This article gives a brief overview of flash business reaction to the referendum outcome, consensus economic forecasts and our views on them, our central and upside cases for trade negotiations, our take on regulatory issues, potential implications for private, public and foreign investment, and a review of the risks of events cascading outside of the parameters of these expectations.
A snap business reaction survey from the Institute of Directors immediately following the referendum concluded that:
Nearly two-thirds (64%) of IoD members think the result is negative for their business, against 23% who think it is positive (9% say it makes no difference)
A third (32%) say hiring will continue at the same pace, a quarter (24%) will put a freeze on recruitment, and 5% will make redundancies
1 in 5 (22%) are considering moving some of their operations outside of the UK; 1% say they will bring operations back
36% will reduce investment, 9% will increase it and 44% will maintain investment levels
The views on GDP growth and inflation of a selection of financial and economic analysts expressed in the week since the referendum are summarised below:
Q3 and Q4 2016 GDP -0.1% (technical recession), turning positive in 2017
Core inflation to average 1.7% 2016 and 2.3% 2017, peaking at 2.5% in Q2 17, with some upside (i.e. higher inflation) risk on food prices (BOE target is 2%)
Shallow recession in H2 2016 driven by a halt in business investment and a consumer spending squeeze.
2017 deeper recession -1.0% (from +2.3%), with downside risk arising from any reduction in foreign investor financing of current account deficit.
Downgrade in growth for 2016 Q4 and for 2017 to 1%, but no recession, based on a BOE 25bp cut to base rates before year end.
Inflation to rise to 2.2% by 2017 Q2.
No growth in 2016 H2 and moderate decline to 1.5% 2017, based on BOE base rate reduction and further QE, with no ‘austerity budget’.
2017 0.2% growth leading to ‘mild recession’ thereafter, driven by weakening trade and deferred investment decisions
Economists’ consensus forecasts 2017 0.7% (versus 2.1% remain), with a return to trend growth thereafter (albeit from a lower base).
The general picture is of significant downgrades to GDP growth in 2016H2 and 2017, with a number forecasting recession. Few at this stage however project a deep or prolonged recession, on the basis of a competent and well prepared Bank of England, much better capitalised banks than in 2008, and the expectation of a rational policy response (Capital Economics, one of the more optimistic economic forecasters noted above, is explicit that austerity measures would be “disastrous”.)
Those who are currently looking forward beyond 2017 are in general tentatively forecasting a return to trend rates of growth, although it should be noted that there will have been a significant absolute reduction in GDP below pre-Brexit expectations, which will notionally widen over time.
(This may be important, because the UK budget deficit and absolute level of national debt remain high. The OBR in Autumn will presumably identify a widening of the deficit compared to previous expectations. That means that borrowing will be higher and GDP lower, increasing the debt/GDP ratio further. Combined with the downgrading of the UK credit rating by S&P and outlook by Moodys, this implies that the principal domestic risk to the forecasts is a weakening of foreign investment flows, resulting in a sharp narrowing of the current account deficit, an uncontrolled collapse in sterling, and increases in interest rates.)
Our baseline case is a relatively pessimistic (but not worst case) one. However, we also believe that there is a plausible (and very desirable) upside case.
We expect that at some point, certainly within 12 months, the pressure to activate Article 50 will become overwhelming (there may even be grounds for a legal challenge to force the the issue), and that it is unlikely that key players will be prepared to negotiate informally outside this framework (Merkel and Hollande have already confirmed this). This will trigger a two year period of negotiation which is unlikely to result in an agreement.
The reason for this is that, on the assumption that the government is a Brexit-implementing Tory one from the autumn onwards, and that there is no change of party arising from a snap general election, the government might not feel able to accept a significant level of budget contribution or, in particular, a continuation of free movement of people. Although the referendum was ostensibly about membership of the EU, the Brexiteer faction appears to be treating it as a referendum on immigration control. Germany may be keen to maintain good trade relations but it cannot act unilaterally. All of the EU members have an interest in maintaining a UK budget contribution, and many , if not all, would find free movement of people to be a red line. Many also have almost no trade with the UK, and could therefore take a robust position with nothing to lose. This is before even considering the desire of some to act punitively against the UK pour encourager les autres.
Over a prolonged period of several years it may be possible to negotiate a limited bilateral trade deal (the ‘Canada model’), but in the mean time the situation would default to WTO rules on the expiry of the two year window.
Although clearly less favourable than free trade, this would nevertheless result in a relatively low level of tariffs, but would be subject to many exceptions, including Non-Tariff Barriers and the financial services passport. There may also be some highly undesirable and complex secondary effects of defaulting to this position. For example: (a) a migration of financial services capability to the Eurozone with a potentially major weakening of GDP contribution (and tax revenues) from this sector, or (b) denial of UK access to the ECAA (the European Common Aviation Area) – which, like the EEA, requires a ‘framework of close economic cooperation’ with the EU. Problems here would have major repercussions, not least for low cost carriers. The Internal Energy Market has similar strictures. Travel companies would also face non-trivial details to be resolved – visas, EHIC, duties, and so on.
