The United Kingdom is no clearer on how to leave the European Union. Following months of brinkmanship and uncertainty, parliament has passed the Letwin act, to ensure Prime minister Boris Johnson asks for an extension should his agreement fail to garner enough votes. He did imminently.
The recent impasse was brought about by a need to prevent a no-deal exit, which would cause the pound to depreciate, prices for goods and services to rise, queues in ports and cause our industries to become less competitive. Although the economy is unlikely to come crashing down, there is ample evidence that Brexit is having an adverse impact on the U.K economy.
The Bank of England’s most recent monetary policy report showed an increasing number of companies are preparing for a no-deal exit, which diverts resources that could have otherwise been used to invest in Brexit contingency planning. Even as unemployment is at record lows and is poised to average 2.75%, capital investments have been growing at a much slower pace since the financial crisis. Admittedly, this cannot be attributed solely to Brexit, even as the decision to leave the European Union has caused unprecedented levels of uncertainty and amplified the falling business investment. The global economy is slowing, and geopolitical uncertainty, as well as rising risks of protectionism, have done little to abate the downturn in business investment. As such, manufacturing activity has contracted in recent months, with business sentiment falling as well as prospects for employment.
It is, therefore, plausible that business investment will be somewhat higher in the absence of Brexit, even as the exact extent remains unclear. The reason for this is, very few understand the extent to which the U.S. — China trade war has caused businesses to shelve investment plans versus the uncertainty stemming from Brexit. As such, while we ascribe falling business investment to Brexit, it is important to disentangle this from the slowdown in the global economy and risks emanating from the trade war. Furthermore, vacancies have slowed from 100,000 at the start of the year to 70,000 at the end of Q2 2019. Although there is little to worry given record-low unemployment and rising wages, the falling trend in business investment is not only causing the economy to grow at a slower pace, productivity is much lower and the potential growth rate could be lower in the coming years. This bodes ill for an economy that is becoming increasingly digitized, financialised and service-driven, the £6.2bn earmarked for contingency planning could, perhaps, be used to facilitate a climate and skills-driven transition. One that will focus on upskilling the labor force via wage subsidies, rather than merely incentivize business investment, which focuses on plant and machinery.
Meanwhile, the September Purchasing Managers Index hit a four-month high of 48.3 points (see chart above). This, however, points to a contraction in the manufacturing sector, with falling new orders, and employment falling at the fastest rate since February 2013. This points to a worrying trend and shows how quickly employers could adjust to political uncertainty in an attempt to reduce waste and insulate their profit margins from further declines. It is unclear that recent amendments passed do anything to reduce business uncertainty, but it reduces the probability of a no-deal exit and ensures an organized exit from the European Union.
Similarly, the service sector, which contributes 60% of U.K. GDP also contracted in September and saw the fastest rate of job shedding since August 2010. The latest survey shows businesses have switched to international markets and it is unclear that any post-Brexit trading plans have outlined exactly how to attract businesses and incentivize investment in specific sectors. So the question now isn’t whether and how Brexit is sorted, the challenge for the government will be to attract business back into the U.K and brand it as an attractive destination for businesses. Continued uncertainty bodes ill for such an outcome and will only serve to make us attractive as a low-tax destination. The net positive effects of a larger and more competitive sector are unlikely to compensate for the lost tax revenue.
Even as business confidence and resultant investment remain uncertain, households’ buttressed by higher real incomes continue to support the economy. As illustrated in the chart above, there has been a continued increase in total retail sales i.e 3m/3m. Nevertheless, inflationary pressures remained somewhat contained, as the recovery in the pound and falling demand likely placed downward pressure on price increases. Meanwhile, tepid demand caused a similar trend to emerge for input prices; this will enable producers to stay competitive as lower overheads are unlikely to necessitate higher prices for consumers. This is consistent with the Bank of England’s outlook for inflation to average 1.8% in 2019, but a Brexit-induced depreciation in the pound could test this call.
The Bank’s monetary policy report will depend on the interplay between FX, inflation, and output. Depending on the severity of a downturn, if at all, the Bank might choose to stimulate the economy and allow inflation to overshoot its target momentarily. Depending on the severity or persistence of the downturn, a more accommodative stance might be appropriate.
The logical thing for the Central Bank to do is lower the policy rate by 25bps, but given the circumstances that will be unwise. Fixed business investment is falling as a result of Brexit uncertainty, coupled with rising risks of trade protectionism and geopolitical uncertainty in the Gulf. If the Bank were to cut interest rates by 25bps, there is no guarantee this will incentivize businesses to make capital investments and higher more workers. If anything, it will only reduce the Bank’s ability to respond to a downturn and will illustrate an imbalance in deliberating the attainment of the inflation target versus financial stability risks.
I advocate a pause if a Brexit-induced uncertainty doesn’t exacerbate structural factors, which can intensify a slowdown. Meanwhile, vehicle registration — a bell-weather for consumers- eased slightly in Q2 2019, despite a slight pickup in the registration of alternatively fuelled vehicles i.e (+5.0%) (see chart above). Nevertheless, it is unclear that lowering the policy rate by 25bps will cause households to spend more as lower interest expense will increase households' disposable incomes, enabling them to purchase other goods or services.
Together with businesses, they might await greater clarity from the Brexit negotiations before making longterm purchases. As a result of the slowdown caused by uncertainty, lower interest rates should only be used as a last resort, rather than preemptively as the Fed and other Central Banks have sought to do in other to stave off the adverse impacts of the U.S. — China trade war. Brexit increases the risk of a recession, but its adverse impacts are already being felt in employment and business investment. Lower interest rates will are unlikely to change this picture just yet, but might only serve to avert a crisis.