Outlook softer whatever happens with Brexit - Capital Economics
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Outlook softer whatever happens with Brexit

UK Economic Outlook
Written by Paul Dales
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Regardless of what happens with Brexit between now and 31st October, the recent weakening in both the global and domestic data has led us to revise down our GDP growth forecasts in all three of our scenarios based on different Brexit outcomes (a deal, a no deal and repeated delays). Only in the deal scenario are interest rates raised. Only in a no deal scenario is there a recession. But we think that interest rates would be cut in two scenarios – if there is a no deal and if there are another one or two delays to Brexit. Meanwhile, if there were a general election before Brexit, the economy might have to cope with either a no deal Brexit or the potentially business-unfriendly policies of a Labour government.

  • Overview – Regardless of what happens with Brexit between now and 31st October, the recent weakening in both the global and domestic data has led us to revise down our GDP growth forecasts in all three of our scenarios based on different Brexit outcomes (a deal, a no deal and repeated delays). Only in the deal scenario are interest rates raised. Only in a no deal scenario is there a recession. But we think that interest rates would be cut in two scenarios – if there is a no deal and if there are another one or two delays to Brexit. Meanwhile, if there were a general election before Brexit, the economy might have to cope with either a no deal Brexit or the potentially business-unfriendly policies of a Labour government.
  • Forecasts – Our three sets of forecasts highlight how the political decision on Brexit required by 31st October could send the economy down vastly different paths.
  • External Demand – The global economy has been a bit weaker than we had expected. So regardless of what happens with Brexit, the external sector will exert a bigger drag on GDP growth.
  • Consumer Spending – Households have become more sensitive to the rise in uncertainty caused by Brexit. The flipside is that they are in a better financial position to weather a no deal Brexit.
  • Investment – Firms are clearly most exposed to a no deal Brexit and investment would probably stagnate at best if there are more delays. A deal, however, could unleash a surge in business investment.
  • Labour Market – While jobs growth and wage growth are probably past their peaks, with the unemployment rate set to stay below 4% the labour market will continue to support the wider economy.
  • Inflation – With firms reluctant to pass on higher labour costs while economic growth is subdued, if Brexit is delayed inflation will probably remain below the 2% target.
  • Monetary & Fiscal Policy – Fiscal policy will be loosened if there is a Brexit deal or a no deal. But public borrowing may not rise much after a deal, while it would surge after a no deal.
  • Long-term Outlook – Over the next 20 years, the drag on the economy’s potential growth rate from lower migration and an ageing population will probably be offset by faster productivity growth.

Key Forecasts Table

Table 1: Brexit Repeated Delays Scenario*

2019

2020

Annual (% y/y)

Q1

Q2f

Q3f

Q4f

Q1f

Q2f

Q3f

Q4f

Average 2010-17

2018

2019f

2020f

2021f

Demand (% q/q)

GDP

0.6

-0.2

0.4

0.2

0.3

0.3

0.3

0.3

2.0

1.4

1.3

1.0

1.5

Consumer Spending

0.3

0.4

0.3

0.4

0.4

0.4

0.4

0.4

2.2

1.6

1.2

1.5

1.6

Government Consumption

0.8

1.1

0.4

0.8

1.1

0.7

0.6

0.7

0.9

0.6

3.5

3.2

2.2

Fixed Investment

0.9

-0.9

-0.1

-0.2

0.3

0.6

0.7

0.6

2.9

-0.1

0.1

1.0

2.0

Business Investment

0.8

-0.4

-0.5

-0.5

0.2

0.0

0.0

0.0

4.3

-1.6

-1.2

-0.5

0.0

Stockbuilding1 (contribution, ppts)

0.9

-1.2

0.1

-0.1

0.0

0.0

0.0

0.0

0.1

0.2

0.4

-0.3

0.0

Domestic Demand2

1.3

-0.9

0.3

0.3

0.5

0.5

0.5

0.5

2.2

1.3

1.8

1.3

1.7

Exports

1.6

-6.6

3.8

0.0

0.0

0.1

0.0

0.2

3.6

-0.9

-0.3

0.3

2.0

Imports

10.3

-13.0

3.4

0.2

0.5

0.8

0.8

0.7

4.0

0.7

3.9

-0.1

2.7

Net Trade2 (contribution, ppts)

-0.8

0.7

0.0

-0.1

-0.2

-0.2

-0.2

-0.2

-0.2

-0.4

-0.8

-0.3

-0.3

Labour Market (% y/y)

 

 

Unemployment (ILO measure, %)

3.8

3.9

3.9

3.9

3.9

3.9

3.9

3.9

6.6

4.1

3.9

3.9

3.9

Employment

1.1

1.3

1.3

0.9

0.8

0.6

0.6

0.6

1.2

1.2

1.2

0.6

0.5

Productivity (output per hour)

-0.3

-0.5

-0.1

-0.2

0.4

0.6

0.5

0.6

0.5

0.6

-0.3

0.5

1.0

Income & Saving (%y/y)

 

 

