EY ITEM Club UK Summer forecast

The world post-Brexit

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Forecast in summary

by Peter Spencer, Chief Economic Advisor, EY ITEM Club

The post-referendum economy will follow a very different path from the one we envisaged in April, which assumed a vote to remain in the EU. Short-term, although the fundamentals will not change, there are likely to be severe confidence effects on spending, only partially cushioned by a fall in the pound. We see GDP growth of 1.9% this year, followed by just 0.4% next year and 1.4% in 2018.

The financial markets have stabilized following the initial shock, but we expect the downward pressure on the exchange rate to persist, leaving the sterling exchange rate index in the last quarter of this year down 15% on a year earlier. Judging by the experience of the ERM exit in 1992, the weakness of the economy should keep inflation under control and we expect MPC to have cut base rates from 0.5% to zero by the end of the year, with an average CPI inflation rate of 2.5% next year.

We have already had a couple of worrying business polls from the IOD and Lloyds Bank, as well as a special consumer confidence survey from GfK which reported the sharpest drop in 21 years. Such surveys will offer an important guide to the course of the economy over the next few months. In the meantime, there seems little doubt that the jitters seen in the run up to the referendum held back business, housing and other transactions and that these transactions will now be further delayed or perhaps abandoned given the heightened level of economic uncertainty.

The path that the economy follows in 2019 and subsequent years will depend upon the outcome of the negotiations with the rest of the EU. However, it seems very likely that Theresa May’s new government will make control of immigration its top priority, at the expense of access to the single market. We are assuming that the UK is able to negotiate a free trade agreement with the EU, similar to the recent EU-Canada deal. But that could prove to be optimistic.

The single market has been vital for industries like aerospace and automotive, which need a large home market to bring down unit costs and ensure success in the world market. This could now be forfeited. However, going forward, these considerations should be less important for growth in the new ‘weightless economy’. The UK is relatively well placed in services and the digital market place. It also enjoys a reputation for high value added pharmaceuticals, designer-label and branded consumer products and has a lot of experience in marketing these overseas. This reorientation should be helped by a switch in the balance of demand in emerging markets away from investment towards consumer goods.

The vote to leave the EU came as a nasty shock to the government, business leaders and investors and it is vital that they respond positively to the challenges and opportunities that lie ahead. Short-term, while we still have full access to the single market, the fall in the exchange rate will provide an excellent opportunity for exporters, while the increase in inflation and unemployment will help to rebalance the economy away from consumption.

As we have consistently argued, infrastructure and housing investment should play a much bigger role in government spending plans when long term financing is so cheap. If we do lose access to the single market, much will depend upon the way the new government uses the freedoms it gains in return.

Business implications

by Mark Gregory, EY Chief Economist

An uncertain outlook….

The EY ITEM Club Summer forecast sets out how challenging and uncertain the economic outlook is with a significant downgrade in expected GDP growth compared to April’s forecast. Given the likely shock to the economy from the decision by the people of the UK to leave the European Union, this change in outlook is unsurprising.

However, all the current forecasts are highly uncertain - we arguably know no more, and possibly less, than we did before the referendum. The result is clear but the UK political landscape is being rebuilt after an earthquake and discussions with the other members of the European Union have not yet started.

…unlikely to change soon…

Businesses should organise their planning and analysis in this uncertain environment around 3 time periods:

  • The short-term, probably until after the Autumn Statement, when we will have more clarity on UK Government policy and sufficient post-referendum economic and corporate data to enable us to develop a clearer view on the likely future path of the economy;
  • The negotiation period: two years seems a sensible working assumption for the process. The hope is that the options will be narrowed down as time progresses and hence uncertainty will be reduced; and
  • The longer-term: post exit when the UK will be pursuing its individual economic course. It is of course possible that a new trade deal may take longer than 2 years but the longer-term should nevertheless be significantly clearer in 2 years than it is today.

…so take the time to prepare.

In the short-term, businesses should avoid knee-jerk reactions. Absent good data, decisions made in this period are as likely to be good as they are bad. The focus should be on shoring up the business and initiating the research and analysis to enable strategic and operational decisions as we learn more.

There are obvious challenges moving forward: the EY ITEM Club expects both business investment and consumer spending to slow for the rest of 2016 and companies will need to adjust to this. However, there will also be opportunities, especially for exporters, as the pound is likely to remain low for some time. Moreover, as the UK develops its new trade strategy, new markets may open up and existing markets could become more attractive under improved trading arrangements.

Monitoring developments will be critical…

The move from the current arrangements to the long-term post-EU position will be driven by four factors:

  • Agreement on arrangements for post-Brexit, UK-EU and UK-rest of the world trade which will impact both exports and imports, the latter critical for many supply chains;
  • Approach to movement of labour between UK and EU and UK and the rest of the world with clear implications for the recruitment and retention of skilled and unskilled workers and also potentially for investment in labour saving technology
  • UK regulation in areas where EU rules no longer apply, offering the scope to “free up” British businesses; and
  • UK Government policy across a range of areas, using the potential freedom from EU “State Aid” rules to forge a new role for the public sector in UK economic activity.

Each of these four areas has clear implications for business but their impacts could vary significantly depending on negotiations. Some effects are likely to be felt sooner than others. Beyond the exchange rate effect already mentioned, shifts in trade are likely to take some time to become clear. But just the potential for changes in the current arrangements for the free movement of labour might start to impact current workforces and upcoming recruitment activity very quickly.

Close attention to the developments in each of these areas in the UK’s exit negotiations will be critical in shaping strategy over the next two years and for the longer-term. Signs of clarity are emerging, the new prime Minister has made clear the approach to the free movement of labour needs to change, and more details in other areas will hopefully emerge in the not too distant future.

…and especially not ignoring opportunity.

Some of the likely opportunities arising from the UK leaving the EU are relatively easy to identify: a reduced regulatory burden and greater trade freedom most obviously. But there are others.

With the likely slowdown in both consumer spending and business investment identified by the EY ITEM Club, the public sector may need to take up some of the slack. The referendum campaign identified concerns over immigration, inequality and geographic differences in economic opportunity amongst others, policy is also likely to evolve to address these concerns.

I expect that there will be a greater focus on infrastructure, education and skills going forward and that this will create business opportunities. It also seems likely that these initiatives will have to be delivered locally meaning an acceleration of the devolution of powers and responsibility to bodies such as the Northern Powerhouse and Midlands Engine.

The outlook is challenging and things may well be rocky in the short-term but the die has been cast and now is the time to begin to shape the future.

Trade viewpoint

by Steve Varley,Chairman and Managing Partner EY UK&I.

Undoubtedly the next couple of years will be challenging for the UK economy. The UK government will need to quickly introduce measures to help offset Brexit blues, support the economy and continue to attract foreign investment.

While investors value the UK’s access to the single market, we shouldn’t lose sight that they also rate the UK’s quality of life, diversity and culture, education, stability of social climate, telecommunications, and labour skills highly. These underlying fundamentals have not changed.

The focus now needs to be on making sure that the UK negotiates the right trade deals that will allow access to key markets. There are numerous opportunities for the economy to remain not only open for business but also attractive, competitive and connected. As the world’s fifth largest economy, the UK will continue to be an integral piece of the global jigsaw.

Contact

EY - Mark Gregory

Mark Gregory

EY Chief Economist