UK 2019 outlook

Brexit looms: stand by your plan

Key points

  • The UK’s economic outlook is materially dependent on how the country leaves the European Union
  • A benign, transitional exit remains our central outlook and in this case, we would likely see an acceleration in UK activity in 2019 (1.8%)
  • Conversely an abrupt exit would most likely deliver a sharp supply-side shock and a potential recession
  • As the UK moves beyond the immediate post-Brexit reaction, the economy will re-synchronise, as the global economy decelerates (1.8% 2020)

Brexit dominates the outlook

The outlook for 2019 and beyond remains dominated by the UK’s decision to leave the EU and the path it follows thereafter. We continue to believe the bleak implications that the UK would face, if it left without a deal –and particularly without a transition in March – will force a political acceptance of the arrangement that the government has brokered with the EU (or a mildly amended version).

Accordingly, we envisage that the UK will enter a transitional exit, to a softer end-state than has been suggested for much of the process. Yet such an outcome is far from guaranteed and while the UK and the EU would clearly not choose a more abrupt withdrawal, miscalculation may result in that outcome, meaning there would most likely be materially adverse consequences for the British economy.

Yet looking beyond the short-term uncertainty, the UK may find that whatever the outcome, the environment could become all the more difficult, as global economic activity materially wanes in 2020, as risks of a pernicious global downturn grow.

Brexit debate well rehearsed but no less significant

At the time of writing, the UK government had just finalised a Withdrawal Agreement, to be agreed at the EU Summit on 25 November. The agreement reflected the UK’s acceptance of a ‘backstop’ Ireland border solution which would see the UK enter a customs union with the EU and agree to maintain a “level playing field”, pledging alignment of goods regulations, as well as mirroring EU state aid and environmental rules.

This deal now needs to be ratified by UK and EU parliaments. However, as recent weeks have clearly illustrated, such a process is far from guaranteed in the UK.

Indeed, UK political uncertainty has been rife in recent weeks, with growing calls for a leadership challenge and a significant risk that the UK Parliament could reject the negotiated deal, at least at its first opportunity, which is expected in early December. Such a course would likely initiate a period of intense market and political volatility.

Exhibit 1: Can Brexit underperformance reverse?

Source: National Statistics, IMF and AXA IM R&IS calculations

Agreement of this Withdrawal Deal – either in December or after a fraught period and a possible second vote in early-2019 – would importantly include a transition phase, (at least until end-2020, but likely to be extended further), significantly reducing the immediate uncertainty surrounding post-Brexit Britain. Moreover, while the UK will formally pursue an ambitious free trade agreement (FTA) with the EU during this transition, this should take several years and we do not expect any FTA to address requirements for the Irish border, which would likely leave the UK in a customs union with the EU for the medium to long term.

Following the significant uncertainty-induced underinvestment in recent years, such an outcome would underpin a rebound in business investment. Rising sterling would however not provide a symmetric benefit to the headwind of 2016’s devaluation[1] but should deliver a slower inflation to boost household real incomes and spending. In addition, following the 2018 Budget, the Chancellor indicated a fiscal easing, which included a net 0.6% GDP shift in the fiscal stance for 2019, with the prospect of more to come in the event of a deal. In total, we forecast 1.8% GDP growth in 2019, if the UK accepts the Brexit deal.

No deal outlook risks recession

Even now the chances of “no deal” are high. The government’s acceptance of a customs union resolution of the border issue reduces the impact of Brexit to migration control. This has made domestic ratification of the current deal difficult.

In the case of no deal without transition, business spending would weaken as firms increased overseas investment. Sterling would fall further, generating inflation and weighing on consumer spending. Exports would also struggle as trade was no longer covered by the EU’s FTAs.

These factors would slow demand and such an abrupt rupture would additionally deliver a supply-side shock. UK ports would be forced to check all goods entering the UK, which they have warned they are unprepared for and estimates suggest a 75% to 88% reduction in goods coming into the country, in the immediate aftermath. Quite apart from the implications for the UK’s 50% of imported food[1], this would severely constrain UK manufacturing supply chains, limiting output. The extent of this impact is difficult to predict without historic precedent[2] but we suggest its effect would be significant, resulting in a recession.

The severity of such an outcome could see the UK attempt to forestall this by seeking to extend Article 50 – albeit not for further negotiation but to prepare for such an exit. This would mitigate some of the supply-side shock, reducing, but not eliminating the adverse impact on the economy. However, such a postponement would require the unanimity of the 27 EU remaining member states.

Beyond Brexit, resynchronising with global cycle

Beyond 2019, the longer-term outlook for UK will also be governed by a re-synchronisation with the global cycle (Exhibit 1). Material deceleration in US economic activity and more modest slowdowns in China and Europe will leave UK trade-weighted demand growth for UK goods and services softer.

In a benign post-Brexit path, we believe the UK will have sufficient, idiosyncratic pent-up demand to buck the global trend in 2019 and 2020. We forecast the catch-up in investment spending, stronger consumer spending and easier fiscal policy to offset the worsening global headwinds that will tighten financial conditions and worsen net trade. Together, we forecast this seeing UK GDP growth rise by 1.8% in 2020, still in excess of trend, despite the global deceleration.

However, in the event of a malign Brexit, a material supply-side shock may only begin to ease in 2020, as ports increase capacity to cope with the necessary customs checks. While the UK economy might begin to post a tentative recovery in growth, it would do so from a more enfeebled position and it would not be as well placed to withstand the expect slackening of global growth.

Monetary policy to tighten unless the economy turns

While the Bank of England (BoE) has warned that it would assess changes in demand, supply and the exchange rate, before judging the correct course of monetary policy, we still consider an abrupt exit in March next year as likely to warrant modest easing in monetary policy. In such a case, we would envisage interest rates falling back to 0.25% and the prospect of QE before the end of 2019.

Equally, a Brexit deal that results in economic acceleration, further above trend in an economy the BoE already assesses has closed its output gap, points to a need for more policy tightening. In our central forecast, we therefore expect the Bank’s Monetary Policy Committee (MPC) to resume tightening policy. The Brexit uncertainty, however, is highly likely to last for most of Q1 2019. We forecast that the Bank will tighten policy in May 2019, again in November and twice in 2020. The final hike to 1.75% is likely to prove contentious as signs of global deceleration gather. However, domestic inflation pressures appear likely to dominate.

 

Table of contents:

Executive summary 

  Eurozone outlook
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  US outlook
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  China outlook
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  Japan outlook
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  UK outlook
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  Emerging markets
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  Investment strategy
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[1] In 2016, the 13% depreciation in trade-weighted sterling (20% from 2015 peak) lifted inflation, lowering household real income growth and spending. However, it did not have the traditional effect of raising business investment and net exports by more, as Brexit uncertainty constrained fresh activity. A rise in sterling over the coming months would provide a headwind to business investment and exports this time.

[2] “Food Statistics Pocket Book 2017”, Department for Environment, Food & Rural Affairs.

[3] Previous episodes of adverse shocks have proved temporary (including the September 2000 truck-drivers’ strike, or oil-shocks of the 1970s), while positive shocks have evolved over time.

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