EU referendum reaction report

1. EU referendum reaction report The Prospects Service

2. EU referendum Contents • Outlook for the UK economy3 • Monetary policy and sterling4 • Housing market impact6 • Impact on the consumer8 • Outlook for Europe10 • Contact 12 This report is produced by Centre for Economics and Business Research (Cebr) as part of our macroeconomic trends, analysis and forecasting advisory membership service, The Prospects Service. This report and all associated material shall remain the property of Cebr and are only made available to bone fide employees of organisations with a current and fully paid-up membership of The Prospects Service. Such materials may not be disclosed or transmitted to individuals or organisations outside the member organisation without prior written permission from a director of Cebr. Cebr is not licensed in the conduct of investment business as defined in the Financial Services and Markets Act 2000. Any client considering a specific investment should consult their own broker or other investment adviser. Any views on investments expressed by Cebr, or on behalf of Cebr, are intended to be generic only. Cebr accepts no liability for any specific investment decision which must be at the investor’s own risk. Whilst every effort has been made to ensure the accuracy of the material in this report, neither the authors nor Cebr will be liable for any loss or damages incurred through the use of this report or associated materials. 2

3. EU referendum Recession can possibly be avoided but only just - Achilles heel will be Budget deficit of £100 billion. • We are in a new world and have quickly updated our forecasts for the UK economy. • Our best estimate for GDP growth this year now is around 1½%. Next year growth will grind almost to a halt but consumer spending may just be strong enough to prevent a recession. 2018 could be quite a strong year as exports lead a recovery – and new trade arrangements start to come into place. Tentatively we are talking about GDP growth of 2½%. • The Achilles heel of the economy next year is likely to be the Budget deficit. Our numbers suggest a deficit of £100 billion. But we believe it will be temporary and it is critical that there is no ‘Punishment Budget’ to make the weakness of the economy even worse. Monetary policy should also be accommodatory unless sterling goes into free fall. But as long as it stays above about $1.10 it would make sense for the authorities not to raise rates until 2018. • We said yesterday that we shouldn’t be surprised by an economic bounce whatever the referendum result. This still looks possible and the economy may have quite a strong two or three months, though fewer than a third of the projects in the investment backlog are now likely to be actioned. • We also wrote slightly fancifully at the beginning of the year in our ‘things to look out for in 2016’ that there could be a new Prime Minister this year. This now looks certain with David Cameron having said that he will step down by October. • The pound and the equity markets have fallen by roughly the amounts that we and most other commentators had predicted – about 10% for each. It is possible that markets will overreact and further falls take place in the coming days but we expect sterling is going to settle on a new lower trajectory; 10 to 15% lower than might have been likely had the UK voted to Remain. • The long term consequences of Brexit will need to be thought through and will depend on the path the UK chooses to follow over the coming months and years. This note therefore concentrates on the short term consequences. • Business investment, after bouncing back a little for the next couple of months as some of the IT investment backlog is actioned, is likely to drop for the rest of 2016 and by rather more in 2017. A 5% fall this year and a 10% fall next year are on the cards. • Consumer spending will be affected by the higher prices that a lower £ will cause. Our view is that consumer spending growth over the next 18 months will average about half the 2.8% seen over the course of 2015. • Inflation is likely to reach 2½% next year squeezing the consumer. • Export growth has been weak and will eventually strengthen. But this will probably not be till 2018.

