EY ITEM Club Autumn forecast
Is the economy taking Brexit in its stride?
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.
At the moment, growth in the economy is being driven entirely by the consumer, supported by rising employment and real wages, as well as ultra-low interest rates. However, sterling’s devaluation will push inflation up to 2.6% temporarily next year. With average earnings still surprisingly subdued, this will slow the consumer. In the meantime, many firms have put investment and recruitment on hold while they assess the likely impact of the Article 50 negotiations on their business and consider their long-term options.
We see GDP growing by 1.9% this year, in line with our July forecast, but that is likely to be the best performance for some time. The forecast sees investment falling back by nearly 2% next year and with consumption slowing down, this leaves domestic demand flat. GDP growth will be driven by net exports, helped by the lower pound, at least while we retain access to the single market. GDP growth slows to 0.8% in 2017 before creeping back up to 1.4% in 2018, 1.6% in 2019 and 1.8% in 2020.
It is increasingly clear that we are heading for a hard Brexit, and that our former European partners are determined to play hard ball. It is now consensus that, as we said in July, we will no longer have unfettered access to the European single market. In that case, it is vital that we get unfettered access to cheap world markets in food and manufactures when we finally leave the EU in the spring of 2019. That will mean trading under WTO rules initially, while we try to negotiate free trade agreements with the EU and others as best we can over the longer term.
This scenario would benefit UK consumers but would hurt farmers and manufacturers. They would need to be supported by subsidies and more imaginative procurement and industrial policies. Financial services are also vulnerable under this scenario, and would surely consider transferring some of their activities to EU subsidiaries. Manufacturers are a lot less footloose, but the worry is that post Brexit, their new models and investment projects will go to the EU rather than the UK. In the meantime of course, uncertainty is damaging to business spending.
Longer term, the dynamic effects will tend to reduce cost to the UK of Brexit. Our membership of the EU has artificially boosted the EU share of UK imports and exports and this boost will now fade, providing we can access cheaper world markets and conduct trade deals with other countries. Despite this artificial boost, the slowdown in EU growth has reduced the EU share of UK exports from 60% in the late 1990s to around 45% currently. Non-EU markets will continue to outpace the EU, further lowering the EU share of UK imports and exports. Nevertheless, a WTO-based Brexit is still likely to take about 4% off UK GDP by 2030.
What does this mean for business?
by Mark Gregory, EY Chief Economist
Brexit: no need to worry?
The economy has not fallen off a cliff since the vote on June 23rd and commentators have been suggesting that this shows that fears about the UK leaving the EU were over-stated. The reality is that it is too early to celebrate the success of Brexit. Our sense from discussions with the corporate sector is that businesses are waiting for both data that has been collected post-referendum and for the details of future policy that the Autumn Statement is expected to provide. There have been no major moves as yet, the mood has been one of wait and see.
However, employment growth is slowing, wages are not rising as fast as EY ITEM Club previously expected and factory gate inflation is increasing and this will hit consumer prices next year. All of this points to a slowdown in consumer spending in 2017. The EY ITEM Club is forecasting consumer spending growth of 0.5% in 2017, a major change from the growth of 2.5% achieved in 2015. While the EY ITEM Club has been advising of a gradual slowdown in consumer spending for some time, the move towards Brexit has accelerated the expected rate of that slowdown.
At the same time, policy uncertainty has risen to record levels and this is feeding through into lower levels of business confidence which EY ITEM Club expects to translate into lower investment in 2017. This is also consistent with what we are hearing. Policy uncertainty together with a squeeze on margins from input cost inflation and a tightening labour market in some areas is leading to investment projects that are seen as marginal either being cancelled or delayed, with some of this capital being diverted to other geographies.
Time to start preparing
I have been an advocate of "wait and see" as far as corporate responses to Brexit are concerned, as there has been little post-referendum data or policy guidance on which to base decisions. While there is still a great deal of uncertainty, it does seem possible based on recent developments, both in the UK and in the policy statements of European politicians, that a "Hard" Brexit, by which I mean based around WTO rules, could happen and is currently probably the most likely case. It may well be that over time, further negotiations improve the situation. Now is the time for businesses to update their strategies and associated business plans to reflect the slowing macro-environment and emerging policy outlook. Slowing growth and rising inflation together with a depreciating currency could potentially be an unhealthy cocktail. "Hard" Brexit is a downside on the current position but should now be the base case for future decision-making.
The key steps are:
- Are there potential vulnerabilities in the current plan? Identifying short-term moves to mitigate these.
- Review capital allocation and consider investment decisions. Contemplate investing more in export capacity given the low pound and push for new trade partners, while investing to substitute increasingly high cost imports.
- Can you change the business to place some parts in the future EU and others outside? This may highlight possible M&A requirements.