How vulnerable is the UK economy to a hard Brexit?

By Zac Tate, Hottinger Investment Management

During the second quarter of this year, the UK economy contracted for the first time since 2012. The Office for National Statistics (ONS) revealed earlier today that the British economy was 0.2% smaller at the end of June than it was at the beginning of April.

Market watchers have put forward a number of preliminary factors to explain this. One was the strong growth in Q1 due to the stockpiling of intermediate goods among manufacturers and other goods producers. Even if Brexit had taken place as planned at the end of March, the effect of this activity was always going to fall out of the second quarter’s figures as factories took their collective foot off the pedal.

The next factor is the state of the global economy. Some of the UK’s largest trading neighbours – including Germany and Italy – are seriously flirting with recession. Last week saw another dreadful round of factory data out of Germany and the Netherlands, and this follows disappointing numbers out of France, which hitherto had been seen as a bright spot.

The UK remains closely integrated into the European economy and will catch a cold whenever the old continent sneezes. It should be noted that even at the height of the British Empire and under the system of Imperial Preference that elevated – for example – the lamb of New Zealand over that of Spain, the European continent was often the UK’s single largest trading partner1. Gravity is hard to suspend.

But the biggest factor has to be the Brexit uncertainty. For over a year, businesses have more or less stopped investing in the UK. In 2018, according – again – to ONS figures, growth in investment (or gross fixed capital formation) at 0.2% was the lowest in the G7 group of nations. This compared to an average annual growth rate in investment for the UK of 4% over the past twenty years. Lack of business investment has been contributing negatively to growth, leaving the consumer to carry the burden.

Consumers have been able to carry the burden because since the EU referendum, they have cut their savings ratio from 7% of GDP in Q2 2016 to 4.1% in Q1 2019. More recently, wages have been growing faster than inflation, providing tail winds for the consumer.

The obvious problem with this model is that it ought to be unsustainable. Higher inflation brought about by continued sterling weakness amid concerns over an acrimonious Brexit would suppress real wage growth. And there is only so far the household sector can cut its savings before dangerous financial imbalances build up among the subsets where income and wealth are lower. Household debt-to-GDP has steadily risen from roughly 85% of GDP during 2015 to above 87% today, according to figures from the Bank for International Settlements.

But there is an even bigger question of ‘sustainability’, involving the British economic model and its relationship with the rest of the world, which makes the outcome of Brexit a critical factor. For most of the period since the UK last saw a quarter of negative GDP growth, the country has run a current account deficit of more than 4% of GDP. This means, crudely, that for every £100 of resources that entities within the UK produce, those same entities (whether they are households, companies, banks or governments) consume £104, with the extra £4 arising mostly through an excess of imports over exports. It is where the phase ‘living beyond one’s means’ is most credibly used when describing the British economy, because the country has to borrow funds from foreign sources to pay for this excess. The question is whether this assessment is right.

Figure 1 shows the sectoral net lending or borrowing positions of each UK economic sector. Each sector can save or borrow resources. Sectors that borrow raise funds from the sectors that save such that the sum of the net lending/borrowing positions is always zero.

Since the EU referendum, all domestic UK sectors (households, businesses and government) have been borrowing from the only foreign sector, the ‘rest of the world’. Whilst it is not surprising that the foreign sector is a net lender, it is highly unusual for a domestic economy as a whole – even one with a large current account deficit – to rely exclusively on foreign funding for its consumption. This is because the household sector is usually a net lender, providing funds to domestic businesses and government. But such is the current state of the UK that stretched consumers appear to be carrying the economy in the way that an airliner’s engine picks up the slack of its busted twin.

The source of this foreign funding is essential. If the source constitutes foreign direct investment or portfolio flows from non-UK citizens whose base currency is not sterling, then the UK is at serious risk of a sudden stop in funding in the event of a hard Brexit. The threat of a deep depreciation could then combine with a spike in inflation, a rise in interest rates and a cut in consumption in a manner which might push the UK into recession. This follows logically from the sectoral balances – whose elements must in toto sum to zero – if foreigners choose to stop lending to Brits. We may already be seeing early signs of this with the fall in sterling against both the US dollar and the euro in recent weeks.

However, given the rally in UK gilts in recent months, in line with the global search for safe assets, it is not obvious that this scenario will play out in the event of no deal on the 31st October.

There is also an argument backed by research from the Bank of England that downplays the importance of this imbalance. It relies on the assumption that while ‘foreign funds’ are financing the domestic-facing UK sectors, these foreign funds are largely held by British citizens whose base currency is sterling. A fall in sterling would therefore increase the sterling value of the UK’s overseas assets. It would mean that the imbalance we see in the chart above could actually be sustained beyond Brexit.

If this story is right then we would then have to rewrite our story as one in which the UK is progressively running down its foreign holdings to fund the consumption of present resources. In practice, this manifests in asset owners liquidating their foreign holdings to fund either their own consumption or that of other British entities – whether households, firms or governments – through lending.

Notwithstanding the global situation, Brexit is a big factor behind the slowing UK economy. The question is whether further downside could yet come and how deep that could be. If the UK does head for a hard Brexit, the outlook for the country depends as much on who is funding the profligate British economic model as it does on the prospect of tariffs or regulatory barriers resulting from a hard Brexit.

1 In most of the years between 1840 and 1880, Europe accounted for around 40% of the United Kingdom’s exports, a share that remained broadly stable as trade with other regions fluctuated. Sourced from Schlote, W. (1952) British Overseas Trade from 1700 to the 1930s.