Can the UK escape the eye of the storm?

Much like the rest of the world, the UK is suffering its deepest recession in modern times, caused by the necessary lockdowns in response to the coronavirus pandemic. The availability of data remains limited, but there is now enough to establish an accurate picture of the scale of the economic damage done during the early stages of lockdown.

The government acted quickly to set up unprecedented support for both households and firms. Millions of people have been furloughed, though the rise in unemployment is likely to gather momentum later this year.

Meanwhile, the Bank of England has cut interest rates and restarted quantitative easing, but might it go a step further and take interest rates in to negative territory? And what about Brexit? The UK is half-way through the transition period with no sign of the trade deal that was promised. Could we be heading for another cliff-hanger at the end of the year?

Lockdown takes its toll

The full extent of the coronavirus lockdowns are on display in the latest estimate of UK GDP. The UK economy contracted 20.4% in the month of April – the first full month of lockdown. This follows the 5.8% fall in March, the month in which the lockdown was implemented in the final week. This means that economic activity has fallen by 25.1% since its peak in January 2020 (chart 1). The fall in GDP is the steepest fall in modern times, but less reliable historic data from the Bank of England suggests it could be the deepest recession in almost 300 years.

Within the details of the monthly data, the construction sector saw the largest fall in activity, contracting by 40.1% month-on-month. Output from production sectors, including manufacturing, fell by 20.3%, while services activity declined by 19%.

Within services, the accommodation and food services sub-sector recorded a devastating 88.1% fall in April, following a 31.1% decline in March. Arts, entertainment and recreation were also severely hit, down 39.7%. In contrast, the public administration and defence sector was flat, while financial and insurance activities only fell 5.3%.

The latest estimate was worse than consensus estimates of an 18.4% drop. Compared to the proportion of the economy implied by the March data to have been shut down, it appears that the lockdown has become slightly more severe.

April should prove to be the worst month for the economy during the coronavirus crisis. On 10 May, prime minister Boris Johnston asked non-essential workers who cannot work from home, but that can safely return to work, to do so.

Google mobility data suggests that the fall in travel to work bottomed out in April, which supports our view that GDP in May could have returned to positive growth. However, many but not all non-essential retail stores in England only opened on 15 June, while most personal services are expected to remain closed until at least 4 July. (Decisions on lockdown are made by the devolved authorities, and so announcements by the prime-minister relate to England. For example, stores in Scotland are due to re-open on 29 June).

Slower re-opening than anticipated

The re-opening of the UK economy has been considerably slower than other parts of Europe, and certainly slower than we had expected.

Unfortunately, the UK has struggled to contain the virus, and according to our calculations using World Health Organisation statistics, the UK has the third highest fatality rate at just over 632 people per million of the population, only behind San Marino and Belgium. This is the main reason why we downgraded UK GDP growth in our forecast from -7.2% to -8.5% for 2020.

We had assumed lockdown would last six weeks into the second quarter which has been proved to have been too optimistic.

Though it is no real consolation, the average implied impact on the economy per day of lockdown has so far been far smaller than we had anticipated, at 20% instead of 30-40%.

As the economy slowly opens again for trade, GDP is expected to rebound sharply in the second half of the year. However, social distancing rules will limit the capacity for many firms, and for some, will make trading unprofitable, or worse, physically impossible. Moreover, many companies that were forced to shut down have been left continuing to pay fixed costs for much longer than expected, even if they have been able to furlough their staff.

The ONS Business impact of COVID-19 Survey (BICS) shows that those companies surveyed between 18 and 31 May, 22.4% had seen turnover fall by between 20% and 50%, while 23.5% had seen turnover decrease by more than 50%.

Although government credit guaranteed loans have been made available, and for some, even grants, it could take many years of trading for these debts to be repaid and for a return to profitability. That is, if demand returns to a sufficient level.

Households are very likely to want to build up a safety buffer in the form of savings. The UK had one of the lowest household savings rates in Europe going into the crisis, which will have left many families desperately short of funds. A change in preferences for higher savings would be prudent, but it would come at the cost of lower growth in the near to medium term.

The slower the re-opening of the economy, the greater the negative impact will be from these factors. Therefore, while we still forecast a rebound in GDP growth in 2021 of 6%, this does not return the level of economic activity back to the pre-lockdown level, and is a downgrade from our previous forecast of 10.3% growth.

Compared to other professional forecasters whose work is collated by Consensus Economics, our GDP projection is below consensus for Q2 this year, but then above for Q3 (chart 2).

