The longer-term impact
A key issue is how Brexit will impact trend growth in the UK. This will be an important longer-term influence in our portfolios. The chart below shows the annual rate of UK economic growth.
Leaving the EU will increase the cost of trade with the EU, which helps explain the negative economic forecasts associated with leaving. But there will be many gains, in my view, too, particularly the further ahead one projects, and of course subject to future policy actions. It is important that in leaving the UK not only reaches a deal with the EU, but that this does not constrain the UK’s future room for manoeuvre on domestic and trade policy. To maximise future potential the UK needs to retain this flexibility and take policies to make the UK competitive while also boosting investment and innovation. I have written about this extensively elsewhere.3
The ongoing issue, even before the Referendum, was the need for the economy - and the markets - to see an increase in UK productivity and future trend growth.
In terms of the economic impact, the economy in the last two years has performed closely to our pre-Referendum expectation in the event of a vote to Leave. Before the referendum our expectation was a ‘Nike Swoosh’, reflecting the shape of that firm’s famous brand symbol, whereby growth would be weaker than it would otherwise have been during the Article 50 period, but not falling into recession. This is how it has turned out. Back in 2016 we were also more positive than the consensus about global growth.
It is hard to gauge fully the impact of the uncertainty of the last two years. On the positive side, sterling's weakness has boosted the competitiveness of exports and the continued fall in unemployment has supported consumer confidence, despite the squeeze in real incomes. On the downside, meanwhile, the temporary rise in inflation triggered partially by sterling’s fall has dented spending power, in an environment where wage growth has been modest. This is similar to what happened post the financial crisis when sterling fell sharply too. Then, after the rise in imported inflation had worked its way through the economy, domestic inflation remained low. Note inflation is now 2.7%, above the 2% target and as such wage and domestic inflation pressures need to be watched closely.
The continued uncertainty about Brexit is likely to have dented investment plans. Although in the case of these plans, this may well prove temporary. It is our contention that, whatever trade deal is agreed, the removal of uncertainty will give an uplift to investment plans during the transition period. Once business has clarity about what lies ahead they can then enact investment plans that may have been paused. The overall impact will naturally depend upon firms’ own business models and the policy adopted.
In assessing the impact of Brexit on the economy so far, a “doppelganger” methodology has been used across the City, mapping growth of other leading economies in the last two years. This is then used as a proxy for how the UK might have performed if there had been no vote to leave versus the UK’s actual performance. This is useful, but I tend to think it is better in qualitative than in precise quantitative terms, as the problem with the methodology is that the empirical correlation matrix of say GDP growth over time in different countries is inherently noisy, and thus not stable.4
Overall, using this methodology, there have been various suggestions, roughly speaking, that the economy is around 2.1% to 2.5% smaller than it might otherwise have been. We are more in line with the figure of a 1% shortfall produced by Julian Jessop of the IEA5, who has pointed out that sterling would likely have fallen anyway, that the euro area growth rebound last year was more of a catch-up, while President Trump’s tax cuts have boosted US domestic demand (the US accounts for close to one-quarter of the size of the economies in the doppelganger comparison). In June, the FT said, “an FT average of several models suggests that by the end of the first quarter of this year, the economy was 1.2 per cent smaller than it would have been without the Brexit vote.”6
There is a current tendency in economics to then extrapolate near-term projections, despite the often large margin of error on even one-year ahead forecasts, to predict the likely shortfall at some arbitrary date in the future - this is particularly so with projections of the budget deficit and future size of the economy. Far more important for our investment outlook is to gauge what is likely future sustainable growth.
From an investment perspective we not only take into consideration the near-term economic outlook, but also likely longer-term performance, too. Moreover, the economy’s trend growth clearly has a bearing on what is the sustainable rate of growth that can be achieved, before inflation and other pressures are seen. Also, this has a bearing on policy - in a number of ways. If trend growth is seen as lower then the economy’s ability to withstand inflation is seen as less, meaning it is more likely the Bank of England will have to hike. We have seen this in the Bank’s explanation of the latest rate hike. Also, trend growth has a bearing on fiscal policy. If the economy’s potential growth is lower, then more of the budget deficit is seen as being explained by structural or longer-term factors as opposed to cyclical or short-term influences, and thus this adds to the pressure for spending cuts, or tax hikes, lessening the room for fiscal manoeuvre. Some of this thinking will be evident in the Budget this October.
Source: ONS, Netwealth calculations
The above chart shows the trend in UK growth from 1975. Since the early 2000s there has been a steady downward move. The UK’s growth rate has been variable. It is also interesting to see that the 20-year average began to fall before the financial crisis. Looking ahead, it may take time for any new policies to fully take effect.
There has been a tendency, post Referendum, for greater caution or pessimism about the UK economic outlook. This may turn out to be excessive. Certainly, as we have touched on in various commentaries here and elsewhere over the last two years, the UK economy is imbalanced, and faces some significant challenges. Hence the vital need for a domestic economic agenda that addresses regional issues, boosts investment, particularly in skills and training, infrastructure, supports innovation and implements the right incentives to help small firms.
Moreover, with the vast bulk of global growth expected to come from outside Western Europe, the challenge and opportunity for the UK and rest of the EU is to position themselves in this changing and growing global economy.
From a portfolio perspective, this leads into many complex debates, not least the shape of the yield curve, the impact of the international exposure of the FTSE 100, where 66% of current earnings emanate from outsider the UK7, and the relationship between the FTSE 100 and FTSE 250, which is more skewed towards the domestic economy.
Here the message is that we will be watching the Brexit progress closely. In coming weeks, as we approach the Budget on 29th October, we will focus on the policy issues and UK economic projections.
Please remember that when investing your capital is at risk.
1The source of all market data in this piece is Bloomberg; economic data is official Government statistics. Market prices referred to here are on the day of the Referendum and the last trading day of September, 28th September 2018
2Monetary Policy Normalisation, Our Views, 3/August/2018
3See, ‘Clean Brexit’, co-authors Liam Halligan and Gerard Lyons (Biteback Publications)
4For the methodology see Ormerod, P. and Mounfield, C., 2002. The convergence of European business cycles 1978–2000. Physica A: Statistical Mechanics and its Applications, 307(3-4), pp.494-504
5See 14/09/2018, “Impact of Brexit on the UK economy grossly exaggerated”
6See Chris Giles’ piece, “What are the economic effects of Brexit so far?”
7See London’s Global Reach and the Half a Trillion Dollars Equity Prize, IEA, February 2018, by Gerard Lyons. Table 3