Nominal Average Weekly Earnings3

3.3

3.9

4.0

3.9

3.8

3.4

3.3

3.2

1.9

2.9

3.7

3.5

3.3

Real Average Weekly Earnings4

1.5

1.5

2.0

2.2

1.7

1.7

1.6

1.5

-0.4

0.3

1.8

1.6

1.5

Real Household Disposable Income

2.2

2.2

2.0

1.3

1.2

1.5

0.9

1.4

1.7

2.7

1.9

1.3

1.3

Saving Ratio (%)

6.4

6.8

6.3

6.7

6.5

7.2

6.5

7.2

9.3

6.1

6.5

7.0

7.0

Prices (% y/y)

CPI

1.9

2.0

1.9

1.7

2.1

1.7

1.7

1.8

2.3

2.5

1.9

1.8

1.8

Core CPI5

1.9

1.7

1.7

1.8

2.0

2.0

2.0

1.9

2.1

2.1

1.8

2.0

1.8

CPIH

1.8

2.0

1.8

1.7

2.0

1.7

1.8

1.9

2.1

2.3

1.8

1.9

1.9

RPI

2.5

3.0

2.7

2.4

2.7

2.0

1.9

2.0

3.1

3.3

2.6

2.1

2.2

RPIX

2.4

2.9

2.6

2.4

2.7

2.2

2.3

2.3

3.2

3.4

2.6

2.4

2.4

Nationwide House Prices (end period)

0.6

0.5

0.4

1.0

1.1

1.2

1.3

1.5

3.4

0.5

1.0

1.5

2.0

Monetary Indicators (end period)

 

 

Bank Rate (%)

0.75

0.75

0.75

0.75

0.75

0.50

0.50

0.50

0.46

0.75

0.75

0.50

0.50

10-Year Gilt Yield (%)

1.00

0.83

0.51

0.60

0.70

0.80

0.90

1.00

0.45

1.28

0.60

1.00

1.25

Sterling Trade-weighted Index

80.0

77.0

77.5

80.0

79.0

78.0

77.1

76.1

82.8

77.0

80.0

76.1

75.8

$/£

1.32

1.27

1.25

1.25

1.25

1.25

1.25

1.25

1.52

1.28

1.25

1.25

1.25

Euro/£

1.17

1.12

1.14

1.19

1.16

1.14

1.11

1.09

1.21

1.11

1.19

1.09

1.09

Current Account & Public Finances

 

 

Current Account (£bn)

-31

-21

-20

-20

-21

-25

-24

-25

-73

-92

-92

-95

-95

% of GDP

-6.0

-4.6

-3.7

-3.7

-3.8

-4.4

-4.3

-4.3

-3.9

-4.3

-4.2

-4.1

-4.0

PSNB6 (£bn, financial year)

98

41

47

55

55

% of GDP (financial year)

5.6

1.9

2.1

2.4

2.4

Global (% y/y)

 

 

World GDP7(CE estimate for China)

3.0

2.9

3.0

2.9

2.8

2.7

2.7

2.8

3.6

3.6

3.0

2.8

3.0

Oil Price (Brent, $pb, end period)

68

67

61

60

60

62

66

70

83

54

60

70

72

Sources: Refinitiv, Capital Economics; 1Excluding alignment adjustment; 2Excluding valuables; 3Including bonuses; 4Earnings deflated by CPI; 5Excluding energy, food, alcohol & tobacco; 6Excluding Banking groups; 7PPP terms

* Based on our “repeated delay” scenario for Brexit, which assumes that Brexit is delayed again and again at least until the end of 2021.

Key Forecasts Tables

Table 2: Brexit Deal Scenario*

2019

2020

Annual (% y/y)

Q1

Q2f

Q3f

Q4f

Q1f

Q2f

Q3f

Q4f

Average

2010-17

2018

2019f

2020f

2021f

Demand (% q/q)

GDP

0.6

-0.2

0.3

0.2

0.5

0.4

0.5

0.6

2.0

1.4

1.3

1.5

2.2

Consumer Spending

0.3

0.4

0.3

0.4

0.5

0.5

0.5

0.5

2.2

1.6

1.2

1.8

1.9

Fixed Investment

0.9

-0.9

-0.1

0.0

0.8

0.9

1.5

1.5

2.9

-0.1

0.2

2.3

4.5

Net Trade1 (contribution, ppts)

-0.8

0.7

0.0

-0.1

-0.2

-0.2

-0.2

-0.2

-0.2

-0.4

-0.8

-0.3

-0.3

CPI (% y/y)

1.9

2.0

1.9

1.8

2.2

2.0

2.0

2.1

2.3

2.5

1.9

2.1

2.0

Unemployment (ILO measure, %)

3.8

3.8

3.9

3.9

3.9

3.8

3.8

3.8

6.6

4.1

3.9

3.8

3.8

Average Weekly Earnings2 (% y/y)

3.3

3.9

4.0

4.0

3.9

3.4

3.4

3.6

1.9

2.9

3.7

3.6

3.5

Bank Rate (%, end period)

0.75

0.75

0.75

0.75

0.75

0.75

1.00

1.00

0.46

0.75

0.75

1.00

1.50

10-Year Gilt Yield (%, end period)

1.00

0.83

0.51

0.90

1.10

1.30

1.50

1.50

0.45

1.28

0.90

1.50

2.00

£/$ (end-period)

1.32

1.27

1.25

1.25

1.28

1.30

1.33

1.35

1.52

1.28

1.25

1.35

1.40

Sources: Refinitiv, Capital Economics; 1 Excluding valuables; 2 Nominal, Including bonuses

* Assumes a Brexit deal is struck on 31st October 2019.

