No Deal Brexit: Project Fear or Simple Facts?

16 December 2018

Following the Brexit debate often reminds me of cartoon characters who, prior to proceeding to their destination, frantically spin their wheels without actually moving. Such has been the case for much of 2018. After the Parliamentary drama of the past few weeks, however, issues have become clearer and options have narrowed. In the weeks ahead, one of four policies will be taken: No Deal, Prime Minister Theresa May’s plan, a second referendum, or Parliament will assert itself by offering a cross-party alternative. For a long time, I assumed the normally common sensical UK lawmakers would find a compromise that would both honour the referendum result and minimize the economic fallout of Brexit.

With the clock running down to the 29 March deadline, however, the prospect of the United Kingdom leaving the European Union and adopting WTO regulations now appears like the most likely scenario.  Having failed to predict Brexit (or President Trump’s victory), experts are derided nowadays.  In the UK, Brexiteers scoff at cautious No Deal appraisals, reverting to the silly “Project Fear” refrain coined during the referendum debate. Notwithstanding, I will assess both why the pessimistic pre-referendum projections went wrong, as well as the longer term Brexit implications (using numerous Charts, as normal!). To be sure, the No Deal outcome creates unique near term risks. Perhaps more importantly, however, the corrosive damage Brexit will inflict is likely to be even more costly. Specifically, the UK’s long-term potential GDP growth will be 0.5% lower annually, and the economy will underperform Germany and the USA over the medium term.

Project Fear: Why the Pessimists Were Wrong, or Were They?

Chart 1 provides a subset of the numerous projections of Brexit’s impact. The negative consequences on GDP range between 2% and 15%, depending on the nature of the future relationship with the European Union.  No Deal/WTO produces the most adverse results, including an especially stark Bank of England forecast. To be sure, pre-referendum forecasts were similarly bleak, as Brexiteers often remind us.  Critics fail to acknowledge, however, Brexit has two potential consequences — the initial shock and the long-term corrosive effects. Fortunately, pre-emptive Bank of England actions — including an interest rate cut — helped the economy deal with the initial shock following the referendum decision.

However, were these warnings actually wrong? The Chart above illustrates that UK GDP growth has underperformed EU gains by about 1% during the past two years (by even more compared to the USA). Lagging by 0.5% annually does not seem like much, but it adds up to 10% over a generation! So Brexiteers, no need to rely on forecasts. The facts speak for themselves! The next generation won’t thank us! The following Chart also illustrates UK growth has slipped from the G7’s fastest to its slowest!

As disappointing as the UK’s recent results have been, economic performance has been cushioned by special factors, which will not continue in 2019 and beyond. Indeed, these items helped boost GDP growth by nearly 1% annually. Without this assistance, GDP would have nearly stagnated during the past two years — widening further the underperformance compared to the G7 nations.

Firstly, strong global growth and the post-referendum sterling collapse boosted UK export volumes nearly 6% in 2017, and the trade sector added 0.7% to GDP. This benefit is now fading: sales abroad have risen only 1.5% this year, and will slow even further next year.  Moreover, the following Chart illustrates UK export have become less sensitive to currency movements, reflecting both the UK’s participation in  EU-wide supply chains and the nation’s chronic productivity deficiency (more later). Rather than adding to 2019 GDP, the external sector is likely to exert a 0.3% drag on growth next year.

Meanwhile, UK household spending has remained tepid since the EU poll, as post-devaluation inflation eroded purchasing power. However, UK consumers have cushioned the impact by digging into savings. Indeed, the following Chart illustrates the plunge in the savings rate since the referendum.  Now, rising wages and employment and lower inflation should help boost real incomes. However, reflecting Brexit concerns, consumer confidence is now at its lowest level in four years. Looking ahead, rising savings will limit consumer growth to 1% in 2019. Spending will remain subdued for years, not just a few quarters!

Brexit anxiety has also taken its toll on business investment. Indeed, the following Chart shows that G7 capex surged in recent years, but the UK performed much worse than its peers. Capital spending has expanded only 0.5% annually during the past three years, and the 2% decline in Q3 2018 indicates trends are deteriorating. Brexiteers often point optimistically to the 2016 surge in inward foreign direct investment.  More recently, foreign inflows have cooled. Overall, businesses appear to be in  in a wait-and-see mode. Surveys suggest business investment is now weakening further — a pattern a No Deal outcome will reenforce.

Structural Headwinds: Brexit Only Makes Them Worse!

Economists tend to enjoy fancy models. Fortunately, however, life can be made much simpler.  A nation’s long-term growth potential is determined by three factors: the amount of available labour and capital supply (e.g. business investment), and the efficiency of these two inputs (e.g. productivity).

The United Kingdom suffers from a chronic productivity deficiency compared to its major competitors.  Indeed, the Chart above illustrates UK efficiency lags the G7 and the USA by 15% and 32% respectively. The following Chart illustrates the UK was successfully narrowing the gap during the two decades prior to the Global Financial Crisis (GFC), e.g. efficiency gains were on par with USA and rising faster than in France and Germany.  Following the GFC, however, British productivity improvements have stagnated, again widening the shortfall versus key trading partners.

