UK economy post referendum – for richer, but mostly for poorer

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We may well never know the true extent of the impact of the EU referendum outcome on the British economy, markets and ultimately standards of living. This may not be the most satisfying conclusion, but this uncertainty is one which policy-makers will have to grapple with.

As to the bigger question of whether the UK is better off today or will be better off in years to come when one takes into account not only the impact on the economy but also broader, less tangible issues such as sovereignty, the answer is and will likely remain even more subjective.

In any case, available data paint a patchy picture of the UK economy post-referendum. Construction and services have been harder hit than manufacturing. Retail sales were strong in July thanks in part to a robust labour market and plentiful lending. While this defies the collapse in consumer confidence temporary factors may also have been at play.

The residential property market at a national level has been softer but resilient post referendum. Mortgage lending remains depressed but government policies are for now more likely to blame. The commercial property market has been harder hit.

Sterling’s 10% collapse since the referendum, following a 10% depreciation between November and June, is seemingly supporting economic growth and demand for UK assets even if history suggests that it is no panacea. Its inflationary impact has so far been very modest but the risk is a squeeze on profit margins and real wages.

At the same time sterling’s collapse has tangibly eroded the UK’s net wealth, at least when expressed in foreign-currency terms – a fact largely ignored by policy-makers and the media.

I would expect the BoE to continue favouring monetary and credit policies which explicitly help spur lending, spending and investment and, implicitly at least, help cap sterling. While this may not translate into another policy rate cut or round of QE near-term, the BoE is likely to keep this option firmly on the table if the UK economy fails to return to trend in the next six months.

Still some head-scratching over impact of referendum on UK economic activity

Quantifying with any kind of certainty and objectivity the referendum vote’s impact on the British economic landscape is, in my view, at best a complex task and at worst a near-impossible one. This, in turn, is likely to cloud our forecast of financial markets, Bank of England (BoE) monetary policy and the government’s fiscal plans.

As a consolation I am seemingly not alone in this thinking. British policy-makers, professional bodies and the media have oscillated between neutral, negative and positive assessments of how the UK economy has fared in the past two months and is likely to perform going forward. Following recent data releases the tone has brightened, but it was only three weeks ago that the Bank of England (BoE) announced an unprecedented package of measures to reflate the UK economy. These included a halving of the BoE policy rate to a new record low of 25bp, a new Term Funding Scheme to reinforce the pass-through of the cut in policy rate, the purchase of up to £10bn of UK corporate bonds and a £60bn expansion of its quantitative (QE) scheme.

 

Separating the wheat from the chaff

Providing a definitive conclusion on whether the UK is, or will be, better or worse off was always going to be a challenging exercise. For starters, one needs to differentiate the direct and permanent impact which the referendum outcome itself has had from the impact of:

  • Events not related to the referendum , such as the government’s introduction in April of new stamp duty rules on buy-to-let homes and the likely ephemeral distraction and feel-good factor from Team GB’s impressive performance at the Rio Olympics.
  • Indirect/temporary factors related to thereferendum . For example, much has happened to the British political landscape since the British electorate voted to leave the EU on 23rd June – a new prime minister and cabinet have taken office and the opposition Labour party has imploded (a topic which seems to receive disproportionate attention in the British media).

These non-referendum factors and referendum side-effects, which may well wear off in due course, could be currently shaping popular opinion and in turn the economy, as much as the actual vote to leave the EU.

Going a step further, one needs to ascertain whether any changes in the UK economy are attributable to the referendum  or to international factors – such as changes in commodity prices and global risk appetite – outside the control of UK households, businesses and policy-makers. Put differently, any analysis needs to acknowledge that international factors beyond the referendum may be playing an important, or even more important, role in shaping the UK economy and future policy decisions.

 

More data will help, but not a cure-all

At the same time, the analysis of the post-referendum UK economy has been largely reliant on surveys and unofficial or preliminary data. Only a handful of official macro numbers – mainly for retail sales and inflation – and partial official data for the labour and housing markets – have so far been released for the month of July.

In any case the impact of the referendum  on the UK economy is likely to play out over months, even years, as the new government has only just started lengthy discussions with multiple partners over the future of the UK’s relationship with its European and global counterparts. Moreover, the impact of sterling’s sharp depreciation post-referendum will take months to fully feed-through to inflation. Any analysis will thus likely need to be updated at regular intervals to remain relevant.