Table 3: Brexit No Deal Scenario*

2019

2020

Annual (% y/y)

Q1

Q2f

Q3f

Q4f

Q1f

Q2f

Q3f

Q4f

Average

2010-17

2018

2019f

2020f

2021f

Demand (% q/q)

GDP

0.6

-0.2

0.3

-0.5

-0.5

0.5

0.5

0.5

2.0

1.4

1.1

0.0

2.0

Consumer Spending

0.3

0.4

0.3

-0.4

0.0

0.2

0.4

0.4

2.2

1.6

1.0

0.4

1.6

Fixed Investment

0.9

-0.9

-0.1

-1.5

-1.9

0.8

0.3

0.3

2.9

-0.1

-0.2

-2.6

2.6

Net Trade1 (contribution, ppts)

-0.8

0.7

0.1

0.1

0.1

-0.1

-0.1

0.0

-0.2

-0.4

-0.7

0.2

-0.2

CPI (% y/y)

1.9

2.0

1.9

1.9

2.5

2.3

2.4

2.5

2.3

2.5

1.9

2.4

2.2

Unemployment (ILO measure, %)

3.8

3.9

3.9

3.9

4.2

4.3

4.3

4.2

6.6

4.1

3.9

4.2

4.1

Average Weekly Earnings2 (% y/y)

3.3

3.9

4.0

3.9

3.6

3.0

3.0

3.0

1.9

2.9

3.7

3.2

3.4

Bank Rate (%, end period)

0.75

0.75

0.75

0.50

0.25

0.25

0.25

0.25

0.46

0.75

0.50

0.25

0.50

10-Year Gilt Yield (%, end period)

1.00

0.83

0.51

0.25

0.25

0.25

0.25

0.25

0.45

1.28

0.25

0.25

1.25

£/$ (end-period)

1.32

1.27

1.23

1.15

1.16

1.18

1.19

1.20

1.52

1.28

1.15

1.20

1.25

Sources: Refinitiv, Capital Economics; 1 Excluding valuables; 2 Nominal, Including bonuses

* Assumes the UK leaves the EU without a trade deal on 31st October 2019.


Overview

Limited upside

  • A general election before Brexit may determine if the economy has to cope with a no deal Brexit or the potentially restrictive policies of a Labour government. So unless there is a Brexit deal, there is little upside for GDP, interest rates and the pound over the next few years.
  • For what it is worth, we think that there is about a 20% chance of a Brexit deal, a 5% chance of no Brexit at all, a 35% chance of a no deal and a 40% chance of Brexit being delayed beyond 31st October and 31st January.
  • It looks as though any delay would be followed by a general election at which neither the best option for the economy (a soft or no Brexit and a business-friendly Conservative Party) nor the worst (no deal Brexit and a Labour Party with less business-friendly policies) is available. Instead, the election may result in the economy facing either a no deal under the Conservatives or a soft Brexit under Labour.
  • Either way, the economy is not approaching this crossroads in good shape. Admittedly, it looks as though the 0.2% q/q fall in GDP in Q2 was followed by a 0.4% q/q rise in Q3, thereby averting a recession. (See Chart 1.) But while the activity surveys are overdoing the gloom, they do suggest that the economy doesn’t have much momentum. (See Chart 2.)
  • And the weaker global backdrop together with evidence that households have become more sensitive to the uncertainty caused by Brexit has led us to revise down our forecasts for GDP growth in all three of our Brexit scenarios (deal, no deal and repeated delays). (See Chart 3.)
  • We still believe that a recession would occur in only one of those scenarios – a no deal. The effects of a no deal are so uncertain that there is a big range of possible outcomes. (See Chart 4.)
  • Our assumption is that GDP would fall by a total of 1.0% in the first two quarters, resulting in a recession. But we believe that a subsequent easing in the delays at the ports, cuts in interest rates from 0.75% to 0.25% and a fiscal stimulus worth 2% of GDP would mean any recession is short and small by historical standards and that growth rebounds to 2% in 2021. (See Chart 5.)
  • We do think, however, that interest rates would also be cut if there were one or two more delays to Brexit. (See Chart 6.) Prolonged Brexit uncertainty would cause both firms and households to continue putting off spending. That may lead to an easing in GDP growth from 1.3% in 2019 to just 1.0% in 2020, which may then keep inflation below the 2% target.
  • Of course, if a Brexit deal is agreed, a rebound in investment could contribute to GDP growth rising to 1.5% in 2020 and to 2.2% in 2021. In that scenario, interest rates may gradually rise from 0.75% to 1.50% by the end of 2021. But the 20% probability of this outcome implies it is more likely that interest rates fall, although we don’t think they will stay quite as low as the markets expect for quite as long. (See Chart 7.)
  • This is also why we don’t think there is much scope for the pound to rise far above its current level of $1.26. (See Chart 8.) That may even be the case if there was no Brexit at all. As that’s most likely to occur if Labour is in power, the boost from no Brexit may be offset by concerns over some of Labour’s other possible policies that may restrain profits.
  • Overall, unless a Brexit deal is agreed, GDP growth will remain subdued, interest rates will probably be cut and the pound is unlikely to strengthen much.

