Brexit has been and continues to be a huge economic burden for the UK economy and its partners. Although the UK economy has so far avoided an outright recession, it has taken a severe hit. Since the Brexit vote, consumers have experienced a loss of purchasing power due to rising prices and a depreciation of the Pound. And firms have delayed their investment decisions: in Q3 2018 real business investment stood -0.8% below the Q3 2016 level. Furthermore, Great Britain has become less attractive for direct investment. Since the Brexit vote, total M&A deals fell by 60% to GBP42.4bn on average, driven mostly by a plunge in cross-border M&A deals (see Chart 1). Finally, negative effects along the supply chain have accelerated in 2018 on the back of the rise in total business insolvencies (+19% 3m yoy in Q3 2018) as well as in major insolvencies (12 cases in H1 2018 compared to 15 cases in total in 2017). Most of these insolvencies are in the most fragile sectors: those very dependent on foreign inputs which see their margins squeezed as imports are more expensive as well as those highly leveraged as the Bank of England embarked into a monetary policy normalization process. A further rate hike is expected in Q2 2019 which will make credit conditions tighter.
Chart 1: UK-targeted M&A deals value in GBPbn, 4Q sum
Overall, the prolonged high Brexit uncertainty has significantly reduced the pockets of resilience for the UK economy. Hence, GDP growth in Q4 2018 and Q1 2019 should prove much weaker and for annual GDP growth in 2019 we expect a meager 1.2%. While labor shortages should keep wage growth above 3% y/y, potential growth is damaged. In addition, households have less leeway to boost spending as the savings rate stands at low level of 4.4% and positive wealth effects are diminishing as housing prices are adjusting downwards and the stock markets are underperforming European peers.
The sterling depreciation (more than 10% since the Brexit vote) has increased import cost and triggered a fall in non-financial corporations’ margins. Real import growth in 2018 is expected below 1%, the lowest level since 2011. This translated into lower outlets of Western European companies into the UK. We estimate that the Eurozone as a whole missed around EUR60bn of potential outlets on the UK market since the Brexit vote.
The lack of consent within the Conservative party has created massive uncertainty regarding the future Brexit process and leaves both parties into what looks like a “prisoner's dilemma”. Despite the win of the confidence vote, the Prime Minister Theresa May has been having major difficulties in convincing her party to go for a soft Brexit.
It may take a last minute decision to avoid the costs of a hard Brexit, which are significant and underestimated by many prominent proponents of Brexit. In our view, a “no deal Brexit” would trigger two consecutive years of recession in the UK and cut Eurozone growth by at least -0.5pp per year. Sterling depreciation would depreciate, possibly hitting 0.88 Euro per GBP in late 2019. In addition to external trade disruption, the domestic economy will shrink with private consumption contracting by -1% and business investment by -4%.
A no-deal Brexit would disrupt the supply chains between the UK and the European continent as custom checks would be introduced possibly as soon as March 29, 11pm GMT. The EU and the UK import tariffs would reach 5% on average, with the EU levying for example 10% on cars, 6% on chemicals and plastics and 4% on beverages (see Chart 2). The UK would trade under WTO Most Favored Nations conditions and would lose not only the access to the Single Market but also most of the 50 FTA it benefits from thanks to the EU membership. Businesses are preparing for the worst through contingency planning and stockpiling, but we believe this would not be enough to mitigate the shock. Business insolvencies would rise in Great Britain by 20% at least in 2019. Export losses for UK companies would reach more than GBP30bn on the back of tariff introduction and the services sector could register close to GBP40bn of losses as it loses the “passporting rights” and the “equivalence status” will require time before implementation.
Chart 2: EU’s WTO MFN applied import duties – top 20 products imported from the UK
A “no Brexit deal” would have strongly negative repercussions for the UK`s trading partners, especially for Germany. Great Britain used to be the 3rd biggest export market for Germany. Due to the ongoing reduction of exports to the UK, it has in the meanwhile dropped to the 4th rank. Exports in EUR terms fell by almost -6% in 2016-17 cumulated (or EUR5bn in value terms) and export losses should reach EUR8bn per year in a “no Brexit deal” scenario (see Chart 3).
Regrettably, a “no deal” would do nothing to solve the Irish conundrum, but rather aggravate the situation as it calls for hard border controls as the UK would trade under the WTO Most Favored Nation principles.
Chart 3: Export losses in a WTO scenario (EURbn and % of total exports)
For the long term development, the type of a free trade agreement between the UK and the EU is most essential. A good compromise in solving the Irish border issue, having zero tariffs on goods, keeping the “passporting rights” for the financial sector and being able to negotiate Free Trade Agreements on its own looks to be a Norway-type of agreement. One should expect intense negotiations between both parties and one should get prepared for a longer transition period beyond 2021! Hence, the process of Brexit will continue to feed into the uncertainty which has kept UK growth below potential. We estimate UK growth to average 1.5% over the transition period, half of the 2000-07 average for example.