As the outlook for the UK’s trade agreement becomes clearer and more hard data gets released, the referendum result’s impact on UK growth, inflation and labour market may become clearer. But even then it is conceivable that changes in the UK economy would have materialised even if the British electorate had voted to remain in the EU, due to well-entrenched cyclical and structural factors at a domestic level. Either way, proving what would have happened in this hypothetical scenario is speculative at best.

The UK economy could also have started to change, whether positively or negatively, well before the actual referendum when then Prime Minister Cameron confirmed on 20th February that a referendum would actually take place. It therefore makes sense to gage the UK economy’s performance in the past six months, not just the past eight weeks. But again the caveats which I highlight above apply.

Putting these numerous caveats aside, we can try to at least get a sense of how UK economic activity has responded in the past six months, when then Prime Minister Cameron confirmed the referendum date, and in particular the past two months. A good starting point is an analysis of official monthly and quarterly data released so far.

 

GDP was steady in H1 but truer picture will only emerge with Q3 data

Final estimates for Q1 GDP and preliminary estimates for Q2 GDP cover the post-announcement period but only capture the first week following the referendum[1]. Real GDP growth slowed to a rate of 0.4% quarter-on-quarter seasonally adjusted in Q1 2016 from 0.6% in Q4 2015 but then rebounded back to 0.6% in Q2 2016 (see Figure 1).

Olivier Desbarres fig1
This ultimately tells us very little as quarterly GDP growth has oscillated between 0.4% and 0.6% with metronomic regularity since Q1 2015. Fixed and business investment contracted in Q4 2015 and Q1 2016 but rebounded in Q2, suggesting no lasting or material impact from the confirmation of a referendum date. It is more likely that oil and gas companies had reined in North Sea spending following the collapse in oil and gas prices rather than UK companies delaying or cancelling investments because of referendum-related uncertainty.

Preliminary Q3 data, due for release on 27th October, will realistically provide the first birds-eye view of how the economy fared in the first three months following the referendum. A quarterly number between 0.4% and 0.6% would point to on-trend GDP growth and a minimal impact from the referendum, in my view, while growth of 0.3% or below would suggest that the economy lost steam post-referendum. The second estimate for Q3 GDP, due for release on 25th November, will again provide greater insight on where the growth was won or lost.

In the meantime we have to rely on a handful of official, sometimes incomplete datasets for July, namely for inflation, retail sales and the labour and housing markets, along with unofficial surveys (Markit PMIs, GFK consumer confidence) and non-government sector-specific data for industry (CBI), retail (BRC) and housing (Halifax, Rightmove, Nationwide, RICS).

 

Inflation – Not much so far but imported inflation bogeyman for producers and retailers

It is still very early days to ascertain how a weaker currency will impact inflation in coming months as the transmission mechanism is rarely immediate given multi-month contractual arrangements between suppliers, producers and end-retailers. But data for H2 2016 suggest that the 10.4% collapse in the sterling Nominal Effective Exchange Rate (NEER) since the referendum – even if it is not reversed any time soon – and higher global commodity prices are unlikely to lead to significantly higher inflation. British producers and in particular retailers are instead more likely to cap prices in order to retain market share.

This would tie with the Bank of England’s models suggesting a limited pass-through from a weaker currency to imported and headline inflation. Its aggressive policy prescription certainly doesn’t pre-suppose that any inflation rise will be large and/or permanent.

The sterling NEER fell about 10% between mid-November 2015 and mid-June (see Figure 3) and commodity prices rose markedly in H1, albeit from a low base, with the price of Brent crude oil about 35% increase. This contributed to a reasonably modest 1.5% increase in output producer prices in H1 (see Figure 4), suggesting that producers tried to slow price increases by capping profit margins and/or their non-imported cost base (by curbing investment and wage growth for example). This was perhaps even more evident at the retail level, with headline CPI-inflation, core CPI-inflation and RPIJ inflation of only 0.3%, 0.3% and 0.5% and respectively.

