Our model suggests that the boost to UK net trade from the fall in sterling and the ongoing global upswing will not be sufficient to save the UK economy from a technical recession. It may have weathered the Brexit storm better than most economic forecasters, ourselves included, anticipated, but it is a case of ‘pain deferred’ rather than ‘pain avoided’.
The majority of forecasters agree that the short- to medium-term impact of Brexit will be to harm, rather than help, the UK economy. Consequently, the debate is over the extent of that impact. We are markedly more pessimistic than both the Bank of England and the consensus, which have forecast growth of 1.6% and 1.3%, respectively.
For reasons covered in a Fathom In Depth sent to our clients last week, we contest the belief that sterling weakness will boost net trade and investment by enough to offset the consumer squeeze and avoid an economic downturn. Instead, we find that what matters more for the UK’s ability to rebalance is global demand, highlighting the importance of maintaining a close relationship with the UK’s major trading partner post-Brexit.
As our chart highlights, the recent referendum-induced drop in sterling has coincided with only a slight improvement in the UK’s trade balance, with net trade contributing a cumulative 0.4 percentage points to GDP growth since the Brexit vote.
Some have pointed to firms’ pricing behaviour as reason for this limited improvement. Indeed, as our chart illustrates, UK exporters have opted to build profit margins, increasing the sterling price of their exports by nearly the same amount as the fall in sterling since the Brexit vote. Recognising this, policymakers have pointed to the beneficial effect on profitability. It is hoped that rising profitability will encourage businesses to invest in additional export capacity.
But when modelling the impact of movements in the real effective exchange rate on the UK’s real trade balance we find a relatively small effect. And, tempered by Brexit-related uncertainty, that tailwind is likely to fall short of that implied by our model. Indeed, the Bank of England’s Agents’ Summary of Business Conditions Survey continues to point to only modest investment growth, noting in the latest release that there were fewer examples of domestically-focused businesses considering exports for the first time than might have been expected, given the fall in sterling.
In addition, a Chartered Institute of Procurement & Supply survey, conducted between September and October last year, suggested nearly two-thirds of EU businesses were expecting to move elements of their supply chain out of the UK. Although fewer UK firms reported plans to diversify, the implementation of contingency plans could prove costly, diverting funds away from investment. Meanwhile, it seems that only the manufacturing sector has enjoyed rising profitability, as measured by the net rate of return in the chart below. The service sector, which accounts for the bulk of the UK economy, has struggled to defend profit margins.
With those caveats in mind, and others expressed in a more detailed note sent to clients, we maintain our belief that there is a greater-then-evens chance that the UK will suffer a mild technical recession this year. Although, as we have commented in the past, trying to predict a recession with any certainty is a “mug’s game”. But if we are right, economic slack in the UK economy will be greater than the Bank of England set out in its November 2017 Inflation Report and further rate hikes will be off the cards.
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