UK economic outlook: Brexit looms large

27 June 2017


Commentary by Vanguard Economist Alexis Gray.

Alexis Gray

In the wake of the 2016 Brexit vote, many feared that the economy of the United Kingdom would collapse into recession. In fact, one year on, the UK has been one of the fastest growing countries in the developed world, with an impressively low unemployment rate of 4.6%1.

This implies, of course, that many commentators miscalculated the initial impact of a Leave vote.

So does this mean that the UK is now out of the woods? The answer, unfortunately, is no. Brexit could still be painful for the economy when the exit eventually takes place – most likely in 2019.

Crash Brexit: the most painful scenario

The most painful exit scenario is one often referred to as a 'Crash Brexit', where the UK fails to reach a deal and effectively falls out of the EU with no backstop. This chaotic outcome would mean a sharp shift away from EU rules towards World Trade Organisation rules. One can imagine that, in this scenario, increased uncertainty would lead to a drop in sentiment and a greater risk of recession.

Hard Brexit: the current direction of travel

A second, less painful scenario is a 'Hard Brexit', where the UK leaves the EU Single Market and the Customs Union and reintroduces immigration controls. The government seems to be heading in this direction at the moment, although public support is mixed. We cannot rule out the prospect of a shift in stance if Theresa May is replaced as the Conservative Party leader, or if another general election is called.

Soft Brexit: little change

Another possible outcome would be a 'Soft Brexit', where the UK joins the European Economic Area and retains access to the EU Single Market and Customs Union. This scenario is now more likely after the election given that May has lost some support for her Hard Brexit approach, and Remain voters have been emboldened to raise their voice again. A Soft Brexit would not, however, lead to much change from current arrangements, which one might argue defeats the purpose of Brexit altogether.

No Brexit at all?

A final, even less likely outcome could occur where Article 50 is revoked and Brexit does not take place. This scenario is difficult to imagine as many voters would conclude that politicians have ignored the democratic process.

What happens next?

Brexit negotiations between the UK and the EU have already started in Brussels. The UK's negotiating stance is far from clear given the hung parliament and lack of support for May's leadership. By contrast, the EU has spent the past year preparing for the negotiation and has remained unified, at least publicly. This arguably puts the UK on the back foot.

The UK could still clarify its position and negotiate a good deal, but time is running out. The divorce settlement and trade deal need to be agreed by October 2018 to allow time for UK parliament review and approval before March 2019. This rushed negotiation approach is certainly not ideal.

What does it mean for investors?

Uncertainty will remain elevated until Brexit is mapped out. This implies ongoing fluctuations in UK asset prices and the pound. To minimise the risk associated with this additional volatility, investors may consider reducing their home bias. That is to say, reduce their allocation to UK investments, which are likely to be most affected by Brexit-related events, and increase their allocation to global investments. This is not just a worthy consideration now during the Brexit negotiations; in general, regardless of political or economic events, global diversification can be a great way of reducing risk and providing additional sources of return over the long term.

1 Source: Macrobond as at March 2017.

Related reading:
Article 50: No change to Vanguard's mission

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