Probably the best outcome available is to negotiate membership of the EEA (the European Economic Area). This would have the effect of retaining access to the single market and avoiding secondary complications (such as those noted above). The UK would probably have some freedom to conclude its own trade deals – a trope of the Brexit campaign – but would continue to be subject to EU regulation, free movement and a substantial budget contribution.
It may be unpalatable for the government to accept these conditions, but the state of the economy will put them under a lot of pressure and they may choose to argue that a clause in the ‘Norway Model’ which allows for temporary immigration controls under conditions of “serious economic, societal or environmental difficulty” is sufficient. This would be naked sophistry, but given what the Brexit faction got away with in the referendum campaign it may still give them a tolerable way out of their predicament.
At this stage however, it would be excessively optimistic to treat this case as likely.
The idea of some kind of bonfire of regulations looks extremely fanciful. As a practical matter the civil service will need to be expanded significantly and the immediate concern will be ‘voids’ – those areas of regulation which have not required primary UK legislation. In any case trade with the EU on any basis will require the UK to comply with any relevant regulations.
It is also not generally appreciated how much regulation is dictated not by the EU but at global level (e.g. WP29 (motor vehicles), Codex Alimentarius (food), ILO (labour), IMO (maritime), Kyoto (climate), Basel (banking), OECD, G20 and GPA (public procurement)).
In construction, it is possible that EU Directives already incorporated into UK law relating to environmental assessments on development plans and to major planning applications could be abandoned. Rules on Environmental Impact Assessments and Strategic Environmental Assessments might thereby be watered down. In travel, the Package Travel Directive could be open to challenge. A raft of bad legislation on IT could be rationally reviewed, and a solution would need to be found for the overturned safe-harbour provisions. In all cases though, there will be a problem with the limited bandwidth of a civil service and legislature struggling to cope with a tsunami of legislative problems.
Although a good deal of regulation is directed from the EU (around half of environmental law, for example), there is no way of guessing at this stage what will change, if anything. Should we retain access to the single market, for example, the status quo would prevail. It is also worth noting that historical UK governments have tended to legislate beyond the requirements of EU directives.
In the context of current political, economic and social uncertainty it would be completely normal for corporates to horde cash and take a cautious view of investment. The IOD flash survey summarised above provides support for this view, as does our own direct current experience. Deloitte’s chief economist Ian Stewart has also noted that a sustained period of declining financial market risk (flight from sterling and equities to gold, gilts, yen and greenback) will lead to weaker risk appetite in corporates – restrained investment and a sharpened cost focus.
The housing and travel markets are clearly seen as especially vulnerable, as emphasised by the disproportionately large hit to quoted housebuilders and travel companies in the stock market adjustment, driven by potentially adverse macro and demand conditions. Both sectors could also face higher costs through a reduction in availability of foreign workforce.
Although Heathrow remains a political football, there have been mumblings from some sources about a paring back of spend on large infrastructure projects generally, notably HS2. For what it’s worth, the DfT has robustly rejected this. The reality is that the position is uncertain; government finances will without doubt come under pressure, but it remains speculation as to whether planned infrastructure spend will be reduced.
The EU had agreed to provide a measure of subsidy to some infrastructure projects, notably HS2 and Crossrail, and presumably some or all of this funding (together with any future subsidies) may now be in doubt.
The risk of a drying up of foreign financial investment putting pressure on sterling has been noted above. There must also be downward pressure on foreign direct investment, in the first instance due to uncertainty, and in the longer term due to being outside ‘fortress Europe’ for those manufacturers and financial institutions needing single market access.
Forecasters are generally projecting ‘central’ scenarios which are well below our previous trend rate of growth, but which are not apocalyptic, and which assume some resumption of growth at some future point.
However, the key feature of the current context is not so much the loss of GDP, but the uncertainty (and hence volatility) which is likely to prevail. There is only so much a strong government could do to alleviate this and shore up confidence, and at the present time the UK barely has any government at all.
(As an aside, with the Tories fundamentally split and the Labour party badly broken, we may start to see new political alignments and groupings around non-traditional lines.)
The specific risks of a downward cascade are obvious but unquantifiable – Scottish independence, agitation in Northern Ireland, Eurozone collapse, populist drives towards further European fragmentation, broader global contagion, retreat from globalisation, rising protectionism, sterling crisis, plagues of frogs, etc.
Against such elevated uncertainty, rational corporates and financial sponsors are likely to take a risk averse approach for the time being.
Planning and Adaptation
Ultimately there are a number of key questions:
How do we assess risk and identify opportunities?
Are there specific historical precedents from which we can learn?
What can we do to mitigate or reduce risk and to exploit potential opportunities?
How can we exploit or shore up our competitive positioning?
Will our competitors be differentially impacted?
How do we avoid paralysis by analysis?