4. EU referendum Pound falls sharply after UK votes to leave the European Union • Sterling has dropped to a 30-year low briefly nearing $1.30 as the final result of the EU referendum confirms a vote to leave. • The volatility of the pound in the run-up to the referendum has been remarkable but nothing like the reaction underway in currency markets this morning. Swings in the public opinion and the perceived likelihood of a Brexit-vote sent the pound below $1.40 directly after the announcement of the exact date of the referendum on February 20th. This week we saw a mini-rally of the pound which climbed to $1.48 yesterday as the odds tipped in favour of a remain vote. Since the early morning hours however, investors have been dumping the pound which is seeing its sharpest one-day fall in over 30 years. • While the pound ha been overvalued in the last year given the persistent current account deficit it remains to be seen how strong the (over-)reaction of the currency markets will turn out to be and if some of the falls of this morning will be recovered over the next days. • Clearly, the value of sterling will also depend on the reaction of the Bank of England (BoE) to the referendum. Governor Mark Carney finds himself between a rock and a hard place this morning as the BoE and the Treasury need to find a balanced response to ensure financial stability and prevent an overly harsh downturn for the UK’s economy. • Broadly speaking, the Monetary Policy Committee (MPC) has to balance the benefits of accommodative monetary policy with the risks of higher inflation in the future. In an attempt to prevent the currency from sliding too much the BoE might consider using its foreign currency reserves to stabilise the pound. Raising interest rates would work towards the same effect. However, the ripple effect of the referendum is very likely to cause a slowdown in the economy at least in the short term. A rate rise at this time could make things even worse for UK businesses and consumers. Higher interest rates would also put pressure on mortgage holders in a time when the housing market is expected to slow. With this in mind, it is more likely that the MPC will actually lower interest rates by 25 to 50 bp to stimulate the economy. But since this would depress the pound even further it would lead to higher rates of inflation as imports become more expensive. • Additionally, the BoE needs to ensure that UK banks are able to cope with the fall-out of the referendum. In his remarks this morning Mark Carney ensured investors that the UK banking system was well-prepared and sufficiently capitalized to deal with the expected market volatility. He repeatedly stated that the BoE’s contingency planning was adequate and that an additional £250 billion as well as foreign currency funds would be made available to ensure that the credit keeps flowing. • With turbulent days ahead the UK will be looking towards the BoE for stability and guidance in terms of monetary policy – it will be Mark Carney’s biggest challenge thus far.

5. EU referendum Sterling collapses to 30-year low in the immediate aftermath of the vote Source: Macrobond GBP/USD bid price

6. EU referendum Housing market to slow following Brexit, but improving affordability in the long term requires efforts on the domestic front • The decision to leave the EU will have far reaching consequences on numerous aspects of British life, including the state of the country’s housing market. EU membership has played a role in the UK property market for much longer than the idea of the referendum has been around. On the demand side, EU membership influences the property market in two primary ways: the free movement of labour and the ‘gateway to Europe’ effect. EU nationals moving to the UK, create additional demand for homes which supports prices. Additionally, those born in other EU countries are more likely than UK nationals to rent privately which creates demand for rental properties. Secondly, companies and individuals that want to establish a European presence often choose the UK as their EU base – they view the UK as a ‘gateway to Europe’. This creates further demand for residential and commercial property alike. • On the supply side, roughly 1 in 20 construction workers are from other EU countries. Numerous constructions firms and industry bodies have recently reported skill shortages becoming an increasing concern. Therefore a greater pool of candidates to hire from has been essential to boosting the housing supply. Only one day after the vote it is far too early to tell what immigration policies will be introduced in the UK, but given that the desire to control immigration was one of the key motivations behind the referendum, it is very likely that the free flow of labour with other EU countries will not be maintained in the long term. This poses a serious risk to the construction sector which has already failed to produce enough new homes in the last few years. • In the coming months (or perhaps a couple of years) it will become clear that many of the shortcomings of the UK property market that have been blamed on EU membership in fact have more complex, and often domestic, roots. Many have pointed to high immigration and foreign investors as the reasons behind high property price inflation, especially in London. While this is true to an extent, it is also an unavoidable fact that building levels in the UK have failed to keep up with demand, as the graph on the following slide shows. This has been a result of construction companies not willing to take many risks following the pains of the 2008/09 crisis as well as the fact that local government building levels have been near zero in recent years. Neither of these circumstances are related to EU membership. On top of these constraints, the outcome of the referendum promises to exasperate the skills shortage. Unless these key, domestic factors are addressed in the long term housing affordability will continue to deteriorate despite an out vote. • In the short term (up to 2018) the outcome of the referendum will almost certainly have a negative impact on both prices and transaction numbers. This is especially true in London, where the prime segment of the market and commercial property are hugely exposed. However, given that the referendum outcome will impact property prices far less elsewhere in the UK, Cebr expects 2016 to still see year-on-year price growth of 4.5% - this is below our projection of 4.9% before the referendum. We also expect 2017 and 2018 to see slower house price growth than would have been the case under an ‘in’ vote.

7. EU referendum The out vote not a solution to the 260,000 housing unit shortage created over the past decade Source: DCLG, Cebr analysis Annual shortfall or surplus in housebuilding, UK

