October/November 2018

No deal Brexit, will it create another recession?

John Ashcroft, Economist and author of The Saturday Economist, weighs up the evidence.
Britain faces a ‘devastating recession’, a plunging pound and soaring prices if a ‘No deal Brexit’ takes place, according to a recent analysis from ratings agency Moody’s.

Here’s how that works out… In the event of no agreement to an orderly exit from the EU, the UK would face a considerable crisis of confidence leading to a fall in output.

Is this likely? Just what will happen next?
Let’s review the scenario… The crisis of confidence would impact in three main areas, currency, consumers and capital investment. Financial markets would push the pound lower, consumers would restrict spending and businesses would hold back on investment plans. That’s the general idea. Let’s look at each one in detail.

Sterling has demonstrated considerable volatility on Brexit fears. The pound rallies on hopes of a deal with Brussels and falls as a solution to the talks appears elusive. Ahead of the referendum at the beginning of June in 2016, the pound was trading at $1.43 against the Dollar. By the end of August it was trading at $1.33. By September the currency had fallen to $1.22 – a drop of 15%. Confidence in a solution to negotiations pushed Sterling back above $1.40 in the Spring of this year. By mid August it had plummeted once again to $1.28. Currently the Pound is trading at $1.30 for reasons we cannot be entirely sure about.

If ‘No Deal’ is the solution, markets would expect a fall in Sterling similar to or worse than the fall in Sterling in 2016. This could push through support levels around $1.20 and move even lower towards $1.10.

Against the Euro, the pound, currently trading at €1.13 against the Euro, could fall to €1.10 or even parity. Foreign investors would lose confidence in the value of the pound. A capital flight would ensue. Overseas investors and central governments would be reluctant to hold UK government gilts. Ten year gilts rates would rise from the ludicrously low levels of 1.50% currently, to an historical norm of 4.50%.

Consumer Spending will be hit… The Bank of England would be forced to act to ‘defend the currency’ and invoke the ‘The Kindness of Strangers’ to ‘Stick with Sterling’ and hold gilts. Base rates would increase suddenly to 5% or 10%! Mortgage rates would be much higher, house price activity would diminish. Pressure would increase on house prices. The fall in house prices could be over 30% over three years according to a Bank of England worse case scenario. The fall in Sterling would lead to higher import prices, leading to an increase in energy costs and petrol prices. Retail prices would rise across the board as import costs increase. The squeeze on real incomes, (rising prices ahead of earnings) would lead to the fall in the volume of retail sales and household spending generally.

Capital Investment will fall… Businesses sensing a loss of output in the medium term would cut back on investment plans, major exporters to the EU specifically would be badly hit. The rising cost of capital would further inhibit spending. Business would relocate manufacturing capacity to within the single market trade area.

Moody’s claim, a no-deal scenario would be ‘credit negative’ for businesses in a wide range of industrial sectors, including car manufacturers, airlines, aerospace and the chemicals industry. The banking industry could see a fall in credit ratings, putting pressure on and within the banking system. The higher education sector would be badly hit with difficulties in recruitment and tenure of EU staff, compounded by a fall in student numbers. We would have trouble picking fruit in the summer months and digging up vegetables in the Autumn.

Transport for London would face the threat of lower passenger numbers affecting income due to a fall in migration, lower employment and a weaker economy. The capital’s transport authority said earlier this year it was facing a £1billion deficit from a surprise fall in passenger numbers. A no deal Brexit would compound the problems for TfL.

Government borrowing would increase… The Government may have to prop up Transport for London. The Treasury would face a drop in income, as tax revenues fell and welfare and unemployment costs increased. The loss of revenue could be as much as £80 billion over a period of ten years according to one Whitehall estimate. The Government Deficit would increase.  Gains made over the last ten years would be surrendered as the fiscal outlook deteriorated. The UK would move in to recession defined as two quarters of negative growth and more. Whilst most analysts expect growth of around 1.5% this year and next, the real income squeeze would persist, unemployment would rise, output would fall and the economy could shrink for up to three years according to the somewhat depressing outlook. How far? Moody’s do not appear to quantify the fall.

The Good News?
The good news in all this? Savers would benefit from a rise in savings rates, pension fund deficits would be alleviated as long term gilts yields rise. There would be a considerable boost to tourism. People will flock from around the world to benefit from a cheap pound and to observe, first hand, the misery of the British people. For those Brits who could afford to travel abroad, they would be unable to fly. Travellers would have to renew their passports, buy a driving permit, two if travelling through France or Spain. They would have to buy special mobile phone packages, spend more on travel insurance and be prepared to buys Euros at parity or less.

No deal Brexit, will it create another recession?
We say no… So, is a recession likely in a Hard Brexit deal scenario? We would say not despite the gloomy outlook outlined. The Pound may fall and inflation may rise. The Bank could act to defend the currency by hiking rates. Equally it could act to defend the economy, by cutting rates to the floor and injecting liquidity into the banking system.

The Treasury could act to alleviate stress points in the economy by cutting taxes, increasing spending on current and capital projects and by interventionist measures in industries under duress like motor and aerospace specifically. Growth would be lower than the moderate 1.5% scenario over the medium term we currently expect. A real ‘Shock’ to output would be avoided. A period of sluggish growth would ensue with a moderate rise in the unemployment rate from the current 4% level to 4.5%.

Dismal yes, but recession no. The drop in the currency would not be a permanent fix as recent history has explained. The Pound would rally at some stage, because of problems in the US and or the EU or just because it does!

No deal? so what’s the outlook…
Leaving the EU and the single market will lead to a loss of output in the manufacturing sector. Specifically we expect a fall in output in Motor, Aerospace, pharmaceuticals, chemicals and textiles just for starters. The boss of Jaguar Land Rover, Ralf Speth, warned last week of thousands of job losses in the UK in the event of a no deal Brexit. In June, JLR said it would shift production of its Land Rover Discovery to a new plant in Slovakia.

The statement follows warnings from BMW, Nissan and other large manufacturers including Airbus, of serious problems ahead in the event of a ‘No Deal’. It is unlikely Airbus contracts in the next round will be awarded to UK plants. Wings will fly to France if Britain leaves the single market. Big Pharma will reposition to within the European regulatory and approval framework to avoid delays on new product introductions.

Plant relocations, short time working, investment plans shelved will become the norm. In 2008, the manufacturing sector faced a shock to output of 10% following the financial crisis. Despite a moderate recovery, output in the manufacturing sector remains some 3% below the prior peak in February 2008.

In the event of a No deal Brexit, we expect a shock to output in the sector of 10% to 15%. The loss to the economy is worth some 1% to 1.5% of GDP over a three year period. There will be continued expansion in the service sector, in government spending, in business and professional services, in hotels, leisure and tourism. There will be an increase in red tape and regulation from which the professional services sector will benefit.

The UK will survive within a much changed trading framework. We may well avoid recession but at the expense of another chunk of our manufacturing base. We may well go searching for markets in far off fields, only to experience a deterioration in the trade balance. Our new friends seek to sell more into the UK rather than buy more from a truly global Britain and the soon to be world class exporting superstar.

We may well have taken back control of our borders, guaranteeing our sovereignty. We may have reduced immigration – compounding problems of recruitment in sectors as diverse as agriculture and education as a result.

We divide the arguments for Brexit into four boxes. Political, Social, Economic and Business. Political about who governs Britain, always a good question. Social, largely about immigration. Argue about these as you will. But do not argue the benefits of Brexit for Business or for the Economy. Alas there are few. Enough to avoid recession perhaps but none providing a stimulus to growth.

Dr John Ashcroft
The Saturday Economist