Britain’s Self-Inflicted Recession

Post-Brexit-vote pain is beginning, and it will get worse. Investors’ attitudes about Britain’s prospects are signaled by the tumbling currency. This week the pound plunged to three-decade lows. Confidence in Britain’s economy has been seriously hurt. The first impacts have been in Britain’s property market. On Monday, Standard Life Investment UK Real Estate Fund suspended trading after a surge in redemption requests. This was followed by similar suspension action by Aviva Investors, M&G Investments, and the Henderson Funds. Commercial real estate investors fear falling property prices. This sector was already declining before the vote. According to the Bank of England, foreign capital inflows into this sector fell almost 50% in the first quarter.

The shock to an already weakened commercial real estate sector will likely be an unwelcome addition to the Brexit-related challenges facing UK banks, as they are said to be significantly exposed to this sector. UK banks’ earnings look likely to be hit by both lower loan growth and higher loan losses in the wake of the Brexit vote. The earnings from the business that overseas banks did in the UK will suffer from the fall in the pound. The City of London currently is the dominant financial center for euro-denominated markets. An open question that will hurt the UK banking sector for an extended period concerns the uncertain future of London’s “passport” for doing business with the 27 other EU member countries. There is a significant threat that business will move from the City to Frankfurt, Paris, or Dublin. Particular attention is being given to whether euro clearing can remain centered in London. France’s president, François Hollande, is calling for euro clearing to be conducted outside of London. That would have a serious impact on the City as it could lose an estimated 69% of its interest rate derivatives market. Of course, London continues to have the important advantages of the English language and English law.

In the midst of the political disarray in England, with both major parties engaged in divisive leadership battles, the sole reassuring development has been the actions and pronouncements of the Bank of England. The BOE moved rapidly. The Financial Policy Committee lowered its capital requirements for UK banks to smooth the path for banks through a difficult time. BOE Governor Mark Carney announced on June 30 that the weekly Indexed Long-Term Repo operations will continue through the end of September. Carney stressed that the BOE will act to mitigate any downturn, but importantly added “…there are limits to what the Bank of England can do.” We will not see until August the BOE’s first forecasts for the economy post-Brexit. Nevertheless, it is evident that Carney expects demand to be lower and inflation possibly higher. He stated that the risks from Brexit have begun to manifest.

The BOE noted three principal risks. First, the commercial real estate market, discussed above, is too reliant on external financing. Second, financing of the UK’s current account deficit is also heavily dependent on inward investment flows. England is dependent on external capital flows. Heightened uncertainty, particularly if it continues for an extended period, which looks rather likely, could lead to a significant drop in those flows. That drop would add to downward pressure on the currency and could threaten the UK’s economic and financial stability.

The third risk cited by the Bank of England is household indebtedness. Increasing expectations for a recession in the UK economy will likely lead to a weaker employment situation and weaker income growth and thus affect the ability of some households to service their debt. The BOE says such a situation would lead consumers to cut back their spending sharply. For this reason, as well as the heavy impact of uncertainty business investment, spending also looks likely to be cut back; indeed it is already falling. We expect both consumer and investment decisions to be delayed until there is somewhat less uncertainty about future prospects for the UK economy. While continued weakness in the pound should help the exports of some companies, costs will also be likely to rise as currency depreciation raises import costs and leads more generally to higher inflation.

We do expect the Bank of England to make full use of the tools at its disposal, including reducing policy interest rates in one or several steps over the next several months and increasing quantitative easing. The chancellor also has stated that a budget surplus will no longer be targeted for 2019–20. In other words, looser fiscal policy is coming, regardless of which party is in power.

We think a recession in the United Kingdom’s economy is highly probable. While second-quarter GDP growth is likely to look surprisingly strong at 0.6%, that figure can be attributed mainly to strong growth in April. A significant slowdown looks all but inevitable for the second half as the repercussions of the referendum play out in the economy. Whether the recession will be relatively moderate and short in duration or severe and lengthy is very difficult to judge given all the uncertainties, most importantly the UK’s future relationship in its many dimensions to Europe. There will eventually be light at the end of the Brexit tunnel. Unfortunately, reaching that light could take years. For the time being we are not taking any direct UK positions in our International Equity ETF Portfolios.

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