8. EU referendum Rising inflation to douse household recovery • The decision of the UK electorate to leave the EU in yesterday’s referendum has already had far reaching effects on financial markets and the uncertainty caused by the vote will no doubt feed into the real economy over the coming weeks and months. • Some areas of the economy will be hit worse than others. Consumers enjoyed a relatively sanguine run-up to the elections. Households continued to benefit from 18 consecutive months of annual double digit increases in disposable income according to the Asda Income Tracker. Similarly, whilst business confidence has collapsed since the end of 2015, consumer confidence has held relatively steady over the course of the referendum campaign. The newly launched YouGov/Cebr UK Economic Index (UKEI) found that business confidence was 2.3 per cent lower than the consumer confidence in the run up to the referendum, standing at 111.0 compared with 113.6. As a result, household spending continued to be the key driver of growth in the UK economy over the first quarter of this year. • Whilst a large share of voters, having voted to leave will undoubtedly be less surprised on the whole than markets, current confidence levels look set to take a hit. Components such as business activity and job security look fragile and a slowdown in house prices and higher inflation will no doubt begin to impact on consumer’s bottom lines in the coming months. • It may not be total doom and gloom for the UK’s household sector though. After the sharp contractions seen overnight, sterling looks increasingly fragile given the vote and the ongoing twin fiscal and current account deficits. This will certainly place upward pressure on inflation. However, given current inflation levels, this may not be immediately sufficient to eradicate past gains in household spending power and could be offset to some extent by further interest rate cuts. Additionally, a survey by Gekko research suggested that almost three quarters of consumers stated that their decision to make an important purchase would not be affected by the result. • Still, even if consumer expenditure continues to rise over the coming 18 months, it looks likely that growth will average about half the 2.8% we saw through 2015. Clearly, this will significantly neuter one of the key drivers of UK growth in recent quarters. Additionally, it’s not clear that this will be a short-term factor. Even under a vote to remain we expected a notable slowing of growth in the household sector as inflation recovered. With exchange rates set to push inflation higher, the consumer recovery looks set to fade.

9. EU referendum Consumers have seen 18 months of double digit rises in spending power Source: ASDA Income Tracker, Cebr analysis Year-on-year change in household discretionary incomes, £

10. EU referendum EU referendum vote to act as strong warning signal for Europe • The UK’s decision to leave the European Union will have far reaching consequences not only on Britain itself, but also on the EU. • In the short term, the economic implications will depend critically on how EU-UK negotiations evolve. The market reaction we have witnessed so far this morning suggests that markets are pricing in a confrontational exit that would result into weaker trade and investment ties with Europe and other countries that use the UK to access the single market, and ultimately into lower UK growth. • The same transmission channels – trade, investment, and financial sector exposure – will also determine the impact of Brexit on the EU. As a bloc, a trade war will hurt Europe less than it will hurt the UK. 44% of the UK’s exports go to Europe – the equivalent figure for the EU is 7%. In terms of its importance to the economy the exposure is even lower -exports to the UK make up 3% of EU GDP compared to the 13% of UK GDP for exports to the EU. However, these average figures mask important differences at the country level. Ireland, Netherlands and Belgium have the highest trade integration with the UK, although admittedly part of this reflects goods that are later re-exported. Amongst the larger European economies it is Spain and Germany that are the most exposed. A weakening in trade ties with the UK would have negative growth effects on these economies.In terms of financial linkages, Ireland is the most exposed with claims by UK bank accounts making up 16% of Ireland’s total banking assets. As for cross-border investment, the UK receives around a quarter of total Foreign Direct Investment into the EU. Brexit will likely reduce this, with some EU economies potentially even benefitting as they see investment redirected towards them. Overall we expect the negative effect from a weakening in trade and in the total level of investment to outweigh any such positive impacts however - we will be revising our economic forecasts for Europe downwards, with the extent of the revisions depending on how the negotiations play out on the confrontational-amicable scale. • Looking further out to the medium term, the UK’s absence in European policymaking will also influence the direction of many EU policies. Traditionally, the UK has argued for a more liberal approach to economic policy with an emphasis on deregulation. This is likely to continue even without the UK’s free market voice. On the other hand, the prospects for economic policies that were key priorities for the UK in Europe, such as liberalisation of the market for trade in services, or the set-up of a Capital Markets Union, look less bright. This is bad news for Europe’s economic trajectory going forwards. • Finally, today’s result will also act as a strong warning signal to Europe in terms of its future direction. Whether the departure of the UK will allow Europe to move faster into closer integration (in the form of a fiscal union and common deposit insurance) or act as the first step towards the disintegration of the Union is a question that will take years to be answered.

11. EU referendum Trade weakening to hurt UK more than EU, but average figure masks important cross-country differences Source: IMF direction of trade statistics, Cebr analysis Exports to the UK, % of total exports

12. Contact • For enquiries on this publication please contact the Macroeconomics team: • macro@cebr.com • The overall assessment of the EU referendum and the economic implications has been covered by Douglas McWilliams, Cebr President • dmcwilliams@cebr.com 020 7324 2860