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MarketWatch November 2017

UK Economy: Brexit Starts to Bite

Alan_Werlau_resized.jpg Alan Werlau
Head of Investment Advisory

It has been a year since the UK’s vote to exit the European Union (EU) and the outlook for the domestic economy remains uncertain. The British economy has fared better than most forecasters feared, but cracks are starting to appear and the future is anything but clear.

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One foot in and one foot out

Gross domestic product (GDP) growth has remained positive and a significant sterling devaluation has helped manufacturing and exports, sparing the economy from a possible recession thus far. Weaker sterling, combined with continued access to the EU single market without tariffs has created a ‘goldilocks’ situation for industry, which can be characterized as a temporary state where the economy is not too hot. This explains why the British government has placed such importance on negotiating a transitional agreement with the EU rather than a more permanent arrangement. The longer the UK can extend this beneficial arrangement, the more time the economy can benefit and possibly prepare for the harder Brexit to come.

While enjoying the current windfall, British industry is fully aware of its temporary nature. Although exports and industrial output have increased, companies are not willing to make significant investment based on a temporary benefit. For all the good news in the manufacturing sector, it still only accounts for 20% of GDP so its ability to lift the economy is limited. The service sector, which accounts for 70% of economic activity, is doing well but is starting to suffer from Brexit uncertainty, particularly the financial services sector. Prime Minister Theresa May’s slim general election victory seems to have been the catalyst for many firms to announce personnel moves to Frankfurt, Dublin and Paris. The most notable was the announcement by Barclays to move its European headquarters to Dublin. It is only a matter of time before the economic impact of those decisions begins to influence growth, tax revenues and unemployment.


Consumers feeling the pain

UK households remain the key to British economic prospects. Despite record low unemployment levels, wages remain flat while inflation has spiked. Households have responded to inflation from sterling weakness by trading down and focusing on essential purchases. As a result, growth in consumer demand has slowed significantly with the modest growth reflecting price inflation rather than incremental spending. The rise in inflation has reversed the positive real wage gains achieved prior to the EU referendum. With a slowing economy, dwindled household savings and persistent high household indebtedness, the UK consumer continues to be a critical yet vulnerable piece of the economic puzzle.

Faced with a rapid increase in inflation, the Bank of England (BOE) finds itself in a quandary. Normal conditions would prompt the Monetary Policy Committee to raise interest rates to try and halt inflationary pressures. But these are not normal conditions. Current inflation is not the result of a strong and overheated economy. Instead, the rapid depreciation of sterling has caused the inflationary spike, which should prove transitory. On the other hand, raising interest rates would immediately reduce the money in consumers’ pockets and increase already-stretched home affordability. Yet the BOE has threatened to raise rates regardless of the damage it may cause. This move has, at least in the short term, caused sterling to appreciate and perhaps by design, countered some of the inflationary pressure that prompted the talk of rate hikes. A small rate hike may not cause serious damage to consumers or the economy. However, additional interest rate increases seem unlikely in the near term and a rate hike now may just be the BOE’s way of putting an arrow back in the quiver should it need to cut rates if the economy slows in the future. As BOE governor Mark Carney reflected recently “it is critical to recognise that Brexit represents a real shock about which monetary policy can do little.”

The US Federal Reserve and European Central Bank have both announced the end of quantitative easing (QE). This puts the BOE and sterling in a very tenuous position, which given the present course of monetary policy, could lead to sterling weakness versus the euro and the dollar.


Property mixed

The UK property market has experienced mixed results over the past year. Enquiries from foreign investors for London commercial real estate have continued to ease and valuations remain stretched according to the BOE. Elsewhere in the UK, domestic and foreign demand has remained strong mostly due to demand for warehouse and storage facilities for online retailers, creating below-normal yields.

The housing market has seen activity and price inflation soften with the secondary market and high price bracket suffering most. Following Prime Minister May’s election, the market has witnessed a more notable downturn. First-time buyers, aided by the Help to Buy scheme, continue to keep entry level home prices resilient.


Negative effects of Brexit

The economy continues to lose momentum, but inflation is likely to peak over the coming months. The political landscape domestically and in the context of the EU exit negotiations remains tense. The negative effects of Brexit are slowly, but more and more clearly, beginning to be revealed. Unfortunately the outlook does not look promising.

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