Olivier Desbarres fig2

This picture was broadly unchanged post-referendum, with output producer prices up 0.3% mom in July, whereas measures of consumer and retail prices were broadly unchanged. In year-on-year terms, CPI and RPIJ-inflation in July rose only incrementally to 0.6% yoy and 1.1% yoy, respectively, from 0.5% yoy and 0.9% yoy in June (see Figure 5). These marginal increases are very much in line with the very gradual trend increase in the prior 12 months. Core CPI-inflation actually fell to 1.3% yoy in July, in the middle of the 1.2-1.5% yoy range in place since last November.

The bottom line is that while a weaker sterling and higher commodity prices will drive higher imported inflation and in turn somewhat higher headline inflation, their main potential impact will be a squeeze on profit margins, investment (already under pressure from the uncertain outlook for the UK’s trade arrangements) and wages. The resilience of consumer demand so far, however, will help mitigate this squeeze.

 

Labour market strong in run-up to referendum but spectre of inflation

While labour market data for July will only be released on 14th September, the sector was reasonably robust in the run-up to the referendum. Real weekly earnings in Q2 rose an annualised and seasonally-adjusted 4.3% quarter-on-quarter in while the unemployment rate in June remained at its multi-year low of 4.9% (see Figure 6). Moreover the number of people claiming unemployment benefits fell by 8,600 in July, the first fall since February flying in the face of expectations of a post-referendum surge in the claimant count.

However, the concern remains that nominal wage growth could (at least temporarily) fall behind rising inflation as companies try to remain competitive by curtailing their cost base (see above). This would in turn eat into workers’ real purchasing power and domestic consumption, including retail sales volumes.

Olivier Desbarres fig 3

Retail sales defying the odds

In a consumption economy such as the UK retail sales data are always going to attract much attention. Both the value and volume of retail sales, including automobile fuel, dipped in March but then bounced strongly in April and May, suggesting that the announcement of a referendum date had no material or lasting impact on retail sales (see Figures 7 & 8).

Perhaps more significantly they resumed their upward march in July with the value and volume of retail sales (seasonally-adjusted) rising respectively 1.6% month-on-month and 1.4% mom (see Figures 7 & 8). This is considerably stronger than the previous twelve month averages of 0.1% mom and 0.4% mom, respectively. Moreover, the growth numbers are similar if we strip out automobile fuel sales (see Figure 9). In year-on-year terms, the value and volume of retail sales (including automobile fuel sales) were up 3.6% year-on-year and 5.9% yoy, respectively (see Figure 10).
Olivier Desbarres fig 4

These data are aligned with the British Retail Consortium (BRC) Retail Sales Monitor which showed that the value of retail sales in member outlets in the UK rose 1.9% yoy in July, the strongest growth since January. Same-store sales rose 1.1% yoy. Strong retail sales also fly in the face of consumer surveys showing a sharp drop in confidence in July (see Figure 18), supporting the idea that survey respondents don’t always act in line with their expressed views.

Olivier Desbarres fig 5

At first glance this would suggest that little has materially changed for most UK households in the wake of the 23rd June referendum, with retail sales egged on by reasonably strong labour and credit markets (see above). However, the unusually warm weather in July (after a particularly wet June) – arguably a temporary factor – will have likely encouraged consumers to go out and spend, as could have the prospect of higher prices which also erode the real value of savings. Also, the weak pound – a likely more permanent factor – has boosted tourism into the UK and in turn likely helped domestic retail sales and conversely encouraged British consumers to delay or cancel planned holidays abroad. The rally in UK and global equities may also at the margin have boosted British consumers’ willingness to spend. In any case these data will support the consumption component of Q3 GDP growth.

 

Terms of trade improvement should help net exports in theory, less obvious in practice

Sterling’s depreciation helped drive industrial orders in July which should translate into larger exports (and industrial output) in coming months, particularly for companies which export outside of the EU and are not prey to the government’s ongoing trade negotiations with EU partners. At the same time, the greater sterling-cost of imports should result in a degree of import substitution, with the net result a narrowing of the trade deficit.

But history suggests that the benefits to external trade from even a large one-off currency devaluation are likely to wear off as increases in companies’ imports and cost base start to erode gains in export-price competitiveness, even if it this does not become more apparent until next year. Indeed, Figure 11 shows that the sterling-value of both imports and exports rose sharply in Q2. The result is that despite sterling’s 10% depreciation between November 2015 and mid-June 2016, the UK’s trade deficit on goods and services actually increased slightly (see Figure 12).

olivier-desbarres-for-richer-fig-11-and-12

Construction and services harder hit than manufacturing

Turning to the supply side of the economy, unofficial data paint a mixed picture with a more competitive currency unsurprisingly providing more of a cushion for manufacturing than services and construction. Official manufacturing output data for July are due on 7th September.