Overview Charts

Chart 1: Real GDP

Chart 2: Activity PMIs

Chart 3: Real GDP in Different Brexit Outcomes (%y/y)

Chart 4: Real GDP (%y/y)

Chart 5: Change in Real GDP During Recessions (%)

Chart 6: Bank Rate (%)

Chart 7: Expectations for Bank Rate (%)

Chart 8: $/£ Exchange Rate

Sources: Refinitiv, IHS Markit, Capital Economics


External Demand

External sector to remain a drag

  • Soft global growth and weaker domestic demand mean that both export and import growth are likely to stay subdued over the next year, and the net effect will probably be that the external sector remains a drag on the economy. As such, the current account deficit will remain large, leaving the pound vulnerable to a further sharp fall at some stage.
  • The global economy has recently weakened further with the composite PMIs in all the UK’s major trading partners falling. In September, the global PMI was at its lowest level since early 2016. (See Chart 9.) As a result, UK goods export volume growth has stayed close to zero. And the surveys suggest that there is further downside to come. (See Chart 10.)
  • Part of the global slowdown is due to the US-China trade war. Admittedly, the direct effect of the trade war on the UK has been small. In fact, there has been a pick-up in UK goods export growth to both countries – perhaps as some demand has been redirected to the UK. (See Chart 11.)
  • That said, the indirect effects, such as reduced business confidence, could have a bigger direct effect. What’s more, a further escalation could have a bigger direct effect on the UK if President Trump raised tariffs on EU imports. In particular, his threat to raise tariffs from 2.5% to 25% on vehicle imports from the EU could reduce UK GDP by 0.15%.
  • The bigger issue is that we expect GDP growth in both the US and euro-zone economies to slow further over the next 12 months. As such, there isn’t much upside for UK exporters in the near term. However, an improvement in global growth in 2021 should prompt a rise in UK export growth to around 2.0%. (See Chart 12.)
  • Meanwhile, if there is another delay to Brexit, continued weak domestic demand means that imports will probably barely grow at all in 2020. (See Chart 13.)
  • Of course, stockpiling ahead of the next Brexit deadline on 31st October, and potentially the one after that on 31st January, means that both exports and imports are likely to remain bumpy. But the big picture is that the external sector will probably remain a drag on the economy. This year net trade may take 0.8 percentage points (ppts) off GDP growth before subtracting a smaller 0.3 ppts in 2020. (See Chart 14.)
  • In a no deal scenario, both exports and imports would plunge as delays at the ports would prevent goods from entering and leaving the country. Exports would probably bounce back once the ports returned to normal, but weak domestic demand in the aftermath may mean imports take longer to recover. As a result, the external sector might provide some support to the economy in 2020, but only enough to offset a small fraction of the weakness elsewhere. As the machinery, chemicals and cars sectors export more than other sectors, they are most exposed to a no deal. (See Chart 15.)
  • In most scenarios, the trade deficit will remain around 1.5% of GDP. However, a recovery in the global economy in 2021 means that the investment income deficit is likely to narrow. That should prevent the current account deficit from widening much further above 4% of GDP. (See Chart 16.) But that would still leave the pound at risk of another large fall in the next five years or so.

External Demand Charts

Chart 9: Composite Activity PMIs

Chart 10: Surveys & Goods Export Volumes

Chart 11: UK’s Export Values by Destination

(3m ave. % y/y)

Chart 12: Trade Partner GDP & UK Exports (% y/y)

Chart 13: Domestic Demand & Imports (% y/y)

Chart 14: Net Trade (Contribution to y/y GDP, ppts)

Chart 15: Goods Exports by Product, 2018 (% of Total Goods)

