Brexit: The UK bravely goes alone

The UK election transformed both the political and economic outlook, though the government deadline of end-year to agree a new relationship with the EU will re-boot anxiety fairly soon. The economy is likely to perk up in the next few months with the help of a rise in business and consumer confidence as well as stronger world conditions. But the lift will be limited by uncertainty over the future relationship with the EU. Longer term, most businesses should be able to deal with the new relationship, although trade with the EU will face more frictions than before and some activities, particularly in the service sector, may have to relocate to the Continent.

A political transformation

The election ended the agonising uncertainty over whether the UK might face another referendum or potentially a very left-wing government. It also marked the moment when the Conservatives completed their transformation from a fiscally conservative, pro-EU party to a high-spending, nationalist party. Confidence has already leapt on some measures and this should show up in all the data in coming weeks. Investment should pick up a little as it was held back in 2020 by the political deadlock.

EU negotiations will be bumpy

Early indications are that the British government seeks only an arms-length trade agreement with the EU since it is not prepared to be a follower on EU regulations or accept comprehensive restrictions in areas such as tax and labour regulation. This means that UK companies will face a plethora of new costs, regulations and restrictions which will hamper some businesses. Until the new rules are agreed, business may hold back on investment or hiring. Once they see the outcome new investments in the UK will have to balance the extra costs of being outside the EU Single Market and Customs Union against the advantages of locating in the UK (such as the ease of doing business, the English language and law, and tax rules).

The process of negotiation is likely to be bumpy since, unlike during Theresa May’s time, the current UK government is likely to take a more combative stance. We do expect an agreement this year, but it may not be comprehensive. Some areas of the negotiation, most likely in services may take longer. But a hard break at end-year, with the UK exiting on WTO rules is unlikely. Even if it did come to that I would expect temporary agreements in certain areas to minimise disruption pending a more comprehensive deal.

Service industries likely to be most impacted

As to the eventual outcome, major goods industries such as cars, aircraft, chemicals, pharmaceuticals and food will be able to continue their trading activities but will face higher costs in terms of paperwork, regulation and delays. Service industries including the financial sector, business services and media face greater uncertainty since it is not clear whether they will be able to attain the same access as currently. Some businesses may simply have to relocate, at least some functions, which will be damaging particularly to London.

Meanwhile the government is unlikely to be able to sweeten the pill for business through tax cuts or other measures. Indeed, the planned corporation tax cut has already been rolled back. The government’s approach, which is likely to be underlined in the Budget on March 11th, will be primarily to increase spending on health and education and on infrastructure in the Midlands and North. On the plus side, this is likely to amount to a small net fiscal stimulus.

Trade deals with other countries

In time, the UK is likely to be able to conclude trade agreements with the US and with the Pacific countries (perhaps joining the CPTPP which includes Japan, Australia and Canada and several emerging countries). But these will be beneficial only over the longer term. And reaching a deal with the US will be difficult and contentious, particularly over opening to US agriculture.

Leaving the EU and Single Market is likely damaging to the UK economy over the medium term. But perhaps half of the negative effect has already occurred, with the slow growth in 2017-19. Moreover, the damage does not mean the economy cannot grow, only that it will grow more slowly. One key factor to watch here is immigration policy. Total UK employment is approximately 33 million people, so a reduction in net immigration of a hundred thousand people, (from two to three hundred thousand in recent years) which is what the government probably hopes to achieve, will cut trend GDP growth by about 0.3% pa, lowering the growth and profit potential for UK companies.

Inflation remains under control

Meanwhile the underlying fundamentals for the UK economy are generally positive. Inflation is still under target, though it is worth noting that it is slightly more buoyant than in the US and much more buoyant than in the euro zone. If the UK economy picks up smartly in 2020-21, as cannot be ruled out, the Bank of England could turn hawkish sooner than anyone expects, given that interest rates are so low currently. However, the BoE is likely to be on hold in 2020.

The most important area of low performance is productivity. This is a problem in most developed countries but labour productivity growth has been particularly weak in the UK. It matters for profitability and growth but also for political stability since the prolonged weak growth in living standards this century doubtless lies behind the rising English nationalism as well as the turn to the left in policy areas.

Finally, the Conservative government will resist a new Scottish referendum. But it cannot be ruled out for 2-3 years’ time and this will bring more uncertainty. A vote to leave would not make good economic sense for Scots given the fiscal subsidy from England and the problem of dealing with the border if Scotland then sought to join the EU but, as we have seen, the outcome of referendums is often unpredictable.