A Brexit deal is still unlikely, but it would remove much of the uncertainty that has caused firms to hold off investment projects and consumers to rein in their spending, and would therefore result in GDP growth, interest rates, the pound and bond yields all rising by more than is widely expected.
- A Brexit deal is still unlikely, but it would remove much of the uncertainty that has caused firms to hold off investment projects and consumers to rein in their spending, and would therefore result in GDP growth, interest rates, the pound and bond yields all rising by more than is widely expected.
- The chances of a Brexit deal have increased since Boris Johnson and Leo Varadkar appeared to agree a way to avoid a hard border on the island of Ireland. The proposal might allow the EU to approve a deal either at the summit this week (unlikely) or an emergency summit around the 29th October (more likely).
- There are still two big hurdles. First, there are reports that the EU will only agree to the new backstop proposal if the UK promises not to slash regulation, something the Government sees as a key benefit of Brexit. Second, any deal must get through Parliament, where the government has a “majority” of minus 45. That’s why we have only revised the odds of a deal up from 10% to 20% and are still publishing two other forecasts based on repeated delays (40% chance) and a no deal Brexit (35%). (See here.)
- Nonetheless, we suspect that a deal would push GDP growth up to 1.5% in 2020 (versus 1.0% if Brexit continues to be delayed) and 2.2% in 2021 (1.5%). With the future trading relationship undecided, uncertainty wouldn’t disappear altogether. But sentiment should still improve due to the risk of a no deal being eliminated and the start of a transition period lasting until December 2020, with the potential to be extended to December 2022, maintaining the status quo.
- That would allow a rebound in business investment. We think Brexit has reduced business investment by over 10% since the EU referendum. Some of that has probably been lost for good. But we expect half of it to eventually be recovered, adding 0.3ppts to growth in 2019 and 0.5ppts in 2020 relative to our repeated delays scenario. (See Chart 1.) A deal should also take the leash off households’ discretionary spending. Brexit worries have dragged on consumer confidence and growth in spending on non-essential items.
- We think both household spending and investment would also get a kick from fiscal policy. A deal would give the Government the fiscal space to cut taxes and increase spending, perhaps at the Budget on 6th November. We have incorporated a giveaway equivalent to 1% of GDP which boosts growth by 0.5%. Note, though, that the acceleration in GDP growth we are forecasting is gradual. Experience suggests it takes six to twelve months for investment to pick up after uncertainty has eased. (See here.)
- Nonetheless, the prospect of stronger GDP growth should give firms the confidence to reflect rising labour costs in their prices. That should offset the downward pressure on inflation from a rise in the pound. As a result, we think stronger underlying growth would eventually cause the Monetary Policy Committee to raise interest rates, from 0.75% to 1.00% in August 2020, and to 1.50% by end-2021.
- That is a vastly different outlook for interest rates than the cut to 0.50% that is currently priced into the market. (See Chart 2.) So although economic growth might be slow to respond, markets would respond quickly. We forecast that the 10-year bond yield would rise from 0.6% to 1.5% in 2020 and 2.0% in 2021 and the pound from $1.27 to $1.35 and $1.40.
Chart 1: Contributions to GDP Growth (ppts y/y)
Chart 2: Expectations for Bank Rate (%)
Sources: Refinitiv, Capital Economics
Sources: Bloomberg, Capital Economics
Andrew Wishart, UK Economist, +44 20 7808 4062, firstname.lastname@example.org