Chart 16: Current Account Balance

Sources: Refinitiv, IHS Markit, CBI, BoE, Capital Economics


Consumer Spending

Households will hold back until uncertainty lifts

  • Households have grown more sensitive to Brexit uncertainty to the extent that it has held back consumer spending. Therefore, for as long as Brexit is delayed, spending growth will probably remain subdued. But at least that would leave households’ finances in better shape to weather a no deal Brexit were it to happen.
  • While we doubt the consequences of a no deal would be as severe as some predict, consumers might understandably be worried about lay-offs, a fall in asset prices, and a bout of imported inflation due to another fall in the pound.
  • Revisions to the data suggest that these concerns have increasingly restrained spending growth. While the old data showed that consumer spending growth had slowed over the past few years, the latest vintage shows a more marked slowdown since the referendum, with annual spending growth now running at just 1.1%. (See Chart 17.) Consumers have predominantly put off purchases of non-essential goods and services. (See Chart 18.)
  • This reticence has spread to the housing market, causing transactions volumes to fall and house prices to flatline. And consumer credit growth has slowed too. But none of this has anything to do with incomes, which have remained strong. Indeed, as inflation has fallen back, increasing pay growth has translated into increases in consumers’ real spending power. (See Chart 19.)
  • Instead, households have chosen to spend less in order to build up their precautionary savings. The proportion of income that households save (the saving ratio) has now reversed much of the fall since the referendum. (See Chart 20.)
  • Admittedly, we think employment growth will ease off a little, which will cause growth in total household income to ease. But it shouldn’t slow to the extent it pulls down spending growth. (See Chart 21.)
  • The upshot is that sentiment will be the key to whether consumption growth increases. Brexit uncertainty has left consumer sentiment strikingly soft. Usually it closely tracks the so-called misery index (the sum of the unemployment rate and inflation), but a gap has opened since 2018. (See Chart 22.) For as long as Brexit is delayed, and households remain concerned about a no deal Brexit, spending growth will remain soft.
  • If there is a deal, sentiment should improve, taking the leash off households’ discretionary spending. Admittedly, in this case we also think that interest rates would rise to 1.50% by late 2021. But that would still leave debt servicing costs close to historic lows. (See Chart 23.)
  • If there is a no deal Brexit, higher inflation and softer employment and wage growth would weigh on real incomes. Sentiment would take a hit too. But the higher saving rate and a further fall in debt servicing costs, assuming the Bank cuts interest rates, means consumer spending growth may not fall below zero. (See Chart 24.)
  • Overall, while household spending has been subdued recently, that has led their finances to improve so a no deal Brexit would be less painful. And if a Brexit deal is struck, the boost to confidence should lead to a strengthening in consumer spending growth.

Consumer Spending Charts

Chart 17: Real Household Spending (% y/y)

Chart 18: Essential & Discretionary Spending (% y/y)

Chart 19: Average Weekly Earnings & Inflation

Chart 20: Household Saving (% of Disposable Income)

Chart 21: Total Real Pay & Spending (% y/y)

Chart 22: The Misery Index & Consumer Confidence

Chart 23: Debt Servicing Costs (% of Disposable Inc.)

Chart 24: Consumer Spending (% y/y)

Sources: Refinitiv, GfK, ONS, Capital Economics


Investment

Businesses remain on strike

  • Businesses have been hit hardest by the uncertainty caused by Brexit, so more delays would leave them in limbo for longer. They would also suffer the most after a no deal. But after a deal, they would drive the probable rebound in GDP growth.
  • If Brexit is delayed again and again, the high level of uncertainty would probably mean that business investment stagnates at best. The risk would be that business investment, which accounts for about half of total investment, continues to fall. After all, it has declined in five of the past six quarters. (See Charts 25 & 26.)
  • Admittedly, if businesses spent on stockbuilding to prepare for a possible no deal on 31st October, then the Q3 investment data may be a bit more encouraging. And if firms expect uncertainty to persist for a lengthy period, then they may start to invest anyway. But research by the Bank of England suggests that most firms expect uncertainty to be resolved in 2020. (See Chart 27.) That provides a greater temptation to keep spending on hold.
  • As such, in our repeated delay scenario we now expect business investment to fall by 0.5% in 2020 and to stagnate in 2021. If there were a no deal, investment may drop by around 2.5% in 2020. (See Chart 28.)
  • Of course, if there’s a deal, business investment would probably rebound. As uncertainty fades, firms’ appetite for risk would rise. After all, business investment is one of the more volatile components of GDP, acting as a bigger drag in downturns and one of the driving forces in the early stages of a recovery. (See Chart 29.)
  • And there could be an awful lot of ground to make up. We estimate that Brexit uncertainty may have reduced business investment by a bit more than 10% since the EU referendum, deducting about 1% from GDP.
  • Some of that investment has probably been lost for good. Indeed, even if there is a Brexit deal, uncertainty is unlikely to disappear altogether. Moreover, concerns about the global economy are intensifying, and as fewer domestic firms are operating above capacity, there less need to invest. (See Chart 30.)
  • What’s more, history shows it can take anything up to a year after uncertainty recedes before investment picks up. (See Chart 31.) That said, even if only half of the lost investment is eventually recovered, as we expect in our deal scenario, this would still result in business investment rising by about 4% in 2020 and close to 7% in 2021. That would be enough to add about 0.6ppts to GDP growth in each year.
  • Meanwhile, the prospects for residential investment (which accounts for a quarter of total investment) remain poor. Even if there is a Brexit deal, with house prices high and regulation capping how much buyers can borrow, house price inflation won’t rise much. As such, there will be little incentive for housebuilders to ramp up investment. (See Chart 32.)
  • Perhaps the only glimmer of hope is that other types of investment get a kick from fiscal policy. The Chancellor announced a £1.7bn rise in capital spending in the 2019 Spending Round and signalled that there may be more to come.
  • Overall, though, unless there is a Brexit deal businesses are going to remain stuck in the mud and investment isn’t going to provide any meaningful support to GDP growth.