Apart from one organisation, the remaining forecasters agree that the level of GDP will not rebound back to its previous level by the of 2021. That said, the Schroders forecast is still slightly below the consensus for 2021 GDP growth.

Job losses are inevitable

The success and speed of the economic recovery will partly depend on how many companies survive and how few jobs are lost. The government has been pivotal in minimising job losses so far by setting up the Coronavirus Job Retention Scheme, which was recently extended to run till October. Employees receive up to 80% of salaries , capped at £2,500 per month, with employers not making a contribution until September. The government even set up a similar scheme to help the self-employed, which is based on reported past revenues.

As of 14 June, 9.1 million or just over 29% of jobs have been furloughed, while 2.4 million or 70% of eligible self-employed workers have made claims (chart 3). The cost of these schemes has been enormous: £20.8 billion spent on the employee scheme, and another £7.6 billion spent on the self-employed.

Indeed, public sector net borrowing so far in 2020 (to May) has reached an astonishing £102.9 billion, compared to just £5.2 billion during the same period in 2019, and is more than total borrowing over the course of both 2018 and 2019! In fact, public sector debt (excluding public sector banks) has broken through the 100% of GDP mark for the first time since 1963.

For the sustainability of public finances, the reopening of the economy is imperative. In the near term, public borrowing will continue to rise, but the number of workers furloughed should begin to fall soon as work resumes.

Unfortunately, not all workers will be fortunate enough to return to work as normal. As discussed earlier, the business models of many companies are now being questioned, with some unlikely to return to profitability.

Of course, it will take a very long time before activity returns to its previous peak, but as the UK tentatively takes further steps to re-open the economy, we expect the economic recovery to gather momentum. In recent weeks, there has been a slew of announcements from companies announcing job cuts in the UK. These include 3,000 at Rolls-Royce; 2,000 at BP; 1,000 at Bentley; 3,000 at Virgin Atlantic; 12,000 at British Airways (not all in the UK); 2,500 at Travis Perkins; and 1,500 at The Restaurant Group.

In September, companies are expected to pay 12.5% of the cost of the compensation to furloughed staff, which rises to 25% of the cost in October. At present, the scheme will have ended by November and so companies will have to either take staff back, or make them redundant. Of course, some companies will not wait that long. Banks and creditors are reportedly forcing companies to slash costs before agreement on credit lines being extended.

Care will be required in interpreting official labour market data in coming months. For example, despite employment falling by 429,000 in the month of April, the unemployment rate remained unchanged at 3.9%. In fact, the number of unemployed only rose by 34,000. Most of those that lost their jobs became inactive, probably due to lockdown. Unless an individual is actively seeking work, then he or she will not be classified as unemployed.

The claimant count rate, an old favourite measure of unemployment of past governments as it tended to exclude the unemployed that did not qualify for benefits (and so was always lower), may be a more useful indicator at present.

It combines claimants of Job Seekers Allowance benefits and Universal Credits for those that are seeking work. However, the measure does not meet international standards as a measure as it excludes some people, and includes some claimants of universal credits that require top-ups due to low income. Still, the claimant count rate is a more timely measure. In May, it rose to 7.8%, which suggests that the unemployment rate may already be around 7.5% (chart 4). 

It is possible that the unemployment rate rises even further, possibly peaking at over 10%, before falling back as the recovery continues. But, given the likely lower demand in the economy, and the difficulties many businesses face, it is difficult to see how the unemployment rate can drop back below to 4% within the next few years.

As a result of prolonged higher unemployment, deflationary pressures are likely to build over the coming years. Inflation is likely to fall below 1% in the near future, triggering letters from the Bank of England to the Chancellor to explain the undershoot. At present, almost all of the fall in inflation is caused by the collapse in global energy prices. However, excess spare capacity is likely to be the bigger problem over the medium term, which will raise pressure on policymakers to keep monetary policy loose.

Could interest rates turn negative?

The Bank of England (BoE) has been quick to respond to the crisis, providing stimulus to aid the economy. The main policy interest rate was lowered from 0.75% to 0.25% on 11 March, then again to a new record low of 0.1% on 19 March. Accompanying the latter cut, the BoE also restarted its quantitative easing programme, announcing £200 billion of new government and corporate bond purchases over the rest of 2020. As early signs of the extent of the damage done to the economy emerged, the Bank announced a further £100 billion of purchases on 18 June.

More extreme measures could be on the horizon. The BoE’s governor Andrew Bailey told the House of Commons Treasury Select Committee on 20 May that negative interest rates were under “active review”, despite dismissing the option a week earlier.

