the prospect of a cliff-edge exit at the end of the transition period in December 2020 will remain a threat. An abrupt transition would likely cause short-term disruption and if no trade deal has been agreed the UK will fall back on World Trade Organisation rules, which could reduce GDP by 5%-10% in the long-term.
The future political declaration also suggests the financial sector will take a significant hit. According to one estimate, London could lose up to 30,000 jobs in banking and related financial services as EU clients move $1.8tn-worth of assets out of the UK. The sector brings in $245bn a year and accounts for 12% of the UK economy, which means the ripple effects would be severe.
In the medium-term, we think that geography, logistics, existing regulatory alignment and strategic considerations mean the UK is likely to remain closely tethered to the EU. Moreover, trade tensions could trigger the emergence of a bifurcated world which could prompt the UK to align itself with its larger neighbour (as we discussed in our last edition of Ahead of the curve).
It seems likely that the UK and EU will eventually form close ties through a Canada-like Free Trade Agreement or a Norway-style European Economic Area. Given the lack of certainty, even renewed EU membership cannot be completely ruled out.
A depleted toolbox
Deal or no deal, the risk of a recession has increased due to persistent Brexit-related uncertainty, trade tensions and weak global manufacturing activity. As a result, the immediate focus should be on making sure the UK’s macroeconomic policy framework is strong enough to respond to all threats on the horizon.
Monetary policy is an obvious tool – it provided about two-thirds of the large-scale policy stimulus during the financial crisis, and the Resolution Foundation reckons that without it, GDP would have been 12% lower in the years after the recession.
But monetary policy is heavily constrained: the policy rate is 0.75%, while the BoE reckons that the effective lower bound is about zero. Quantitative easing and a Japan-style yield-curve-control policy are possibilities, but even with these measures, monetary policy – both conventional and unconventional – could probably only provide stimulus equivalent to a 150-200bp cut, given that long-term yields are already low. By contrast, the historical average for an easing-cycle cut in the is 500bps.
The BoE is likely to maintain its neutral bias in the short-term, although it acknowledged at its last meeting that limited tightening may be needed if there is a smooth exit from the EU. But the recent decline in external demand, coupled with the fact it could take years to come to a trade agreement, means that a rate cut cannot be ruled out entirely. Governor Mark Carney’s tenure also ends in January, which makes the outlook even more opaque.
The diminished potency of monetary easing opens the door for a more active role for fiscal policy (we talked about this in our May edition of Ahead of the curve). The Resolution Foundation recently highlighted how fiscal expansion tends only to be allowed in response to a 'significant negative shock' and is seen as an exception that is limited to emergencies. But this approach risks limiting the size, timeliness and effectiveness of a policy response.
There is clearly a need for a more explicit, counter-cyclical use of fiscal policy. Automatic stabilisers have weakened in recent years and any efforts to strengthen them would be appropriate. In addition, low borrowing costs that are well below nominal GDP growth should also help the UK engage in traditional fiscal stimulus (see chart 5).
Chart 5: A borrower's paradise
Source: Refinitiv, Office for National Statistics, Bank of England, as at October 2019.
Fiscal loosening certainly appears to be on the horizon, although the extent of easing will depend on what kind of withdrawal deal is reached and how much disruption there is to the economy. In September, UK Chancellor Sajid Javid announced an increase in public spending worth £13.4bn, or 0.6% of GDP.
The announcement was light on detail and there was no mention of funding sources or possible tax adjustments. But taking the figures at face value – and assuming there are no other changes to revenues – the announced spending measures could boost GDP growth by 0.3 percentage-points in 2020.
Yet it looks like the government has already broken existing fiscal rules, which cap the deficit at 2% of GDP and commit to reducing the public-debt burden. In March, the Office for Budget Responsibility (OBR) put the government’s fiscal headroom at almost £27bn, but cut it to £10bn after changes to student-loan accounting.
Moreover, the Institute for Fiscal Studies (IFS) argues that the September spending plan and the fact that growth has fallen mean the government has more than exhausted its fiscal space. Under the new proposals, the budget deficit is set to reach £52.3bn by 2020-21, more than double the £21bn forecast by the OBR in March.
The budget set for 6 November has been postponed, although OBR forecasts released the next day will shed light on the government's fiscal headroom as it goes into elections on 12 December.
Although some level of fiscal easing is clearly needed, going too far would risk the long-term sustainability of public finances, given that public debt as a share of GDP is already high (see chart 6).
Chart 6: Debt reduction in jeopardy
Source: Refinitiv, Office for Budget Responsibility, as at March 2019.
Whatever it takes
UK economic growth is buckling under the weight of chronic Brexit-related uncertainty and weaker external demand. Monetary easing has run out of steam and a greater role for fiscal easing beckons. A revamp of fiscal policies and rules need not be irresponsible, and should look beyond Brexit to focus on the myriad of long-term challenges – productivity and widening inequalities, to name the most prominent – that could be tackled by higher public spending.