IHS believes that the vote to leave the European Union is bad news for the UK economy, certainly in the near- and medium-term. Even supporters of the Leave campaign have acknowledged that there will be a near-term hit to the economy from heightened uncertainty affecting business and consumer activity, as well as from financial market turmoil, according to By Howard Archer, Chief UK and European Economist at IHS Global Insight.
The financial markets have certainly taken the view that the decision to leave the European Union is bad news for the United Kingdom in the near term at least. Sterling has plunged to a 30-year low against the dollar (moving from US$1.50 to below US$1.35), while the FTSE is set to suffer substantial losses.
Following the UK’s decision to leave the EU, IHS is substantially cutting its GDP growth forecasts to 1.5% (from 2.0%) for 2016, 0.2% (from 2.4%) for 2017 and 1.3% (from 2.3%) for 2018. Major economic and political uncertainty will be a fact of life for some considerable time, likely weighing down markedly on business and household confidence and behaviour, so dampening corporate investment, employment and consumer spending. Weaker asset markets and tighter credit conditions are seen further hampering UK growth, while the housing market could suffer a marked downturn. Financial sector activity in the City of London may well be hit quickly. Foreign investment into the United Kingdom is expected to suffer (both direct and portfolio). Sterling has fallen sharply following the vote to leave the European Union; and while this should help UK exports, it will likely push up inflation thereby squeezing consumer purchasing power and lifting companies’ input costs. Furthermore, the United Kingdom’s decision to leave the European Union will undoubtedly dampen European growth, which will hamper UK exports despite a weaker pound.
Economic uncertainties relate not only to what will happen after the United Kingdom leaves the European Union, but also to when exactly the divorce will occur. The United Kingdom will exit two years from when it formally notifies the European Union that it is leaving (under Article 50 of the Lisbon Treaty), but the “Leave” side has indicated that notification may not occur until 2018 given the time needed to negotiate trade and other agreements with the European Union (especially given a need to also negotiate many trade agreements with non-EU countries). However, this delayed exit could prove unacceptable to European Union countries. The more messy and antagonistic the negotiations with the European Union prove (particularly over new trade agreements and access to the European single market), the more the UK economy is likely to suffer during 2016-2018. IHS suspects that UK negotiations with the European Union will prove difficult, given that EU leaders will not want to set a precedent for an easy withdrawal for other countries that could reconsider their status such as Denmark. Mitigating this, the European Union will be keen to protect its significant trade surplus with the United Kingdom.
Over the long term, how the United Kingdom economy fares outside the European Union depends on many factors. This notably includes the extent of the trade agreements that are reached not only with the EU but also with other regions/countries; how much the UK is affected by non-trade barriers when exporting to the EU; the amount of deregulation that is undertaken in the UK; what immigration policy is followed, how the City of London’s role as a dominant financial centre is impacted; and how foreign direct investment into the UK is affected. It could take 5-10 years for all of these matters to be sorted. In the meantime, there is a very real risk that Scotland at least could leave the United Kingdom. This would substantially aggravate political and economic instability.
We expect the Bank of England to cut interest rates from 0.50% to 0.25% before long and it could also very well resuscitate Quantitative Easing. We suspect that growth will become the main concern within the Bank of England. The Monetary Policy Committee will be prepared to look through any near-term spike in inflation from a weakened pound. The Bank of England will likely take the view that the weakened growth outlook means it will be harder to hit the 2.0% inflation target in 2 years’ time. Of course, the Bank of England’s position may well be made even harder if there is a sharp flight of capital from the UK after the EU exit vote, thereby exerting pressure for higher interest rates to attract the inward investment that is needed to finance the large current account deficit.