Investment Charts

Chart 25: CBI Uncertainty Balance & Business Investment

Chart 26: Investment Intentions & Business Investment

Chart 27: Time Horizon over which Uncertainty will Lift (% of Firms)

Chart 28: Business Investment (% y/y)

Chart 29: GDP & Business Investment (%y/y)

Chart 30: Business Investment & Capacity Constraints

Chart 31: Business Investment (Peak in uncertainty=100)

Chart 32: House Prices & Residential Investment (% y/y)

Sources: Refinitiv, BCC, CBI, BoE DMP, Capital Economics


Labour Market

Economy to continue to benefit from strong labour market

  • Subdued economic activity will be a drag on employment growth over the next year, but continued Brexit uncertainty would continue to ensure that firms prefer labour over capital.
  • We suspect annual employment growth will fall from about 1.2% to 0.6% in 2020 as subdued economic growth over the next year limits demand for workers. Indeed, the change in the level of employment has already slowed from 222,000 in the three months to January to just 31,000 in the three months to July. And the fall in full-time employment growth suggests firms are becoming more cautious. (See Chart 33.)
  • However, the uncertainty caused by Brexit, and in particular the risk of a no deal, means investing in capital will remain less appealing and hiring workers more appealing. This has supported demand for labour since the referendum. (See Chart 34.)
  • After all, capital investment is hard to recoup if things change. In contrast, labour can be utilised quickly and the cost of reversing hiring decisions is relatively small.
  • Another delay to Brexit, and continued reluctance by businesses to invest, would probably therefore mean that demand for labour continues to grow. Admittedly, the labour market already looks quite tight. The unemployment rate has fallen to just 3.8%, its lowest level in decades, so firms may have difficulty hiring the right people.
  • However, the labour market is probably not quite as tight as it appears. The share of part-time workers wanting a full-time job has not yet fallen back to pre-crisis levels. (See Chart 35.)
  • More importantly, we think that the natural rate of unemployment may have fallen below the Bank of England’s current estimate of 4.25% and could now be between 3.75% and 4.00%. (See Chart 36.)
  • A lower natural rate means there should be less upward pressure on wage inflation than otherwise. Indeed, some of the latest surveys suggest that wage growth may have peaked. (See Chart 37.) But equally, as the current unemployment rate of 3.8% is close to our estimate of the natural rate, there is little reason to think that wage growth will fall back much. However, the annual rate of productivity growth fell to 0.0% in Q2 and would need to rise at some point to sustain the recent upturn in real earnings growth. (See Chart 38.)
  • Even in a no deal Brexit, we think wage growth would only slip to around 3.0%. That would be low by recent standards, but quite good compared to the past few years. (See Chart 39.)
  • And even though we do not expect the unemployment rate to rise above 4.5% if there is a no deal Brexit, some industries will be more heavily affected than others. For example, both the hotels/food services industry and the transport industry rely heavily on EU workers. And they have relatively high vacancy ratios, perhaps indicating they are already struggling to attract workers. (See Chart 40.) A drop in net inward migration following a no deal Brexit would only exacerbate hiring issues in those industries.
  • All told, regardless of Brexit, decent wage growth and the low unemployment rate should mean the labour market continues to provide reasonable support to the economy over the next couple of years.

Labour Market Charts

Chart 33: Employment (3m/3m Change, 000s)

Chart 34: Employment & Business Investment (%y/y)

Chart 35: Measures of Labour Market Slack

Chart 36: Unemployment Rate & NRU (%)

Chart 37: Private Sector Earnings & REC Salaries Survey

Chart 38: Real Pay & Productivity (% y/y)

Chart 39: Earnings (3m av. of % y/y)

Chart 40: Vacancies & Workforce Immigration

Sources: Refinitiv, BoE, REC, Capital Economics


Inflation

Inflation will only be pushed up by labour costs if the economy improves

  • For as long as Brexit is delayed, we think firms will absorb higher costs in their margins rather than pass them on to customers in the form of higher prices, leaving inflation a little below target. But inflation should rise if there is a Brexit deal, due to stronger demand, or a no deal Brexit, because of a weaker pound.
  • Most of the easing in CPI inflation from a peak of 3.1% in late 2017 to 1.7% in August, as the 2016 depreciation of the pound has worked its way through the system, will probably be sustained. (See Chart 41.)
  • Admittedly, inflation is likely to rise to over 2% briefly in early 2019 as clothing price inflation returns to positive territory and a drop in inflation in the volatile recreation and culture category proves temporary. At the same time, agricultural commodity prices suggest that food price inflation will rise from around 2% in August to a peak of about 3% by the end of the year. (See Chart 42.) But beyond the first quarter of 2020, unless there is a no deal Brexit, there are two reasons to doubt inflation will be much above the Bank of England’s 2% target.
  • First, energy price inflation will remain muted. While we forecast that the oil price will rise from $60 per barrel now to $70 by the end of 2020, that would only be a 15% increase compared to a rise of 60% in late 2018. What’s more, falling wholesale gas and electricity prices will pull down utility price inflation. A lower Ofgem utility price cap could result in utility price inflation swinging from adding 0.25ppts to CPI inflation now to taking off 0.25ppts in 2020. (See Chart 43.)
  • Second, while pay growth has risen from around 2.5% to almost 4% over the past two years, core services inflation has flatlined. (See Chart 44.) This might be understandable if the amount each worker was producing was increasing rapidly. But output per worker has been stagnant, so higher pay growth has pushed up unit labour costs. (See Chart 45.) According to the Bank of England, they are now rising at a pace consistent with “the top end of the range estimated to be consistent with CPI inflation at the target”.
  • Despite this, we no longer think that the gap between pay growth and core services inflation will be closed by a rise in the latter. Indeed, the faster rise in firms’ overall costs hasn’t made any difference to how fast they are raising their prices. (See Chart 46.)
  • That’s because firms’ margins are pro-cyclical, increasing when firms feel demand is robust and not when it is weak. For as long as Brexit is delayed and demand is subdued, we suspect margins will continue to be squeezed and overall inflation will remain below 2% for the next couple of years. That’s particularly the case now as firms’ margins might have been larger than usual to start with following the fall in costs in 2014 and 2015.
  • If there is a Brexit deal, a strengthening in demand should give firms the confidence to pass on some of the rise in labour costs. As a result, inflation would be a bit higher in that instance but, due to a stronger pound, still close to 2%. (See Chart 47.)
  • Only if there is a no deal Brexit do we think inflation would be decisively above the 2% target. In that case, the pound would fall further, leading to another bout of import price inflation, albeit a far milder dose than following the referendum result. (See Chart 48.)

