UK: The way forward
The Bank of England decided to cut interest rate in early August, after the initial shock of the UK’s referendum vote to leave the European Union.
GDP figures published suggest the economy performed well in the run up to the referendum. However, survey-based evidence covering the weeks immediately after Brexit do not make for pretty reading, suggesting a dramatic decline in activity, and a significant risk of recession.
Calm before the storm
The preliminary estimate of second quarter UK GDP growth shows a strong economy ahead of the EU referendum. The economy grew by 0.6% quarter-on-quarter, an acceleration compared to the 0.4% growth in the first quarter. The results were also better than expected as consensus estimates were looking for 0.5% growth. Year-on-year, growth was running at 2.2% – a healthy pace consistent with falling unemployment.
Growth was driven by the services sectors as usual, although the production sectors also made a noticeable contribution over the quarter, thanks to the fastest quarterly growth in industrial production since 1999. Both the construction and agriculture sectors made small negative contributions, but the overall picture looks robust. However, once we delve further into the details of the GDP report, we find that the initial data that the Office for National Statistics (ONS) has collected shows that most of the growth in the three main sectors of the economy came in April. The ONS’s estimates suggest the economy then probably contracted in May, before eking out a little growth in June.
If we take the ONS’s estimates at face value, they suggest the economy was already losing momentum as the UK approached the EU referendum.
Warning bells ringing loud and clear
The difficulty in assessing the impact of Brexit is the lack of economic data in the next few months. As a result, private business surveys, which offer more timely but less accurate readings of activity, have already started to grab the headlines.
Data firm Markit released an extraordinary one-off set of “flash” purchasing managers’ indices (PMI) for the UK, showing a sharp decline in reported activity. The macro composite PMI fell from a balance of 52.4 to 47.7, well below the neutral mark of 50 and suggesting a contraction in economic activity. Compared to consensus estimates of 49.0, the result was worse than expected and represents the lowest reading since the global financial crisis (2009). If the macro composite was to remain at this level, it would suggest the economy will contract by 0.5% in the third quarter. However, it is too soon to draw such a conclusion from only a few weeks of data. Moreover, PMIs have a history of overreacting to global shocks. For instance, the Asia crisis in 1998, the 9/11 attacks in 2001, and the hangover from the tech-bubble bursting in 2003 all prompted the PMIs to collapse, yet the UK economy remained resilient.
Despite the Bank of England disappointing in July by not changing policy, as we had predicted, the BoE has acted at the 4 August meeting by cutting interest rates to 0.25% and expanding QE.
Over the medium term, we think interest rates could be kept on hold until at least 2019. Money markets on the other hand are pricing in more than a 50% chance of a further cut, with interest rates only returning to the level of 0.5% at the end of 2021.
Beyond the UK, Europe remains calm political stability in Europe was a key concern just after the EU referendum result, as many investors projected the UK’s animosity towards the EU on to other member states. While it is too soon to judge the political fallout, so far, the economic impact appears to be limited.
It appears that the UK was on a reasonably robust footing ahead of the EU referendum, although the early indicators since the vote for Brexit suggest a marked slowdown to follow. We continue to place a 40% probability on the UK experiencing a technical recession, but do expect the newly-launched policies will boost the economy. So far, there are few signs that the Brexit referendum has impacted Europe, although it is too soon to make a conclusion on political contagion.
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