  • The services PMI fell by almost five percentage points in the first full month following the referendum, to 47.4.
  • The manufacturing PMI fell by a more modest three percentage points in July to 49.1.
  • The Confederation of British Industry (CBI) order book balance decreased to -5 in August of 2016 from -4 in July while the export order books reached a two-year high (of -6). This suggests that sterling’s depreciation may be feeding through to stronger overseas demand and will ultimately translate into stronger industrial output.
  • The construction PMI was almost unchanged in July at 45.9 but was still down significantly from around 54 in February and close to 60 at end-2015 with the commercial sector reporting the greatest downturn

Olivier Desbarres fig 7

Lending to consumers strong, mortgage lending still down

The Bank of England is clearly keen to avoid a repeat of the 2008-2009 great financial crisis when lending and borrowing dried up. Its decision on 6th July to ease lenders’ capital requirements to free up about £150bn of fresh lending and its latest package of measures announced on 4th August are squarely focussed on ensuring that bank lending remains available and cheap. At the same time the BoE will be hoping that households and companies respond by borrowing and ultimately spending and investing.

It is clearly too early to judge whether the BoE has been successful, but unofficial data from the British Bankers’ Association (BBA) suggest that consumer credit growth held up nicely in July. Credit card, loans and overdraft lending continued to grow at about 6% yoy in July, thanks in part to favourable interest rates. Borrowing by non-financial companies increased £2.3bn in July after falling slightly in the run-up to the referendum.

However, mortgage lending does not appear as robust. The value of net-mortgages rose only 3% yoy in July and the number of mortgages approved for new house purchases continued to fall, to 37,662 – the lowest seasonally-adjusted number since January 2015 (see Figure 15). Whilst the referendum outcome may have played its part, the government’s introduction in April of new stamp duty rules on buy-to-let homes is clearly dampening demand for mortgages. This is clearly visible in BoE data up to June which show that while net unsecured lending held up well in Q2, net secured lending collapsed (see Figure 16).

Unless this trend is reversed in coming months, this could create more visible headwinds for the housing market. BoE credit and mortgage data for July are due for release on 30th August.

Olivier Desbarres fig 8

Residential property market softer but resilient, commercial property market harder hit

It is probably too early to ascertain with great confidence whether the referendum had a negative impact on the UK property market given the multi-month leads and lags in the buying and selling of properties. Moreover, the government will only publish the official House Price Index (HPI) for July in September.

Based on current data, which admittedly paint a rather patchy picture, the residential housing market has so far held up reasonably well following the announcement of the referendum and actual referendum outcome, although there are signs that at a national level price growth has slowed and transaction volumes are down (see Figure 17). The plentiful supply of cheap credit and robust labour market have likely helped underpin housing demand and there is anecdotal evidence that the cheaper pound has attracted foreign buyers. The non-residential property market has seemingly been hit far harder.

  • The UK Nationwide average house price index (seasonally adjusted) shows that prices rose every month since July 2015, by an average 0.4%, with decent increases in both March (+0.7% mom) and July (+0.5% mom) – see Figure 17.
  • The Halifax housing price index is a little more choppy but still points to a broad trend of rising prices year-to-date, even if prices did fall a seasonally-adjusted 0.9% mom in July. The government house price index rose a solid 4% between end-February and end-June (see Figure 17)
  • The Royal Institute of Chartered Surveyors (RICS) reported that amongst its members 5 percentage points more saw a house price increase than a price decrease. However this price balance of +5 was lowest survey reading in three years and 12% more respondents predict a decline in house prices over the next three months.
  • Rightmove reported that in July the average asking price of properties coming to market fell 0.9% mom, after six consecutive months of price gains. However, this is broadly in line with seasonal patterns – since 2010, the asking price has on average fallen 0.4% mom in the month of July.

Moreover, the worst fears that residential buyers and sellers would pull out of transactions en-masse post-referendum were seemingly overdone.

