Authors: John Hawksworth, UK chief economist, and Jan Willem Velthuijsen, Eurozone chief economist
The UK vote to leave the EU was a huge political and economic shock. But, three months on, the world seems to have stabilised itself surprisingly quickly.
First, there was no ‘Lehmans moment’ for financial markets, which bounced back quickly after the initial shock of the EU referendum vote, buoyed by a new round of monetary easing by the Bank of England in August.
Second, the UK had a new Prime Minister and Cabinet in place within three weeks of the referendum, much quicker than initially expected.
Third, both the Eurozone and UK economies still seem to be in reasonable shape. The UK economy is expected to be most affected, but retail sales were relatively strong in July and August, unemployment and house prices broadly stable, and business and consumer confidence rebounded in August after dropping sharply in July. The Eurozone economy seems largely unaffected, with modest but positive growth continuing through the summer based on the latest available data (see our Brexit monitor series for more details on this).
The general sense from our clients is that most have returned to ‘business as usual’, while planning as appropriate for the uncertainties ahead.
But is this just the calm before the storm? There are certainly some reasons for caution.
First, the main channel by which the Brexit vote is likely to affect the European economies in the short term is through increased economic uncertainty reducing business investment. There is some rather mixed anecdotal evidence on this from business surveys, but it will be late November before we get even preliminary official data on business investment.
Second, the relative resilience of the UK economy both before and after the EU referendum owes a lot to strong consumer spending, which in turn reflects strong jobs growth and low consumer price inflation. But the weak pound is already starting to push up import prices and this will feed through into consumer prices in due course, squeezing real household spending power. Furthermore, if businesses are less certain about the future, they are also likely to put hiring plans on hold, which will feed through into slower jobs growth and possibly an eventual rise in unemployment. All this is likely to dampen UK consumer spending growth as we move through into 2017.
On the other hand, the weaker pound should provide some boost for net exports, as is already evident in some manufacturing and tourism survey data, while the new Chancellor in the UK is generally expected to relax fiscal policy in his Autumn Statement on 23rd November. This could take the form of increased public sector investment in areas like transport and housing to offset weaker business investment.
Taking everything into account, our central view is that UK growth is likely to moderate from just under 2% this year to just under 1% in 2017, and then gradually recover (see chart below). Of course, there are many uncertainties around this and it would be prudent for businesses to look at a range of alternative scenarios as discussed in more detail in our latest UK Economic Outlook report. Even in our downside scenario, however, we only project a mild recession not the kind of deep depression seen after the global financial crisis in 2008-9.
For the Eurozone, the impacts are even more moderate, and since June we have therefore revised down our growth projection for the Eurozone in 2016 and 2017 only marginally as the chart below shows.
Looking to the long term: conflict or compromise?
Negotiations between the UK and the EU on Brexit will not begin formally until next year, when Article 50 is expected to be triggered. There will then be a two year negotiation on the legal terms of Brexit, but probably also a much longer negotiation, perhaps lasting 5-10 years, on the detailed trading relations and immigration control arrangements between the UK and the EU. There will probably therefore be a need for transitional arrangements between the UK formally leaving the EU in, say, 2019 and the later agreement and ratification of some kind of free trade agreement.
The outcome of these negotiations will depend on whether the parties see this as a ‘zero sum game’ or not. If they do, then it may prove very difficult to reconcile the UK government’s political imperative to increase control of EU immigration and the EU’s fundamental belief that freedom of movement is an essential prerequisite for efficient functioning of the EU Single Market.
If this is the case, then we could be in for a long and acrimonious divorce, with the best case outcome being a limited free trade agreement covering goods but not most services, and the worst being a reversion to WTO rules (which modelling by PwC and many other economic experts has suggested would impose significant long term economic damage on the UK, but would also be bad for the 500 million citizens of the EU more generally as over 40 years of economic integration was unwound).
But a superior outcome could be possible if both sides are prepared to be more flexible. For the EU this would involve recognising that some labour mobility is essential to make the Single Market work but not complete free movement (at least on a temporary basis while Central and Eastern European countries catch up with income levels in other EU countries). For the UK, this would involve being prepared to accept such a compromise (and probably also some limited contributions to the EU budget) in return for retaining access to the Single Market. The recent proposal for a ‘Continental Partnership’ between the EU and the UK by five leading European economists is one example of how such a mutually beneficial compromise might be reached – but it remains to be seen how politically feasible this will be.
In summary, the Brexit vote was a major shock, but so far it looks like the global economy has been largely unaffected. The UK economy will likely suffer a slowdown rather than a recession in the short term. Beyond that, there are long and difficult negotiations ahead, but also the potential for a mutually beneficial compromise if both parties approach the talks with a flexible mindset. Business can also play a role here in contributing constructively to the debate on post-Brexit options, focusing on areas where the UK and the EU can continue to work together to boost growth and innovation across Europe.
John is Chief Economist for the UK and editor of the Economic Outlook publication, and many other reports and articles on macroeconomic and fiscal policy issues. He has over 20 years of experience as an economics consultant to leading public and private sector organisations, both in the UK and overseas. Read more
Jan Willem Velthuijsen is managing partner of PwC Strategy & Economics in Amsterdam since 1999 – specialised in macroeconomics, finance, strategy & risk, market and demand analysis, competition & regulation economics, econometrics, modelling and complex valuations. In 2013 he became Chief Economist of PwC Europe. In that function he is responsible for PwC’s thought leadership and research.