What a difference a year makes….

Rathbones’ Asset Allocation Strategist, Ed Smith, reflects on one year since the outcome of the Brexit referendum and assesses the impact of the decision to leave the European Union on the UK economy.
 

• We believe UK growth could disappoint this year; full impact of ‘uncertainty shock’ possibly still to feed through.
• Over the long run, we place a 30% probability of a significantly adverse economic scenario resulting from the decision to leave the EU.
• Our analysis of the election result suggests that Conservatives do not necessarily have the political incentive to soften their approach to Brexit.
• Longer-term threat from non-tariff costs far greater than from tariff costs; risk to financial services key.
• Incentives for R&D investment required to bolster foreign direct investment after Brexit.

“This weekend marks one year since we learned the UK intended to leave the European Union. We thought it opportune to recount some of our key views – on the economy since the referendum and the outlook for the rest of this year; on the ramifications of the general election as Brexit negotiations get underway; and on three of the key areas that would be impacted by Brexit, trade, financial services and investment.

“Although we correctly forecast the magnitude of the fall in the pound, we were wrong-footed by stronger household consumption – after the referendum households actually decreased their rate of savings and took out even more consumer credit. That said we were always more optimistic than many of our peers, some of whom were floating the possibility of recession. It’s been pleasing to see consensus estimates for growth in 2017 being revised up; nevertheless, what drives markets in the short term is not so much the level of growth as the level of growth relative to expectations. As a result, we now see more risk of a disappointment than a pleasant surprise. 

“In particular, we see a threat to household consumption. This is crucial, as it accounts for about 65% of the economy and has been the only component to make a consistently positive contribution to growth over the last three years. Our analysis suggests that real (inflation-adjusted) pay growth is unlikely to return to anything much above zero for the next six months or so, and rising prices will erode consumer confidence. Also, our theoretical econometric modelling suggests that the effect of an ‘uncertainty shock’ is felt most acutely three to five quarters after the source of the shock. It may be that the impact of the vote to leave on confidence is taking time to feed through.

“A poor start to negotiations could further unnerve some people. In the first week of official negotiations, the government appears to have jettisoned its previous insistence that talks on trade should accompany the first phase of talks on rights of EU citizens residing in the UK, the size of the divorce bill and the border between Northern and the Republic of Ireland. Is this the first clear sign of a weakened hand? Regardless, if the economic implications are predominantly about a ‘hard’ of ‘soft’ withdrawal from the single market, we may be waiting some time for any hint of clarity. There is no set timetable for the beginning of phase 2.

“Many have inferred the collapse of a popular mandate for ‘Brexit at whatever cost’ from the results of the general election. But despite anecdotal evidence, it’s not quite so clear that the result was a backlash against the ‘hard’ Brexit Prime Minister Theresa May appeared to be heading for. The Labour manifesto was quite unequivocal: they too would withdraw from the Single Market and the Customs Union, and curb immigration – that sounds like a hard Brexit to us (although a poll in 2010 found that a little less than 1 in 3 voters actually read manifestos at all!). Moreover, we have cross-referenced data compiled by the House of Commons Library and poll aggregation service Britain Elects to analyse election performance in ‘remain’ constituencies. The median net gain of the vote share for Labour in constituencies that voted ‘remain’ was no higher than their net gain in constituencies that voted ‘leave’. Of the seats that Labour gained, almost half were in constituencies that voted ‘leave’. The Liberal Democrats offered a firm commitment to averting a hard Brexit: even in those most vociferously ‘remain’ seats, they only gained an average 0.7% of the vote (and made barely any gains at all in ‘remain’ seats in general). 

“As such we are not so sure the Conservatives have an incentive to soften their approach. Indeed, this week’s Queen’s Speech provided official confirmation that the Conservatives intend to stick to May’s vision of Brexit as set out in her Lancaster House speech in January.

“Thinking about the long run, we sketched out the probability of a significantly adverse economic scenario in our detailed report released before the referendum (follow this LINK to view the report). We put that probability at 10%, arrived at by a hard Brexit and also the possibility that the EU project revivifies, bringing further gains from integration. If the EU completes the single market without the UK, then it is much more likely that capital will be reallocated from the UK towards the mainland than if further progress in the EU project stalls. Today, we assign a much higher risk of an adverse economic scenario. Although we encourage readers to take these numbers with a pinch of salt, it’s perhaps as high as 30%. This increase is due to knowing the result of the referendum, understanding a higher political will for hard Brexit, upgrading the probability that the EU integrates further after the election of Emmanuel Macron in France, and including a risk that the UK struggles to complete trade deals with other nations in a timely manner.

“To finish, we set out our views on three topics apropos Brexit commonly focused on in our conversations with investors.”

Trade – we are not concerned about the imposition of tariffs in the event of a hard Brexit. The average weighted tariff that would be payable on the UK’s exports to the EU under World Trade Organisation rules would be a little over 3%. Clearly, that has been paid many times over by the 21% fall in the Euro to Sterling exchange rate since it peaked in August 2015. We are much more concerned about non-tariff costs to trade (in Western markets dominated by complex regulatory and certification costs, quality assurance and labelling regimes, state subsidies and minimum import prices). The academic literature is fairly unanimous that non-tariff costs are significantly larger than tariff costs. But this is a longer-term threat: given that the UK is already set up to comply with EU regulation, additional non-tariff costs in the short term would be broadly limited to more onerous burdens of proof.

Financial Services – this is our biggest concern. The ‘export’ of financial services is a significant contribution to the UK economy. The UK’s trade surplus in services is almost entirely in financial, and other professional and technical services often ancillary to finance. Again this is not a risk that would be realised overnight. We should not underestimate London’s history of financial innovation and predisposing government policy. However, if the UK failed to negotiate a bilateral agreement that enshrined the continued passporting of its financial services, it is difficult not to envisage a gradual loss of business and investment. This would add to our already negative view for commercial property – central London vacancy rates have already edged above their long term averages.

Foreign direct investment (FDI) – investment intentions had been on a downward trend since 2014. They have actually improved this year, but remain low and we do not expect business investment to make any meaningful contribution to UK growth while the cloud of Brexit hangs over UK commerce. Research suggests the most important drivers of global FDI are market size and agglomeration – a fancy term to describe the benefits when firms and industry networks locate near one another. A hard Brexit would clearly impact market size but other factors that compel agglomeration in the UK would remain. Investment will not be immune, but again we would not envisage inward investment collapsing in the event of a hard Brexit. Surveys by EY tell us that R&D is ‘the business function that will attract the most investment in Europe in the coming years’. We would like to see government incentives for R&D-based investment to improve the outlook for investment overall.

Edward Smith 
Asset Allocation Strategist, Rathbones