EY ITEM Club
Winter forecast

Prospects for the economy as
the UK prepares to leave the EU

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EY have been sole sponsors of the ITEM Club for 25 years. It is the only non-governmental forecasting group to use HM Treasury's model of the UK economy. Our reports provide a detailed economic analysis and forecast of economic activity for the period ahead. They are independent of any political, economic or business bias.

Forecast highlights

by Peter Spencer, Chief Economic Advisor, EY ITEM Club

It may look like the economy is taking the referendum in its stride, but we think that impression is deceptive. Sterling’s shaky performance so far this month provides a timely reminder that troubles lie ahead.

Our forecast sees the UK economy undergoing a fairly gradual dip and recovery over the coming four years, with GDP growth slowing to 1.3% this year and just 1.0% in 2018, before picking up modestly to 1.4% in 2019 and 1.8% in 2020. However, the economy’s ability to deliver against this is forecast will depend critically on its foreign trade performance – which we think will improve this year as consumer spending slows down.

We also see inflation as measured by the Consumer Prices Index rising temporarily to 3.1% by the final quarter of 2017, before falling back towards the Bank of England’s 2.0% target next year. With wage inflation remaining subdued and the economy slowing down, we think the Monetary Policy Committee will hold base interest rates at their current level of 0.25% until the spring of 2018.

Turning to more immediate matters, recent Government statements – including those by Prime Minister Theresa May – have now given us greater clarity on what the UK’s exit from the EU will look like. This is already influencing the economy even before the start of Article 50 talks, and we think the most likely outcome is that the UK will be trading with the EU under World Trade Organization rules by the end of the decade.

But whatever the outcome, the fall in sterling has signaled the need for a significant shift in the structure of the UK economy, away from an over-dependence on domestic consumer spending and towards a better performance overseas. This reflects the fact that rising inflation will force a slowdown in household spending this year, adding to the pressures from a weakening jobs market, subdued wage growth and the cash freeze in working-age benefits.

Ideally, exports would increase to take up the slack – but to date the UK’s trade performance has remained disappointing, with exporters mainly using the lower pound as an opportunity to increase their sterling export prices. Combined with rising import prices, the effect is to widen the UK’s visible trade deficit in sterling terms. However, more positively, the surge in export profitability is creating a big incentive to find overseas customers and build export capacity and expertise. Given these effects, we expect net exports to strengthen this year, as overseas markets improve and the consumer slowdown curbs import volumes.

Against this background, we think export volumes will rise by 3.3% this year and 5.2% in 2018, against increases in import volumes of 3.0% and 2.3% respectively. As a result, net exports will add an average of ¾% a year to UK GDP from 2018 to 2020. We also expect the overall deficit on the current account to narrow from 4.9% of GDP this year to 4.5% in 2018 and 3.7% in 2019.

Looking further ahead, the UK’s trade performance and output growth in 2019 and beyond will depend critically on the exit terms that can be agreed with the EU27 and other countries. While we now have greater clarity about the UK’s negotiating position, the elections coming up in the Netherlands, France and Germany later this year will mean it takes longer to get a clear picture of the views on the EU27 side. In the meantime, the US election result has heightened uncertainty over the US’s economic and foreign policy, which could also complicate Britain’s exit from the EU. If nothing else, we can be certain that these are interesting times.

Economists are right: the UK economy is changing. So don’t wait for Brexit and get left behind

by Mark Gregory, EY Chief Economist

Economists have come in for criticism in recent months …

Following the vote to leave the EU, the UK economy has performed better than some economists predicted. This outturn has been interpreted by a number of commentators as signalling a failure of economic forecasting. However, Brexit is just one of several factors – including the new US administration and upcoming elections in Europe – that are combining to increase uncertainty and make forecasting more difficult.

…but writing off economic forecasts risks complacency…

Also, the reality is that it’s still too early to know what Brexit’s impacts will be. And there’s a real danger that the current attitude to economic forecasts means significant changes to the economic outlook will be ignored and risks not properly mitigated. So businesses and consumers must avoid being lulled into a false sense of security.

…because the UK economy is slowing and changing…

As the EY ITEM Club Winter forecast demonstrates, there are already signs of significant change in the UK economy. As the UK moves towards Brexit in 2019, the key features of the UK economy for the next two years will include:

  • A lower pound – down by around 15% on a trade-weighted basis since January 2016, and likely to stay at these levels;
  • Rising inflation – CPI has already reached 1.6% and is forecast to touch 3% in 2017;
  • Lower consumer spending growth – slowing from 2.8% in 2016 to 0.4% in 2018, as household incomes are squeezed;
  • Falling business investment – declining in both 2017 and 2018 as overall growth slows, confidence weakens and uncertainty continues;
  • Improving external conditions – with world markets improving and the lower pound providing some support to UK exporters.

Taking all these factors into account, the EY ITEM Club expects UK GDP growth to slow to 1.3% in 2017 and 1% in 2018, as stronger external demand fails to compensate fully for slowing domestic demand.

…even before Brexit

While forecasting the outcome of the Brexit negotiations is extremely difficult, the EY ITEM Club have assumed that the UK’s future trade with the EU is most likely to be governed – at least initially – by WTO rules. While this is not the Government’s preferred outcome, it remains possible given the risk that the ambitious objectives set by Theresa May cannot be achieved within two years. In this scenario, UK GDP growth will not recover to the 2% level before 2020.

Brexit is only one of the issues to address

I’ve consistently advocated "wait and see " as the sensible corporate response to Brexit, given the lack of detailed information for decision-making. However, even before any formal Brexit, there are clear signs of a slowdown and shift in demand in the UK economy over the next two years.

In light of this, now is the time for businesses to review and update their strategies and business plans. Slowing growth, rising inflation and a depreciating currency could be an unhealthy cocktail. It would not take much for the economy to spiral further downwards, at which point starting to act may be too late.

The key short-term steps are:

  • Review the business plan for the next two years and identify any required realignment and risk mitigation activities. Then assess the “knock-on” effects for the post-Brexit plan.
  • Evaluate the scope for changes in international activities. With the pound set to remain around current levels for some time, both export and import activities should be re-assessed. The US could become a more attractive market if President Trump delivers the widely-anticipated stimulus, while strengthening commodity and oil prices may boost emerging markets. However, rising imports prices may mean sourcing and location strategies need reviewing.
  • Looking beyond the next two years, Brexit will become key. While the precise outcome is difficult to call, it’s vital to develop options for the future. Certainly stress-testing the business against a WTO option after 2019 would be a sensible move.

    Finally, it’s important to keep providing the UK Government with guidance on the priorities for the exit negotiations and fostering future trade.

Contact

EY - Mark Gregory

Mark Gregory

EY Chief Economist