  • Rightmove concluded that buyer demand in the fortnight following the referendum was comparable to demand in the corresponding period of 2014 (a non-election year), while the up-tick in the number of properties coming to market (+6%) almost made up for the 8% fall in the fortnight prior the referendum.
  • HM Revenue & Customs (HMRC) reported that the seasonally adjusted estimate of the number of residential property transactions decreased only 0.9% mom in July.
  • However, RICS said that “across the UK 34% more respondents reported a fall in transactions, with the monthly pace of decline in both July and June at the fastest since 2008”.

Moreover, the number of non-residential property transactions decreased 7.5% mom  in July – the largest monthly fall in years, according to HMRC. This would suggest that companies were more responsive to the referendum vote than residential buyers and sellers.

Olivier Desbarres fig 9

BoE likely to keep emphasis on credit measures…and implicitly cheap pound

Even if we are able to isolate and quantify the referendum’s direct and long-term impact on the UK economy, there is an important distinction to be made between 1. the impact on flows and stocks measured in sterling terms, such as the change in the UK’s real GDP, and 2. the impact on flows and stocks measured in foreign-currency terms.

Sterling’s gain in competitiveness – one of the few undeniable consequences of the referendum vote – has seemingly helped support industrial orders, retail sales and the residential property market, in turn likely minimising any downturn in UK real GDP growth. Moreover, to the extent that a weaker currency boosts inflation and tax receipts, sterling’s collapse may ease the debt servicing burden of a British government which had net liabilities of £400bn at end-2015.

These are after all the reasons why policy-makers across the globe are keen to keep their currencies competitive and in some cases willing to engage in so-called currency-wars. It is therefore unsurprising that the British government has focussed on these silver linings – reminiscent of Prime Minister Harold Wilson who in the wake of sterling’s devaluation in 1967 emphasised, rather unconvincingly, the importance of the “pound in your pocket”. The BoE, which forcefully eased monetary policy at its last policy meeting, also seems confident that the inflationary impact of sterling’s depreciation will be modest and/or short-lived. Meanwhile the British media has seemingly been distracted by the Olympics and ongoing saga surrounding opposition leader Jeremy Corby.

With this in mind I would expect the BoE to continue favouring monetary and credit policies which explicitly help spur lending, spending and investment and, implicitly at least, help cap sterling. While this may not translate into another policy rate cut or round of QE near-term, the BoE is likely to keep this option firmly on the table if the UK economy fails to return to trend in the next six months.

Weaker pound is no panacea to growth… and has drastically cut UK wealth

Even so a weaker pound is no panacea to the UK’s multiple challenges and government policies will have to do some of the heavy-lifting. For starters, it is unclear whether the UK’s improved terms of trade conditions will significantly narrow the trade deficit. At the same time, a weaker pound and a rise in the sterling-value of imports (30% of GDP) could squeeze the profitability of domestically-oriented companies, which along with even a modest rise in inflation could dent real wage growth and returns on investments.

More glaringly, both the government and media, with the notable exception of former BoE Deputy Governor Rupert Pennant-Rea writing for the Financial Times, have paid scant attention to the less savoury fact that sterling’s collapse has also depressed the value, when expressed in US dollars for example, of the UK’s:

  • Nominal GDP, a flow which effectively measures the size of the UK economy.According to some estimates, the UK’s nominal GDP expressed in dollars may now be slightly below that of France’s; and
  • Total net wealth (a stock) which was valued at £8.8trn at end-2015. This includes domestic savings, financial stocks, machinery & equipment, corporate buildings and structures and household dwellings (i.e. the housing). Assuming that about 90% of these assets were (and still are) sterling-denominated, I estimate that the fall in GBP/USD from 1.48 at end-2015 to the current exchange rate of 1.32 has cut the $-value of the UK’s net assets by about $1.3trn.

Olivier Desbarres fig 10

Households are the biggest losers from this currency effect. They had an estimated net worth of £10.2trn – the only institutional sector with net assets according to the ONS – comprised largely of sterling-denominated assets, including housing ( £5.3trn) and currency and deposits (£1.5trn). Sterling’s depreciation will have cut these assets’ purchasing power in $-terms. Put differently, the price in sterling-terms of a US holiday or property will have increased, all other things being equal, by about 11% (the change in the GBP/USD exchange rate) since the EU referendum.

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

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