Inflation Charts

Chart 41: CPI Inflation (%)

Chart 42: Wholesale & Consumer Food Prices

Chart 43: Wholesale Energy Prices & Utility Inflation

Chart 44: Pay & Core Services Inflation

Chart 45: Unit Labour Costs

Chart 46: Firms Costs’ & Core Services CPI (% y/y)

Chart 47: CPI Inflation (%)

Chart 48: Sterling TWI & Core Goods Prices

Sources: Refinitiv, Capital Economics, DEFRA


Monetary & Fiscal Policy

Higher chance of a further fiscal stimulus and more rate cuts

  • We have incorporated a further fiscal stimulus into our deal and no deal Brexit scenarios, but only in a deal scenario is that offset by higher interest rates.
  • The unexpected rise in public borrowing in the 2019/20 year so far, the extra £13.4bn of government spending for the 2020/21 year announced in September’s Spending Round and the reclassification of some student loans as spending rather than lending mean that the Chancellor has used up all of the previous fiscal “headroom” of £27bn and is on course to break his fiscal rule. (See Charts 49 & 50.)
  • In our repeated delays scenario, borrowing rises from £41bn (1.9% of GDP) in 2018/19 to £55bn (2.4% of GDP) in 2020/21. That implies the Chancellor would need to tighten fiscal policy to meet the rule that borrowing is below 2% of GDP in 2020/21. (See Chart 51.)
  • But it is more likely that the rules are changed to allow policy to be loosened, perhaps at the Budget on 6th November. There is some rationale for that. Raising the borrowing limit from 2.0% to 2.6% of GDP would account for the reclassification of student loans. And the low interest rate climate means the government can tolerate a higher debt ratio than before. (See Chart 52.) And that ratio would still fall as long as borrowing was below 2.9% of GDP.
  • We’ve incorporated the 0.4% boost to GDP from the extra spending announced in the Spending Round into all three of our Brexit scenarios. As such, public spending will probably support GDP growth by more than since before the financial crisis. (See Chart 53.)
  • We have not built a further stimulus into our repeated delays scenario. But our deal and no deal forecasts include a further stimulus worth 1% and 2% of GDP respectively, which may boost GDP growth by a respective 0.5% and 1.0%. The main difference is that after a deal the stronger economy would prevent borrowing from rising much further, while it would leap after a no deal.
  • Looser fiscal policy is on the way regardless of if the Conservatives or Labour are in power, although under Labour taxes would probably be raised at the same time.
  • Only after a Brexit deal would the Bank of England offset looser fiscal policy by raising interest rates, perhaps from 0.75% now to 1.50% by the end of 2021. (See Chart 54.)
  • If there is a no deal, we suspect the Bank would cut rates from 0.75% to 0.25%. The blend of looser monetary and fiscal policy is one of the key reasons why we suspect that, after a short recession, economic growth would rebound to around 2% about 18 months after a no deal.
  • With politicians hamstrung in our repeated delays scenario, we suspect the Bank would cut interest rates from 0.75% to 0.50% in order to support GDP growth and prevent inflation from drifting too far below the 2% target. We’ve assumed that rates wouldn’t be cut unless Brexit is delayed beyond 31st October and 31st January. But it’s possible that the Bank pulls the trigger in November or December. After all, the activity surveys are already at levels consistent with rate cuts. (See Chart 55.)
  • Even so, global factors may be enough to lift 10-year gilt yields from below 0.62% now to around 1.25% by the end of 2021. (See Chart 56.) Regardless what happens with Brexit, the markets have gone too far in expecting rates on average to be less than 0.75% over ten years.

