UK economic outlook: Brexit starts to bite
21 February 2018 | Markets and Economy
Commentary by Alexis Gray, economist in Vanguard Investment Strategy Group, Europe.
Since the United Kingdom voted to leave the European Union in June 2016, the economy has seemed to fare better than expected. Not only have we managed to avoid the recession that was predicted by some of the gloomier forecasters, but unemployment has fallen to its lowest level since 1975.
Does that mean that the impact of Brexit has been negligible so far? It's hard to say, because we can't compare the performance of the economy today against a scenario where the UK voted to remain in the EU. We therefore don't know if the economy is stronger or weaker than it would have been otherwise.
The UK: An economic underperformer
One rough way that we might gauge the impact is to compare the UK's performance against that of its key trading partners since the Brexit vote. Over those 15 months, the UK economy grew by 2.3% while the United States grew by 3.0%, France by 2.4% and Germany by 3.1%. Meanwhile, Ireland grew by 11.1% and Switzerland by 1.3%1. Prior to the vote the UK had been outperforming four out of these five economies. The UK's underperformance relative to most in this pack suggests that Brexit may already be weighing on the economy.
We must also remember that Brexit has not yet occurred, so any changes in the economy since the EU referendum relate to the anticipation of Brexit, not the event itself. The true, long-term effects of Brexit will not be felt until after the UK leaves the EU. The official exit date is 29 March 2019; however, a multi-year transition deal now seems likely, which may push back the real changes until several years later.
So what could happen from here?
Uncertainty should slowly diminish as the negotiations continue and details are mapped out. All other things being equal, this should be generally positive for the economy. At the same time, though, the practical preparations for Brexit will ramp up, which could impact business investment and hiring plans. This suggests some further economic drag in the lead up to Brexit.
Although it's too early to know what the final deal will look like, we can group the possible outcomes under five headings:
- No Brexit: Article 50 is revoked and Brexit doesn't happen.
- Soft Brexit: The UK joins the European Economic Area and retains access to the EU single market and Customs Union.
- Compromise Brexit: A compromise between Soft and Hard Brexit, where the UK establishes a customs arrangement with the EU and leaves the single market. A free-trade deal may then be struck between the UK and the EU providing low to zero tariffs on goods and services.
- Hard Brexit: The UK leaves the EU single market and the Customs Union, and reintroduces immigration controls. A free-trade deal may then be struck between the UK and the EU providing low to zero tariffs on goods and services.
- Crash Brexit: 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.
Compromise is gaining ground
At this stage option 3, 'Compromise Brexit', is becoming a more likely outcome. Under this scenario the UK would leave the EU and regain the freedom to set immigration policy. This would go some but not the whole way to satisfying Brexiteers. The UK would, however, retain close ties with Europe, and most likely strike a trade deal with low or even zero tariffs on goods.
Free trade on services seems less likely, but cannot be ruled out. The downside of a Compromise Brexit is that the UK would be required to contribute to the EU budget, and would be unable to strike trade deals with other countries. For this reason, we view this option as a compromise between the desires of Leave and Remain voters.
Implication of Brexit scenarios
Colours indicate attractiveness from a UK perspective
|No Brexit||Soft Brexit||Compromise Brexit||Hard Brexit||Crash Brexit|
|Freedom to impose immigration controls||No||No||Yes||Yes||Yes|
|Freedom to pursue trade deals with other countries||No||No||No||Yes||Yes|
|No contribution to the EU budget||No||No||No||Yes||Yes|
|Greater flexibility to adopt own approach to regulation||No||No||?||Yes||Yes|
|Passporting of banks from the UK possible||Yes||Yes||?||No||No|
|Free trade on goods and services with the EU||Yes||Yes||?||No||No|
So what does Brexit mean for investors?
Investors seeking to tailor their investment strategy to Brexit face three levels of uncertainty:
- We don't know how the political negotiations will play out.
- We don't know exactly how the results of those negotiations will affect the economy.
- And we certainly don't know how the politics and economics will affect investor sentiment.
However, we can make a couple of forecasts. On the economics side, given the low level of unemployment and rising inflation, we suspect that interest rates will gradually rise over the coming year.
As for the markets, we can expect ongoing fluctuations in UK asset prices and the pound, although the direction of any future movements depends on which of the above scenarios plays out.
One strategy that investors could consider to mitigate Brexit risk is to reduce their home bias. That is to say, reduce their allocation to UK investments, which will be most affected by Brexit-related events, in favour of global investments.
Diversification: a strategy for all weathers
Indeed, investing globally can be a good strategy regardless of political or economic events, as global diversification reduces risk and provides additional sources of return. Similarly, diversifying across equities and bonds reduces the reliance on either asset class and should help to reduce overall risk.
Overall, this approach is consistent with our view that it is difficult for investors to predict how political events will play out, let alone how those events will affect financial markets. So a globally diversified balanced portfolio represents a robust approach for investors to follow.
1 Source: Macrobond.
Economist, Vanguard Investment Strategy Group, Europe
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