UK Economy After Brexit: Slowdown or Recession?

Brexit is already showing its effects, starting with currency. The British pound has weakened notably since the Brexit vote and we expect some further weakening before stabilizing at 1.3 against the US dollar. Major effects of Brexit are also expected on confidence and investments, which should impact future GDP growth.

In fact, there will be protracted uncertainty on negotiations with the EU and on the degree of “separation” from the Single Market (with special emphasis on the possibility that London will lose its role as the financial center for Europe). This will put the brakes on the flow of investments to the UK in 2016-2017 and will likely lead to a drop in business confidence, resulting in domestic UK firms to slow their investments. Furthermore, consumers are expected to slow down their expenditures, particularly on durable goods.

Currency devaluation will likely have a positive effect on the short-term demand for exports. Longer-term we believe exports will not be able to withstand the decline in investment, which usually has a positive correlation with export capacity.

On the inflation side, we believe that the Consumer Price Index (CPI) will be higher in 2017-2018 due to sterling depreciation, but not so much as to prevent an easing in monetary policy. In this landscape, we assume that monetary policy will turn accommodative with the Bank of England cutting rates in the second half of this year and again in early 2017 by setting the reference rate at 0.

The Brexit vote may also negatively impact the housing sector. We will probably see lower demand (banks will lend less; buyers will lose confidence and London may become less attractive for companies) and lower supply (UK housing shortage; interruption of investment inflows in the construction sector; lower supply of labor from immigrants).

The overall economic effect will likely be a decline in GDP growth to 1.5% this year and 0.8% in 2017, without excluding the possibility that a couple of (non-consecutive) quarters will be (mildly) negative. In the end, we believe that the UK economy is in good shape and an additional dose of easing measures should help prevent a deep recession and deflation.

Since the UK is one of the EU’s most important trade partners, much will also depend on the new trade agreements and on the evolution of exit negotiations.

Apart from these aspects, which will become clearer in the next few months, the main worry for investors is that Brexit will trigger a new wave of political risk in Europe. Britain’s vote could pave the way for the success of euro-sceptics, with populist political forces in various countries putting the existence of the EU at risk.

From an asset allocation perspective, we believe moving to a risk-off stance after Brexit with a focus on diversification and relative value opportunities would be prudent