“Britain could not be half-in, half-out of the EU”, the UK Prime Minister Theresa May said on January 17, leading the negotiations to a ‘Hard Brexit’. Through the speech, May confirmed that Britain would leave the EU single market, which guarantees the free movement of goods, services and people within the block, since her first objective is to regain full control of immigration and lawmaking. Hence, in the forthcoming negotiations with the EU, Britain would seek a wholly new arrangement to replace the current provisions of EU customs union. In this article, I will illustrate some empirical evidence that leads me to believe that the UK is on the path to recession, but, more importantly, I will provide you with the numbers necessary to create your independent point of view.
To begin with, we need to have a clear picture and a general understanding of the numbers involved. As shown, UK has a GDP of $2.85 T (2015), a small amount compared to the aggregate European GDP of $14.15 T (excluding the UK). Even if it is not a qualitative number, it gives a color of the magnitude of the two parties involved in the discussion, as well as a sense of what giving up access to European single market could mean for the UK. Simultaneously, from the ‘GDP Composition Breakdown’ chart, we can see how the UK economy relies mostly on services, which account for 79.0% of total GDP and that its main partner is the EU, with more than half of both exports and imports. Theresa May claims that, when the two blocks will seat at the table, Britain’s trade deficit with the EU will put it in a strong bargaining position for an ‘Hard Brexit’, but, as shown below, 12.7% of British GDP depends on trade with the EU, whereas only 3% of EU GDP depends on trade with Britain.
What is happening…
The vast majority of economists expects the decision to leave the EU to hit growth in the medium to long term as businesses delay investment plans and rising inflation start squeezing household incomes. Up until now, UK growth in 2016 has been stronger than forecasted, as has happened in the US and in the EU, with little sign of any immediate post-Brexit slowdown. However, up to now, we have only seen the (short-term) ‘benefits’ of Brexit: a weakened pound, now at its lowest since 1985, is boosting export companies, consumer spending, growth (due to a spike in inflation) and tourism, but it is not going to last long.
Source: Bloomberg, average forecast by major banks in gold
In fact, Brexit is already affecting the real economy, especially companies’ decision making, due to uncertainty of the future, on:
- Jobs and Investment: several companies have discussed cutting jobs in the UK
- Profits and Prices: a weak pound is prompting import-dependent companies to raise prices
- Headquarters Moves: a few companies have warned of possible moves, such as Wells Fargo, L’Oreal, Vodafone and others
- Deals: Brexit clouds prospects for corporate M&A because of uncertainty over the UK’s future access to the EU’s single market and labor
…and how could the future be
As I see it, one of the main issues that the UK could face going forward in the negotiations, and in its future outside the Euro Zone, is that its economy is not self-sufficient; just to give a sense, it imports over 50% of its food and exports account for almost a third of the total GDP. In my opinion, we are going to get to a point where the country will have to pay for the real costs of Brexit:
- Decrease in exports: UK financial companies (account for more than 10% of GDP) would not be able to work with EU clients as usual due to the blocking of EU pass-porting which allows banks and insurance companies to provide financial services in every country in Europe. Other sectors will be affected as well, e.g. the automotive sector exports more than 60% of the cars, a significant part of which in the Euro Area, and they are very likely to have a tax levied on trades with the single market;
- Gilts are going higher: investors are moving capital out of the UK due to uncertainty on the negotiations (and markets hate uncertainty because it prevents investments and future plans) and raising inflation. The 10-year government yield more than doubled since the ‘Leave’ vote, and I think there will be even more volatility and room to go ‘north’ for government bonds as the negotiations move forward ;
- Inflation: a lower pound means that imports would become more expensive and this is in turn likely to mean the return of inflation. In my view, inflation is set to grow at a rate of around 3 to 3.5% (look at the swap forward 5y5y) thanks to higher costs of imports (that accounts for 26% of GDP and have already been affected by a depreciation of the currency of around 16% vs USD and around 10% vs EUR, meaning that after the ‘Leave’ vote companies that import goods had to raise prices by about 5-10%). The issue with inflation is that the Bank of England has a legal obligation to keep it as close to 2 % a year as possible. If a fall in the pound threatens to push prices up as much as 3%, the BOE will have to raise interest rates. This acts against inflation in three ways. First, it makes the pound more attractive, because deposits in pounds will earn higher interest. Second, it reduces demand by raising the cost of borrowing, and especially by taking larger mortgage payments out of the economy. Third, it makes it more expensive for businesses to borrow to expand output. This is going to hit UK growth strongly. In fact, the downside is that household mortgages, private company loans and government borrowing are going to be more expensive, thus decreasing and finally leading to lower growth;
- Job Losses and paycheck cuts: several companies, such as JP Morgan, Llloyd’s, and many others, already have job cuts and relocation outside the UK on the table. In addition, some EU Authorities will have to relocate too, e.g. the European Bank Authority. This is causing and will further cause salaries to slump. The combination of raising inflation and decreasing wages is going to especially hurt low-income individuals and subsequently consumers spending.
Inflation Spikes, while Wages Fall
Source: Bloomberg, UK Wages and Salaries current prices
Source: Bloomberg, Inflation Chart. Actual UK Inflation Rate (in white), UK Inflation Zero Coupon 2Y* (in yellow) and GBP Inflation Swap Forward 5Y5Y** (in green)
Total Costs and Trade Deals
In case of a Hard Brexit, towards which Theresa May is heading, a rough estimate of the potential GDP losses for the UK economy could be in the order of 150-200 B pounds (around 7-8% of total GDP). This derives from:
– Higher costs for imported goods (difficult to avoid since the UK has little or no production for certain goods onshore, especially for basic stuff like food);
– Higher interest rates, leading to lower consumer spending (decreases in loans and mortgages) making it more expensive for the government to boost the economy;
– Inflation, eroding household savings and spending capacity;
– Job losses combined with lower salaries;
– EU’s bill for leaving the EU. Michael Barnier, who will lead the negotiations on behalf of the commission, speculates that the bill stands between £35bn and £55bn.
Last but not the least, until now, most of the UK’s trade deals were done by the EU, and, once it leaves the single market, it will have to renegotiate almost all of its trade deals. Usually, it takes a few years to negotiate a new trade deal, meaning that if Theresa May, as she said, wants to do a Hard Brexit within two years she needs to be fast and strict on timing. She needs to establish a team that starts negotiating with more than 100 countries as soon as possible. The UK has to be ready the day after it leaves the single market, and must give details to companies allowing them to plan their strategy, otherwise they would assume leaving the UK to be the easier choice.
As I see it, for the above-mentioned reasons, Brexit is going to be a loose game for the UK , but the worst part, is that the low-income middle class is going to be the most affected (especially because of a high inflation level).
* The UK Inflation Zero Coupon 2Y tells to market participant the market expectation of the average level of inflation over 2 year period
** The 5y5y forward swap rate is actually the 5y5y breakeven rate. It tells to market participant the market expectation of the average level of inflation over 5 years 5 years from now. It is very useful to central bankers as it tells them what the market thinks the long term impact of both monetary and fiscal policies will have on inflation.