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Can the UK avoid a Brexit-induced recession?

7 minute read

12 November 2019

By Jai Lakhani, Investment Strategist and Maria Vittoria Malavolta, Investment Analyst

As more clarity emerges on Brexit and a resolution edges closer, is it time to invest in UK assets again?

In the aftermath of the 2016 Brexit referendum, economists predicted that the UK economy could be heading for an imminent recession. The Bank of England (BOE) cut interest rates by 25 basis points at its subsequent August meeting, with the reasoning that insulation for businesses was needed against a “Brexit recession”.

However, the warnings discounted incorrectly the difference between the beginning of a process to leave the European Union (EU) (one that is still ongoing) and leaving the EU. As a result of this, and a domestic sector which benefited from full employment and steady real wage growth, the UK economy has so far survived the recession scares.

This is not to say that the paradigm of a future relationship without the EU has not come at an economic cost. Moreover, the cost is likely to continue, mitigated (albeit to varying degrees) with clarity on when the UK leaves the bloc and the extent of amendments to the withdrawal agreement bill (WAB), in principle passed through parliament, in October.

Difference between no recession and stagnation

While the UK economy is yet to encounter a technical recession, (two consecutive quarters of contraction), growth has slowed and lagged the pace of global growth. Furthermore, the economy shrank in the second quarter of 2019 by 0.2%. In the absence of growth in the rest of the year of 0.62%, this will translate to growth below potential in 2019.

While the UK economy is yet to encounter a technical recession…growth has slowed and lagged the pace of global growth.

Labour market cracks

The tightness in the labour market can only be partially explained by steady gross domestic product (GDP) growth. Part of the reason behind full employment can be traced to Brexit-driven business uncertainty, resulting in lower fixed capital creation by the corporate sector, with companies having to retain workers as opposed to investing.

A tight labour market without productivity gains will eventually become too high a cost for businesses to bear and evidence of this is starting to appear. The August unemployment rate rose to 3.9%, from 3.8% in July, with employment falling for the first time in just under two years. More concerning was vacancies falling for an eighth consecutive month, to their lowest level since November 2017, with companies reining back hiring plans (see chart).

Tight UK labour market starts to slacken

UK real estate market suffers

Brexit has hit the UK housing market, with overseas investors quick to pull their money from the country and weaken demand for the London market in particular. Despite the region boasting the highest average asking price, growth has contracted (year on year) in the 18 months to August 2019. There has also been some contagion, with regions such as the south-east and the east also struggling.

UK house price growth grew by 0.1% in 2018, sharply down from the 4.5% experienced in 2016 and dramatically below the 13% growth seen in 2014.

While demand and supply imbalances will help house prices, real estate remains at risk given that a no-deal departure remains a possibility as well as there being a growing case for a resolution. So the real estate market may not generate the same returns over the next ten years as seen in the last decade.

The real estate market may not generate the same returns over the next ten years as seen in the last decade.

Sterling’s volatile ride

In June 2016, the pound sharply declined against all major currencies, with markets ex-ante not pricing in the possibility of the UK departing from the EU. Sterling has stabilised at lower levels over the past couple of years, but never reached its pre-referendum highs.

Volatility significantly increased in 2019 as Article 50 deadlines were repeatedly postponed, Theresa May’s draft deal was rejected three times and the prime minister eventually resigned, to be replaced by Boris Johnson. Sterling weakness persisted, although it has rallied considerably in October as the likelihood of a deal increased, with the currency up 7%.

Over the medium term, we believe sterling will remain volatile as several outcomes (extension, change of government and potential amendments to the existing bill) remain on the table. However, we expect the currency to eventually strengthen on the back of a positive resolution.

Sterling’s depreciation initially drove UK inflation higher, with the consumer price index (CPI) spiking to 2.8% in September 2017, from 0.8% in June 2016. However, inflationary pressures were temporary and have eased since, on the back of modest GDP growth and weak energy prices. CPI has recovered to healthier levels, at 1.7% and slightly below its 2% target, while inflation expectations have decreased as hopes of a Brexit deal resurface.

Uncertainty or no-deal: what hurts most?

What is widely agreed upon among investors is that an unplanned, and sudden, no-deal departure will impede the supply side of the economy. Businesses would then face trade barriers like new tariffs, additional customs checks and import/export certifications. This in turn would hit demand due to cost pressures being passed to final goods and services.

The UK’s future trading relationship with the EU can still take many forms

Agreeing the withdrawal agreement in principle is a step towards transparency. However, even in the case that the full WAB is ratified in parliament, this is only the beginning of the process and hinges on the outcome of the general election on 12 December 2019.

The transition phase, should we get to this stage, puts the necessary protocols in place to leave the EU in line with the WAB. Failure to do this, and not extend the transition period, would mean a departure without a deal after a prolonged period of uncertainty, something that business would struggle to manage.

The impact of the heightened period of uncertainty so far on UK business has meant lost opportunities to invest. As Bank of England Governor Mark Carney has mentioned, given the EU-UK Brexit agreement, business investment will likely recover but “it won’t all come back, obviously, because we don’t know the exact nature of the future relationship.”

Should further extensions of Article 50 with no end product be the norm, businesses would remain in limbo. Ambiguity hurts is the key takeaway from this. A no-deal scenario would hurt, but if it was known to be the final outcome, at least companies would be able to outline contingency plans and focus on the business more once they get past the initial shock.

Time to invest in UK assets?

With the withdrawal agreement at the early stages of negotiations, alpha generation through active management for UK assets seems more prudent. A Brexit resolution being more likely than before, we have increased our conviction on UK equities over the medium term.

We believe it is time to gradually invest in this unloved market…with equities at their largest discount to eurozone ones in 10 years.

Following the large post-Brexit capital outflows from the country, we believe it is time to gradually invest in this unloved market. Valuations look undemanding, with UK equities at their largest discount to eurozone ones in 10 years. However, earnings growth in the UK of 50% over the last three years is triple that of European counterparts.

Strong UK earnings growth, despite Brexit

These anomalies in the past have tended to be short-lived and are likely to be leveraged should more clarity emerge. However, clarity should not be the deciding factor given the resilience of the FTSE 100, which is likely to remain somewhat immune from domestic disruptions given its exposure to international markets, with 80% of sales generated from outside the country.

Although the inverse correlation between a weak pound and the FTSE 100’s performance has been weakening, this could be fortuitous for international businesses. On the one hand, these businesses would suffer less than domestic-focused companies from the impact of a no-deal Brexit due to currency weakness, as sterling depreciation would aid revenues when repatriated back home. On the other hand, should a resolution lead to a strong sterling, this would not drag performance as much, given the positive impact a deal could have.

Inverse correlation between FTSE 100 and trade weighted GBP weakens
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