One week on from the seismic referendum result and the only thing that’s clear is that the UK is in the midst of its deepest political crisis since at least the Second World War, with a vacuum at the top of Government. While David Cameron remains as Prime Minister until early September and the Conservative Party plays parlour games to choose his replacement, he holds that position in name only – he has no power to do anything. At the same time it has become painfully apparent that the Leave campaigners have no plan how to actually put the Brexit vote into practice. They have no clear timetable for invoking Article 50 to kick off the exit negotiations, are displaying a woeful ignorance of the EU's rules and appear completely naïve about the motivations and red lines of the UK’s EU counterparts. They are unable to agree among themselves what sort of post-Brexit trading relationship to seek with the EU. They say they want full access to the Single Market, but having campaigned on an anti-immigration platform they will be unable to accept the free movement of labour that such membership entails. And while they think that the EU will be able to cut the UK a special deal, they are deluded.
All the while, EU Leaders have displayed what is, for them, remarkable unity. They want Article 50 triggered shortly after a new Prime Minister is appointed. They have also made it clear that the UK will not be able to pick and choose - Single Market access will require free movement of labour. The EU’s Trade Commissioner and the Visegrad Group of Central and Eastern European countries, meanwhile, have said that they will not negotiate a new trade deal with the UK until it has formally left the EU (i.e. when the Article 50 negotiations are concluded). And given that any new trade agreement between the UK and EU will require the unanimous approval of the other 27 member states (and parliamentary approval and referenda in some countries) the hurdles to getting any agreement eventually (and that could well be 10 years or more away) are clearly very high. The Leavers are rapidly finding out that their optimism about the UK securing a special deal was based on nothing but self-delusion and that extricating the UK from the EU is going to be a whole lot harder than running a campaign of untruths to win the referendum.
For the economy this uncertainty is clearly a massive negative. It looks as though the economy went into the referendum in not too bad shape. While the final Q1 GDP figures yesterday confirmed growth of 0.4%Q/Q, down from 0.7%Q/Q at the end of 2015, economic data for the months leading up to the EU referendum have generally been firmer than expected. Indeed, figures from the services sector showed a 0.6%M/M increase in activity in April, leaving the three-month on three-month growth rate falling by just 0.1ppt to 0.5%, while retail sales growth was strong in both April and May. We expect GDP growth to have been unchanged at 0.4%Q/Q in Q2 as a whole.
However, the economic outlook has been transformed markedly for the worse by the referendum result. There are any number of reasons to expect a much weaker growth profile and recession in the coming quarters. We expect a sharp contraction in investment due to the hit on business confidence and significantly lower consumption growth as real incomes get squeezed by rising inflation resulting from the sharp depreciation in sterling (which we expect to fall further from here) and rising unemployment as firms adjust workforces downwards. At the same time, uncertainty will hit construction activity and real estate transactions – and any falls in house prices will serve to put further downward pressure on consumption growth. And while net trade will benefit from falling imports on the back of the drop in domestic demand, weaker sterling is unlikely to boost exports significantly, not least given the uncertainty over the UK’s future trading arrangements. Against this backdrop, we see GDP shrinking by 0.4%Q/Q in Q3, followed by contractions in both Q4 and Q117. And while we expect growth to return thereafter (for a while at least), it can be expected to be lacklustre at best, weighed down by continued political uncertainty and downward pressure on real incomes. Broadly consistent with the estimates provided by almost all credible economic outfits ahead of the referendum, we expect the level of GDP at the end of 2017 to be about 3% lower than it would otherwise have been.
UK Economic forecasts
*May 2016 Inflation Report.
Source: BoE and Daiwa Capital Markets Europe Ltd.
Despite the anticipated weaker growth, we have nonetheless raised our inflation forecast to reflect the impact of the fall in sterling. We now expect inflation to rise back above the BoE’s target in the second quarter of next year (see table for full forecast). But, as Mark Carney indicated in a hastily-arranged speech yesterday, the BoE will ignore this one-off shock, instead concentrating on the demand hit, and loosening policy accordingly, cutting Bank Rate aggressively (but possibly not quite to zero), probably as soon as this month. And he also indicated that in August, when the MPC will have a new full set of forecasts, further policy action could occur then, presumably via an increase in asset purchases.
Financing the UK’s current account deficit
Source: ONS and Daiwa Capital Markets Ltd.
The risks to our forecast are weighted to the downside for growth and to the upside for inflation. In particular the political uncertainty could have a bigger impact on investment than we anticipate. This is particularly true for investment from overseas, where uncertainty about whether the UK will continue to maintain access to the Single Market, a key reason why the UK has the second largest stock of foreign direct investment in the world, is likely to see foreign firms freeze investment plans. That would obviously be bad for growth. But, as other data yesterday showing that the UK ran a current account deficit of 6.9% of GDP in Q1 demonstrated, it is also potentially dangerous for sterling given the UK’s need for large inflows of foreign capital to pay its way. When added to the fact that political risk has risen sharply, expectations about the future path of sterling have become more negative and interest rates have fallen, attracting the required foreign capital is going to be much more difficult post-referendum. That, we think, points to a further required downward adjustment in sterling, which we see falling another 10% at least over coming months. Indeed, the experience of sterling following its ejection from the ERM may provide a useful benchmark here. Having depreciated sharply in the initial wake of coming out of the ERM, it took five months until it hit its low against the dollar as interest rates fell and confidence in UK economic policymaking remained low. And that was all at a time when the UK’s current account deficit was much smaller than it is now and the structural shock to the economic and political system of ERM withdrawal was much less profound than that of a potential EU exit.
Sterling in wake of September 1992 ERM exit
Source: Bank of England
Overall, the referendum result has transformed the UK’s economic prospects in both in the short and long term. Recession is now the consensus call, and one we concur with. At the same time, sterling is set to fall significantly further as interest rates fall, political uncertainty remains elevated for months and probably years to come and the UK’s longer-term economic prospects are re-evaluated on the back of the large negative economic shock withdrawal from the world’s largest single market will entail.