Why the downside risks of Brexit are mounting

While the UK economy did better than predicted in 2016 in the immediate aftermath of the referendum vote on leaving the European Union, growth has since stalled and inflation has risen. Beginning in January, I have been saying that risks from Brexit are rising. Let me reiterate that case below.

Now, because this is such a contentious subject, with Britain evenly split on the issue, I think a timeline is in order here. I will use my blog posts as the markers.

June 2016: Six days after the referendum, when I wrote my first post-Brexit blog post, there was still a lot of shock that the UK had voted to leave the EU. Remain supports were particularly vocal in voicing concern about downside risks, to the point where there was a widespread belief that Britain would immediately fall into recession. I pushed back against that narrative as motivated reasoning.

My view at the time was that “the unexpected ‘Leave’ victory in the recent referendum on EU membership introduces considerable political risk by elevating tail risk scenarios to reasonable worst case status” but that most of the risk was financial and much of it centered outside the UK due to where financial sector vulnerabilities lay. Italian banks were an example. Regarding the UK, I wrote that “my base case scenario is that there are minimal medium-to longer-term impacts on the economy or earnings”. Why is that?

Because Britain has its own currency, it also has the natural stabilizing force of flexible fiscal policy and exchange rates to offset economic shocks. And so, while Brexit would create shocks to investment and trade flows, these shocks would be dampened, if monetary and fiscal authorities reacted appropriately. The losses would be minor – though cumulatively it would mean an impoverishment of Britons of say 5-10% through higher inflation and lower growth. Let’s come back to this point later in the timeline but move forward to later in the summer first.

Summer 2016: Two days after my first post and eight days after the referendum, I wrote that because UK fiscal and monetary policy offsets would kick in, it was bullish for gilts. So, contrary to the prevailing view about recession, what I was saying is that no investment and consumption decisions were going to be revised straight away. People don’t work like that. Even so, if things started to go south, the currency would depreciate and fiscal policy would kick in enough to take the sting out of things. In a scenario of uncertainty though, coupled with the likelihood of lower interest rates, it was clear to me that there would be a flight to safety and British government bonds would benefit greatly – at least over the short-term.

By early August, my predictions had proved right. There was no recession. The Bank of England had cut rates. Gilts had rallied tremendously to as low as 0.677% for 10-year paper. And Sterling declined to $1.31, well short of my reasonable worst case scenario of $1.20.

The talk was still of recession – though this was now being pushed back to 2017. Here’s how I described the forecasting at the Bank of England.

“But if you look at the reasonable worst case scenarios for 2017, they include recessions, meaning the UK could indeed have a recession in 2017, depending on the circumstances, though this is not their base case. Many private sector economists are worried about recession. For example, the National Institute of Economic and Social Research – an economic think tank – says that Britain’s economy will shrink this quarter already and that it has a 50 percent chance of suffering a mild recession before the end of next year – and they blame the Brexit vote. Clearly then, recession is a base case here for the NIESR. I don’t see it. But if true, it only bolsters the case for curve flattening in the UK that makes long-term government bonds relatively more attractive.”

For me, this didn’t hold water. Remember, people like Gavyn Davies were saying that global growth was re-accelerating. You’re not going to get a UK recession when the rest of the world’s growth is increasing, especially when you have fiscal and monetary tools on offer. Bottom line: there were downside risks for the UK but recession should have been seen as an outlier.

Jan 2017: The UK economy did better than expected in 2016 – no recession, 1.8% growth for the year, driven by strong consumer spending. However, when we hit the beginning of this year, I said that’s when I believed the negative impact of the referendum would start to be felt.

I said, ask yourself this: “what happens if and when the UK actually files Article 50 to exit the EU? That’s when the rubber hits the road. The likelihood of the UK carving out a special status with the EU looks remote. And so the UK will have to see through a hard Brexit and all the pitfalls that could entail. There won’t be any uncertainty then. If consumers actually do stop buying and business investment sinks, it is then that we should see that response. All of the financial stability concerns could indeed come roaring back too. And that’s when policy offsets might prove inadequate. So from where I sit, the risk from Brexit now is actually higher, not lower.”

These points bear stressing because they are key to understanding why the downside risks are mounting. When Article 50 was triggered in March, the reality set in. That’s when the clock began ticking. And that’s when people began to make some consumption and investment decisions based solely on Brexit – not immediately after the referendum. Moreover, even as I write this, the May government is having a tough go at negotiating. Her Brexit Minister David Davies is still threatening to leave the EU without a deal in place, so far apart are the EU and the UK on terms. That’s a scenario in which the maximum trade frictions and investment losses are crystallized. And so people have begun to react and pull back.

Spring 2017: By May, when the EU released it’s Spring Forecast, the slowing was clear (link here).

And the prediction was for slower growth due to lost consumption and investment – but no recession.

Nevertheless, could the UK be headed for an inflationary recession? Remember when I talked earlier about using appropriate fiscal and monetary policy to offset economic shocks. Well, we have the economic shocks now. Yet the Chancellor of the Exchequer Phillip Hammond is still practically in austerity mode. And the Bank of England’s monetary stance has tightened due to the rise in inflation. There is a clear danger that, if the UK economy continues to weaken, the fiscal and monetary offsets will not be enough.

Today: Fast-forwarding 4 months to the present day and the picture looks no better. Look at growth and inflation the largest EU economies through August.

Growth and inflation in major EU economies so far this year — highlighting the UK pic.twitter.com/ncfzOQ8Plk

— Edward Harrison (@edwardnh) October 17, 2017

The UK is the slowest grower with the highest inflation. And yet, the talk is still of rate hikes and fiscal restraint. The British media has cast Chancellor Hammond as playing an intergenerational game of tax the old folks to appease the Millennials. But the real focus has to be on how inadequate his budget is in countering downside risk from Brexit.

For example, the UK deficit for August was the lowest in 10 years, 18% below last year’s. And the media have portrayed this as a good thing, a sign of budget discipline. The reality is that Hammond is targeting a surplus by the end of this Parliamentary term. He is taking a measure – the deficit – and making it a target of policy. And that’s going to restrict his latitude and potentially lead to disastrous results, even recession.

Bottom Line: The UK government have made a hash of Brexit. The negotiations are expectedly difficult. After all, the EU wants to discourage other nations from leaving. So the UK has less control over this process. Where it does have more control is in preparing the economy for an eventual shock when a Hard Brexit comes. From what I can see, the UK is totally unprepared and that means the downside risks are mounting. Ironically, if you’re a UK Gilt investor, that might be bullish.

Post-script: The medium-term is where the problems lie for the UK. Getting over the hump through March 2019 is not the only problem. There will be big trade flow, investment and consumption pattern changes afterwards if Brexit is hard as I suspect it will be. I still see a cumulative loss of 5-10% of GDP as a baseline, shading now toward the higher numbers.

Longer-term, Brexit is less significant. Once the die is cast and flows have settled down, the UK will settle in as a poorer but sovereign nation. Think of the United Kingdom post-Brexit as a super-Canada with nukes or a Mega-Norway, a big country but certainly not a giant on the world stage. Only time will tell how it uses its newfound independence.