Brexit is likely to exacerbate this problem.  There is a widely accepted link between productivity and the competition promoted by free trade. Many factors have contributed to sub par UK productivity, e.g. defciencies in educational achievement, infrastructure, R&D spending, business investment environment, geographic/regional inequality, and housing. The distraction of Brexit — along with the fiscal strains resulting from the GFC — continue to prevent policymakers from seriously addressing these issues.

Secondly, low levels of savings and investment lead to weak productivity, and diminish long-term GDP growth.  As discussed, Brexit anxiety is already adversely impacting capital spending. The Chart above illustrates  UK business investment has lagged the European Union for nearly two decades.

Meanwhile, the availability of labour supply is determined by the combination of population growth and immigration. During the past five years, immigration accounted for 70% of the UK’s labour force increases. In the absence of foreign workers, the UK population would only expand 0.25% annually. The government aims to reduce immigration to below 100,000 annually. The surge in non-EU immigration will make this difficult, even if EU immigration falls further (reflecting both lower inflows as well as expats returning home as UK economic prospects dim). Overall, I anticipate that the contribution labour supply to GDP growth will diminish from 0.8% to only 0.4% annually after Brexit.

Brexiteers often argue that a new skills-based immigration policy will attract higher quality immigrants in the future. However,  the following Chart illustrates the educational qualifications of UK immigrants is already far higher than that of the local population.

Debunking Myths and Wishful Thinking
  • Advocates of No Deal Brexit will need to confront harsh realities. While the EU is likely to agree to maintain the implementation period through December 2020, WTO tariffs will be applied on 30 March 2019. WTO rules require that all countries without explicit FTAs face the  identical EU tariff schedule ( the so-called “Most Favoured Nation” rule).  In addition, as Theresa May warned members of Parliament, all possible Brexit outcomes will require an Irish back-stop, including the No Deal option (even if it is unlikely to be utilised).
  • A key advantage of Brexit is the prospect of reaching Free Trade Agreements with non-EU partners. Brexiteers suggest the world is waiting with open arms. Recent experience reveals that reaching agreement is difficult. As the EU has much to lose from a hard Brexit, this negotiation should have been relatively easy. Wait until talks with the USA, China, and others begin, who have less at stake. Also, Brexit would only add value if the UK achieved superior FTA terms independently compared to those negotiated from within the EU. Highly doubtful!
  • The Tory Party’s negotiating “red lines” — leaving the Single Market and Customs Union and maintaining an open border on the island of Ireland — were (and remain) incompatible from the moment they were uttered in the Lancaster House speech. In an attempt to placate the right-wing of the Conservative Party, Theresa May pledged her government to deliver an impossible outcome, which assured failure. Prime Minister May had a tough job to begin with, but she succeeded in making it an impossible one! In trying to satisy everyone, she has satified no one!
  • Tory Brexit supporters (amongst others) suggest Prime Minister May’s Withdrawal Agreement — especially the Irish “backstop” — reflects timid negotiating tactics. It is suggested a tougher approach (by a new leader if necessary) would bring results.  This ignores the EU’s own “red lines”: keeping open the Irish border, maintaining the integrity of the Single Market, and ensuring the UK was worse off post-Brexit to provide disincentives to other nations considering  leaving the EU. The twin objectives of maintaining an open Irish border and preserving the Single Market requires a back stop — no matter how much the Brexiteers pound the table!
  • Brexiteers continue to claim that negotiating an FTA with the European Union should be straight-forward. However, past EU FTAs have taken between 4 (Korea) and 8 years to negotiate (Canada and Japan). Negotiations with the Uk may well progress more quickly, but  concluding a deal by the end of 2020 is impossible. The “back stop” will eventually become operational, despite claims that neither side wants that outcome.

  • Brexiters contend trading under WTO rules will pose no problem for UK exporters. The Chart illustrates that EU tariffs are very high for agricultural products. Manufactured goods charges are roughly 4%, although the key auto sector is 10%. With sterling undervalued, this should be manageable overall. Heightened border checks will be more costly. Most UK SMEs have never filled out customs forms! It’s not rocket science, but will take time to adjust. Also, the WTO does not cover trade in services — the sector accounts for 80% of UK GDP and 40% of total exports.
Strategic Implications
  • Post-Brexit, especially a No deal version, the UK’s long-term growth potential will shrink to 1-1.25%. Economic growth has lagged both the EU and USA since the referendum. This will continue in 2019: UK and EU GDP will expand 1% and 1.6% respectively. In the UK, stimulative monetary and fiscal policies should help offset the headwinds of weaker consumer spending, capex, and exports.
  • I forecast one 25bp rate hike in the second half of 2019. It is quite plausible, the Bank of England will remain on hold the entire year.
  • The Chart illustrates that sterling is approaching extreme levels of undervaluation. Nevertheless,  I remain bearish until some clarity on the future EU-UK relationship emerges.
  • Likewise, UK equity valuation have rarely been cheaper relative to the rest of the world. To be sure, UK equities should trade at a discount to European stocks initially following Brexit. My recommendation to overweight UK stocks may be premature. However, unless the UK slips into recession next year, cheap valuations should help the FTSE  outperform next year.