A number of central banks in Europe have used negative interest rate policy (NIRP) in recent years, mainly to deter overseas capital, which would otherwise lead to an unwanted appreciation in the currency. However, some central banks, in particular the European Central Bank (ECB), have primarily focused on the perceived benefit of encouraging greater spending (and lending by banks) by penalising cash saved on deposit.

The evidence from Europe suggests that NIRP did help to stop unwanted capital inflows, but its use to encourage greater lending activity in the economy is dubious. Lending was stagnant until the ECB introduced Targeted Long-Term Refinancing Operations (TLTROs), Europe’s version of the funding for lending scheme which was pioneered in the UK. Indeed, this was an important step as without it, lending could have been even more constrained by NIRP.

Unlike traditional policies, NIRP is not a cost free policy tool. There are serious consequences from distorting economies in this way, and potentially even greater consequences from a behavioural finance point of view.

The practical implementation is questionable. Most banks charge a spread in addition to the wholesale funding rate (largely driven by the central bank), which covers the cost of operations including a profit for the activity. The standard variable rate (SVR) charged by banks on mortgages is a good proxy for this, which has roughly averaged three percentage points higher than the BoE rate. Naturally, riskier forms of lending require a higher spread.

If banks are charged rather than paid for the cash reserves they hold with the central bank, this eats into their profit margin and requires them to recoup the cost in some way. In theory, banks should pass on the cost to savers by charging a negative interest rate. In reality, where NIRP exists, banks have been reluctant to do this, choosing instead to either increase banking fees and charges, or in some cases, raising SVRs for borrowers. Where neither option is possible, some banks have simply reduced lending, which may be the worst possible outcome given the policy’s intention to stimulate activity. 

To avoid charges, some households will decide to withdraw savings from banks and instead invest in a home safe. Not only is this a security risk, but the withdrawal of assets from financial institutions reduces liquidity and the ability of banks to lend. 

For these reasons, the majority of central banks have decided not embark on NIRP. Indeed, the Swedish Riksbank, which recently ended its five-year long experiment with NIRP, decided to keep interest rates at zero rather than experience the “negative effects” of sub-zero rates that are still being seen elsewhere. Though central bank governor Stevan Ingves did not rule out the policy altogether, he was clear that QE was the preferred policy in stimulating the economy.

For the reasons outlined above, we doubt the BoE will cut interest rates below zero. Instead, further expansions in QE are possible, with forward guidance that interest rates will remain on hold for some time.

Brexit talks forced to a head

Despite the disruption of the coronavirus pandemic, the UK government is refusing to allow for more time to complete the trade negotiations before the Brexit transition period comes to an end. As set out in the Withdrawal Agreement, the UK can request a two-year extension to the transition period by the end of June 2020; however, with the UK government determined to draw a line under the whole affair, many are becoming increasingly concerned that a trade deal may not be agreed in time. 

On 15 June, UK prime minister Boris Johnson took part in a virtual meeting with European Commission president Ursula von der Leyen and European Council president Charles Michel. Though neither side was willing to back down, they agreed to “inject new momentum” into trade talks, setting a new deadline for the end of July.

Talks have reportedly been in deadlock for weeks over several key areas. The EU is pushing for access to UK fishing waters, which the UK refuses to accept, while the UK is refusing to sign up to being a rules and standards taker for any future changes in standards. Moreover, the EU wants the UK to agree to maintaining a “level playing field”, or in other words, not to undercut the EU on labour laws, environmental standards and corporate subsidies (or state aid).

The reportedly positive mood following the meeting suggests both sides believe in the mutual benefits of a trade deal, and that there is room for compromise. The EU states that 31 October is the real deadline as member states will need time to ratify the agreement. Unlike the Withdrawal Agreement, the trade deal will require unanimous backing, which raises the risk of hold-outs.

Some will remember the 2016 EU-Canada trade deal (Ceta pact) which almost collapsed when Belgium delayed its ratification due to opposition from the Walloon regional parliament. There has to be enough time to overcome such obstacles.

We continue to expect a partial trade deal to be agreed by the end of the year, with potentially an add-on deals agreed in subsequent years.  Give the lack of available time, the agreement is likely to focus on the sectors that take the highest priority for both sides. As previously indicated by the UK government, services will not be included in the agreement.

If both sides fail to agree on even a partial deal, then we can expect to see tariffs being applied to the flow of goods heading in both directions, potentially raising prices and reducing demand. Both sides would suffer, though the impact on the UK would be larger given the relative sizes of economies.

However, given the current economic backdrop, the negative impact from a no-deal Brexit would be a drop in the ocean compared to the impact from the coronavirus lockdown. It will be incredibly difficult to separate and distinguish the impact of each shock.