It’s too early to understand the full economic consequences of the UK’s decision to leave the European Union. Right now, that depends on the magnitude of the shock to business and consumer confidence. Longer term, it depends on coming up with a plan for the UK’s continued access to the single market, skills and trade deals
The UK economy was on a reasonably steady footing going into the referendum. Although caution was already affecting business optimism, household spending was supported by stable job creation in a low inflation environment. Business investment was generally holding up well.
But the dramatic falls in financial markets since the vote reflects, in part, a weaker outlook for the economy in the months ahead, as uncertainty weighs on demand. But determining how significant this effect will be is the hard part. Many of our members have spoken about the need to keep calm and assess the UK’s prospects in a measured way.
Sterling has obviously borne the brunt of increased uncertainty. And it is unlikely to recover significantly from current levels – close to the lowest level against the dollar for thirty years – while the nature of the UK’s future relationship with the EU remains unclear.
Financial fallout starting to fade
Only the fallout from Black Monday, during the storm that swept the UK in October 1987, comes close to the daily drop in share prices we saw last Friday on the FTSE 250. This eroded some of the gains that the more domestically-focussed FTSE 250 had made in the spring, bringing the level down close to that in October 2014.
Bank shares have been hard hit reflecting both the uncertainty over the future of passporting rights and the impact on banks’ profitability of a lower path for interest rates. Other sectors feeling the brunt of the pain are commercial property, housing and construction sectors, which are sensitive to broader confidence and capital flows into London; and airlines, reflecting higher fuel costs and expectations of weaker consumer demand. But share prices are starting to recover as volatility settles down and people assess the UK outlook more fully in the cold light of day.
Foreign investors, who have been happy to finance the UK’s large current account deficit on the grounds that this supports a growing economy, will reassess their views in light of the uncertainty facing the UK economic outlook. Any reduction in their willingness to buy UK debt, extend bank loans or invest in British companies is likely to feed through to higher financing costs for UK households and businesses.
These concerns are behind the downgrades by Standard & Poor and Fitch to the UK’s sovereign debt ratings on 27 June. But gilt yields have so far fallen alongside global yields, reflecting continued safe haven investment flows within the UK and expectations of lower interest rates.
The Bank of England has jumped in to provide liquidity, helping to keep financial markets running smoothly – and comparisons with the financial crisis so far seem overdone. The Bank is now battled-hardened to dealing with financial crises as I can attest having been there when Northern Rock went under. And as the governor, Mark Carney, highlighted last Friday, the capital requirements of our largest banks are now ten times higher than before the crisis, with the Bank standing ready to do what it takes to protect financial stability.
The impact on confidence
Investment and hiring intentions will be affected by how long the current period of political uncertainty lasts, which highlights the need for clear signals that the UK is open for business. It will also depend on whether political developments at home and among remaining EU members support continued access to the EU’s single market, to talent from the EU and around the globe, and to existing trade deals.
Weaker domestic demand in the coming months should be partly cushioned by a stronger contribution from net trade in the near-term, as a lower pound provides a boost to exporters. But any benefit from net trade will be short-lived if we fail to secure access to the single market and to markets around the world.
In addition, with complex global supply chains, many manufacturers will also face higher input costs. Higher import prices feeds through to higher inflation, adding to the squeeze on household incomes.
The outlook for monetary policy
As the governor hinted on Thursday, the Bank of England seems likely to ease monetary policy in the weeks ahead, with all eyes on the MPC’s meetings in July and August.
Policymakers face a dilemma between the need to support activity in the midst of a shock to domestic confidence and the short-term impact of the sharp drop in sterling which will push up inflation. But, given the current dovish inclinations of the MPC, and the nature of the shock, it seems likely that the Bank will prioritise supporting growth. Many expect to see credit-easing measures and a rate cut at the August meeting if not before, which would mitigate some of the increase in lending costs for households and businesses.
The road ahead
The most important effects of the vote will likely flow over the medium to long term. And that will depend on the change in the UK's terms of trade, its access to skills and productivity growth.
It’s essential that the UK remains an economy with openness to trade and global talent at its heart and we keep policy focused on driving growth and productivity across all of the UK’s regions. That’s the best response to the economic shock we’re facing at the moment.