Monetary & Fiscal Policy Charts

Chart 49: Public Sector Borrowing (£bn, Cumulative)

Chart 50: Cyclically-Adjusted Borrowing, 2020/21 (£bn)

Chart 51: Public Sector Borrowing (Excluding Banks)

Chart 52: Public Sector Net Debt (As a % of GDP)

Chart 53: Contrib. of Govt Spending to y/y GDP (ppts)

Chart 54: Bank Rate (%)

Chart 55: Activity PMI & Bank Rate

Chart 56: 10-Year Gilt Yield (%)

Sources: Refinitiv, IHS Markit, OBR, BoE, Capital Economics


Long-term Outlook

Productivity recovery to support long-term growth

  • The drag on the economy’s potential growth rate from lower migration and an ageing population over the next few decades will probably be offset by a boost from higher productivity growth.
  • While Brexit will influence the economy over the next few years, it’s unlikely to have a big impact on growth in the long term. Larger forces will be at play, in particular the extent to which productivity growth recovers after its dire performance in recent years.
  • There are good reasons to think that faster productivity growth is in store. The UK’s strengths, such as the flexibility of its labour market, mean that UK productivity growth should catch up with the likes of Germany.
  • And the UK’s relatively progressive attitude to adopting new technology, at least relative to Europe, should allow it to take advantage of new growth industries such as artificial intelligence, aerospace and biotechnology. The UK already has a comparative advantage in these areas so it is well placed to capitalise on productivity-boosting innovations.
  • We expect these factors to raise productivity growth to 1.5% by the mid-2020s, more than double the rate seen in the past ten years. (See Chart 57.)
  • This should help offset the adverse effects on the economy’s potential growth rate of the reduction in the working age population, due to increasing life expectancy, relatively low fertility rates and the retirement of the post-war “baby boomers”. (See Chart 58.) Indeed, the proportion of the population above the retirement age is set to rise from about 18% in 2018 to around 25% by 2040.
  • And the UK’s retirement age is already one of the highest in the EU – the State Pension Age is set to increase to 67 in 2028 and to 68 from 2037-39 – and participation is significantly above the EU average. So there’s not much scope for these factors to rise further.
  • The UK will probably impose a stricter immigration policy after it leaves the EU, which would further reduce labour force growth. We expect annual labour force growth of just 0.2% over the next 20 years.
  • All told, we think that real GDP growth will average around 1.7% over the next 20 years, down from 2.0% or so over the last few decades. (See Chart 59.)
  • Meanwhile, unless the government restrains spending or increases revenues, the ageing population will lead to a steady worsening in the public finances. Our forecast is that the debt to GDP is still around 80% in the 2030s. Even so, we think the government deficit of 5.0% will be only a little higher in the 2030s than its average of 4.0% over the past five years.
  • Finally, given its relatively good history of controlling inflation, there’s no reason to believe the Bank of England will let inflation diverge from its 2.0% target in the long term. But as productivity growth picks up, we think that the neutral interest rate will rise towards a long-run rate of around 2.5% in the 2030s.
  • Meanwhile, we expect the 10-year gilt yield to average 3.25% in the 2030s (see Chart 60), despite the deterioration in the public finances. Indeed, there are no signs that the bond market is concerned about the UK’s ability to pay.

Long-term Outlook Charts

Chart 57: Output Per Hour Worked (% y/y)

Chart 58: Contributions to Potential Real GDP (ppts)

Chart 59: Real GDP (%y/y)

Chart 60: Bank Rate & 10-Year Gilt Yield (%)

Sources: Refinitiv, Capital Economics

Table 4: Key Long-term Forecasts (% y/y, Averages, unless otherwise stated)*

Actual

Forecasts

2000-2007

2008-2012

2013-2017

2018-2022

2023-2027

2028-2037

Real GDP

2.8

0.0

2.2

1.4

1.5

1.7

Real consumption

3.3

-0.4

2.4

1.6

1.7

1.9

Productivity

1.8

-0.2

0.6

0.7

1.4

1.5

Employment

1.0

0.2

1.5

0.7

0.1

0.2

Unemployment rate (%, end of period)

5.3

8.0

4.4

3.9

4.3

4.3

Wages

4.3

1.8

1.9

3.4

3.4

3.5

Inflation (%)

1.6

3.3

1.5

1.9

1.9

2.0

Policy interest rate (%, end of period)

5.50

0.50

0.50

1.00

2.50

2.50

10-year government bond yield (%, end of period)

4.50

1.81

1.23

1.50

3.25

3.25

Government budget balance (% of GDP)

-1.5

-8.6

-4.0

-1.0

-2.9

-5.0

Gross government debt (% of GDP)

33

67

85

81

76

88

Current account (% of GDP)

-2.5

-3.4

-4.7

-5.1

-4.7

-4.8

Exchange Rate (US dollar per pound sterling, end of period)

2.0

1.6

1.4

1.3

1.3

1.3

Equity Market (FTSE 100, end of period)

6,457

5,898

7,688

7,165

8,530

12,325

Nominal GDP ($bn)

2282

2510

2759

2868

3438

4641

Population (millions)

60

63

65

67

69

70

* Based on our “repeated delay” scenario for Brexit, which assumes that Brexit is delayed again and again at least until the end of 2021.


Paul Dales, Chief UK Economist, +44 20 7808 4992, paul.dales@capitaleconomics.com
Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com
Thomas Pugh, UK Economist, +44 20 7808 4693, thomas.pugh@capitaleconomics.com
Andrew Wishart, UK Economist, +44 20 7808 4062, andrew.wishart@capitaleconomics.com
William Ellis, Research Economist, +44 20 7808 4068, william.ellis@capitaleconomics.com