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Since the Brexit referendum the UK economy has far exceeded the expectations of market observers. The positive momentum of the pre- referendum economy and strong consumer confidence, have carried the nation through a period of heightened uncertainty.
This article is from our latest edition of MarketWatch, an in-depth report focusing on the Global Economic Outlook for 2018.
The goldilocks combination of continued tariff-free access to the European Union (EU) and a weaker sterling has provided a boost to British exporters. This has also given support and a significant tailwind to the UK economy. However, there should be no doubt that Brexit will determine the path of the UK economy and politics for years to come.
So far there has been little clarity around what the UK would like the ultimate trade arrangement to be once it leaves the EU. The agreement reached in December on the Brexit bill, EU citizens’ rights in the UK and the Irish border means the next phase of negotiations can begin. A quick agreement on the transition arrangement could provide an upside to current growth forecasts. However, given the UK’s continued stance on controlling immigration and not accepting the European Court of Justice’s (ECJ) jurisdiction, any eventual deal could resemble a no-deal hard Brexit in all but name.
The UK economy will face tougher challenges in 2018. Davy forecasts UK gross domestic product (GDP) growth at 1.5% for 2017, slowing down to 1.2% in 2018, significantly below the 2.6% growth rate in the two years before the referendum. This deceleration comes at the same time as there is a squeeze on consumer spending from rising prices and slowing house price inflation. In addition, Brexit uncertainties continue to provide a drag on employment and investment.
We expect real wage growth to remain weak, even with inflation falling back towards 2% from 3% currently, as the effect of sterling’s devaluation works its way through the economy. Therefore, we expect consumer spending will rise by just 1%.
Unemployment is at its lowest level in 42 years and this has failed to result in higher wages because of lower productivity and a concentration of wage pressure in a few sectors, namely public healthcare and schools, which are subject to government budget caps. Continued government austerity will provide a drag on growth and the fiscal deficit remains high despite seven years of austerity. Debt to GDP is twice the level it was 10 years ago. Business confidence and investment will continue to fall as exporters are nervous to invest given the uncertainty around future trade arrangements. We expect a pick up in mergers and acquisitions (M&A) and outward investment by UK corporations looking to diversify their business away from EU end markets.
While economic activity is cooling, the Bank of England (BoE) has announced its intention to raise rates in 2018 given the increase in inflation. We think this is not a great combination and runs the risk of choking off growth.
The single biggest risk to the economy is the deteriorating state of the consumer - previously the driver of GDP growth. According to BoE statistics, one-fifth of all households had no savings whatsoever by the second half of 2016. Of course, many households have resorted to consumer debt to make up for the shortfall caused by rising prices and static wages.
The end of the BoE’s ultra-low interest rate policy and steps to encourage banks to begin tightening credit standards will not be welcomed by consumers. Government austerity will also continue to bite in 2018 with much of the fiscal consolidation focused on welfare spending cuts.
We expect the housing market to weaken this year as already-stretched affordability suffers from increased mortgage rates. Consumers could feel “less wealthy” as a result of weaker house prices, further accentuating the negatives. Property prices have held up reasonably well, but are slowly adjusting to lower demand and the impact of departing immigrants.
Brexit, which many argue began as an attempt to resolve conflicts within the Conservative (Tory) Party, is now a potential catalyst for an implosion of Tory parliamentary power. Who would have imagined just one year ago that the Conservatives would lose their parliamentary majority and that the Labour party, under Jeremy Corbyn, would pose a real threat to the Tories? Although the next general election is due to take place in May 2022, the possibility of a no confidence vote in Prime Minister Theresa May and an election as early as 2018 are not insignificant.
The fate of the Prime Minister and the Tory’s political dominance seems to be indelibly linked to the outcome of the Brexit negotiations and her ability to keep her minority government together. This will be no easy feat. May’s successful conclusion of the first round of Brexit talks represented a major compromise by the UK but it avoided a hard Brexit, which is the preferred choice of hard-core Tory leavers, including Boris Johnson and Michael Gove. The final Brexit deal still needs to be approved, but May has so far dodged several major challenges from within her coalition.