U.K. Recession Post-Brexit Referendum?

Executive Summary

Although the United Kingdom will remain a member of the European Union for the foreseeable future, the UK and the EU will need to enter into negotiations to determine the rules that will govern their economic relationship in the future. In our view, uncertainty related to this ultimate relationship will depress investment spending in the UK. Indeed, there already is anecdotal evidence that uncertainty ahead of the June 23 referendum has already contributed to weakness in investment spending. In our view, further contraction in investment will lead to a modest U.K. recession later this year and into early 2017. We believe that the Bank of England will provide further policy accommodation in an effort to combat the downturn in the economy. We also look for the British pound to weaken further vis-à-vis the U.S. dollar in coming quarters.

The direct effects of a U.K. recession on the rest of the world should be limited because the British economy accounts for only 4 percent of global GDP. If the financial market volatility that was observed in the immediate aftermath of the June 23 referendum should return and intensify, then the outlook for other economies could darken. However, financial markets seem to have stabilized, at least for now. Expectations about a potential breakup of the EU could be a catalyst for financial market volatility to return, but we believe that the probability of a shattering of the EU is low, at least in the near term.

Uncertainty Likely Will Weigh on U.K. Investment Spending

The U.K. economy has generally been expanding since it pulled out of recession in Q3-2009, and real GDP currently stands more than 7 percent above its pre-crisis peak. Prior to June 23, we had looked for this expansion to continue through at least the end of 2017. This forecast was predicated on the assumption that British citizens would vote on June 23 to keep the UK a member of the European Union. However, voters decided by a margin of 52 percent to 48 percent to leave the EU (a.k.a., Brexit). Post-referendum, our views of the U.K. economic outlook have changed. In short, we now look for the British economy to experience a modest recession later this year and into 2017.

As we noted in a recent report, the UK will remain a part of the EU for at least the next two years.1 Until new terms under which trade in goods and services between the UK and the EU are negotiated, British exports to other EU countries, which accounts for nearly 45 percent of total UK exports, will continue to enter those countries on a duty-free basis. So why is the U.K. economy now facing recession? The answer relates to uncertainty.

Although nothing has changed at this point regarding British exports, the terms under which trade between the UK and the EU is ultimately conducted are uncertain at this point and will depend upon the negotiations that will be conducted between the UK and the EU. By leaving the EU, the UK may lose its “passport” status to the other 27 members of the EU (EU-27). That is, businesses can set up centralized operations in the business-friendly environment of the UK and then use these operations to export duty-free to other EU countries. If the UK were to lose this passport status, then some businesses may want to move operations to another EU country where the passport was still valid. Although it is impossible to know the ultimate outcome of the negotiations between the UK and the EU, the point is that many businesses may put their expansion plans in the UK on hold until the uncertainty is cleared up.

The financial services industry is a notable sector which now faces uncertainty. London is the financial capital of Europe due, at least in part, to the passport that allows British firms to provide financial services to EU-27 countries. Uncertainty over the status of the passport likely will lead investment by financial services firms in London to come to a screeching halt. Some firms may even opt to move some of their operations to the continent. Hiring and non-residential investment in London likely will weaken in coming quarters.

Residential investment likely will take a hit as well. There are about 2 million workers of EU-27 origin who are employed in the UK. Everything else equal, the outcome of the Brexit referendum dampened their enthusiasm to invest in real estate because their legal status to remain employed in the UK in the long term is now uncertain, pending negotiations.

In sum, investment spending in the UK, which already had decelerated ahead of the referendum, likely will contract further in coming quarters (Figure 1). Indeed, there is anecdotal evidence that uncertainty ahead of the referendum has played a role in weakening investment growth to date. In its statement following the policy meeting on June 16 the Monetary Policy Committee (MPC) noted that “there is growing evidence that uncertainty about the referendum is leading to delays to major economic decisions that are costly to reverse, including commercial and residential real estate transactions, car purchases, and business investment.”

As investment spending weakens further, employment growth should slow and may ultimately turn negative, which will weigh on personal consumption expenditures. We look for the U.K. economy to experience a modest recession later this year/early in 2017 (Figure 2). We now expect that real GDP in Q4-2017 will be about 2-½ percent lower relative to the forecast we made about a month ago, which had looked for the economy to continue to expand through the end of next year.

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