Transcript - Episode 19: Understanding the impact of Brexit on the UK economy

Emily Khan: Welcome to our latest Beyond Brexit podcast, I am Emily Khan. One of the areas I am most often asked about by our clients is the impact of Brexit on the UK economy.

So, to help me dive into this today, I am joined by Mike Jakeman, Senior Economist at PwC, who works on our UK Economic Outlook; and Barret Kupelian, a Senior Economist within the firm, who has been working on economic impact analysis for our own contingency planning for Brexit, as well as for our clients. Mike, our most recent UK Economic Outlook was released in November and focused extensively on the different Brexit scenarios, talk us through what the analysis tells us for 2019?

Mike Jakeman: Sure.  Hi Emily. All of our projections, our main scenario assumes a reasonably smooth Brexit.  By this we mean that a deal is agreed with EU that allows the UK to leave the Union, and that there is some early progress in negotiations on the future trading relationship.

Emily: Right, okay.

Mike: This would be analogous to a parliamentary approval of the withdrawal agreement that Theresa May struck in November, or something similar. If we get a softer Brexit, which involves keeping the UK in the customs union permanently, or a harder one, we would revise these numbers.  But, on the assumption of this reasonably smooth Brexit that I mentioned, we think that growth in 2019 in the UK is going to pick up a bit from about 1.3% in 2018 to 1.6% next year.  That is all about the return of business investment to growth.

We’ve had three quarters of contraction in business investment so far in 2018.  Firms are crying out for a bit more certainty about what the future conditions are likely to be in the future.  We think the government are going to spent slightly more next, we got a preview of that in the 2018 budget, but consumer spending is going to slow.

We’ve got slightly higher interest rates, quite high debt levels, and it has been consumer spending that has powered the economy in 2018.  And we think that it is probably unlikely to expect the same level of growth in 2019.  So, if you net all that out, you get a slightly stronger economy next year, but that’s really dependent on an improved business investment picture, which again is dependent on exactly what kind of Brexit we get.

Emily: That makes sense. You mentioned there at the beginning that you would revise those numbers a little bit if it was slightly softer or slightly harder, and clearly those scenarios are a little bit less known.  Roughly, how would those numbers move?

Mike: We’ve got a low growth scenario for 2019, which is essentially flat growth, and the sorts of assumptions that go into that would be a no deal Brexit, perhaps an intensification of the trade war between the US and China, general cooling of the global economy, but primarily that’s Brexit related.

The high growth scenario, which would take growth up to 2.5% or slightly stronger, would require another boost to the global economy, a cessation of trade hostilities, and a very smooth Brexit.

Emily: Right, that makes a lot of sense, and really interesting that actually there is other factors at play there.  That is important to remember that whilst Brexit feels like very much the dominant force here in the UK at the moment, there are other things in the world going on that have a bearing in our economy too.

Mike: Absolutely, but yeah the politics are such that it becomes a bit all encompassing, but there is more for businesses than just Brexit.

Emily: Looking beyond 2019, because the economic outlook does look a bit further than that, what about the 2020s, what might they bring?

Mike: Yeah and here Brexit is a less important factor, because we are looking so much further out, but again, we have to assume this reasonably smooth Brexit is one of our main assumptions. And here if you look out to the 2020s as a whole, we are expecting growth of between 1.5% and 2%.

There are three key drivers of economic growth.  There is the size of the labour force, how many people are contributing to the economy, the flexibility and the efficiency of the labour market, so how well can people get the work that they want, and productivity.  We think about those in turn, with the size of the labour force, we’ve picked some of the low hanging fruit already.  We’ve got much higher proportion of women into the workforce than we had previously.  The next frontier I think is to keep older workers in the workforce for longer, particularly as life expectancy continues to rise, you can actually get some good output from all the workers, who are leaving the workforce in their 50s and 60s at the moment.

On the second point, and about flexibility, the UK economy has benefitted from having the increased flexibility of having EU nationals working in the UK very easily in sectors like retail and healthcare.  Obviously, this is going to become more difficult post to Brexit.  We’ve already seen some fairly steep decline in the number of EU nationals coming to the UK since the referendum.

On the third point, on productivity, the UK and other advanced economies in the G7 have all seen productivity growth slow over the last two decades.

This is one of the biggest puzzles in contemporary economics and there are lots of competing theories as to why.  My particular suspicion is that, because of globalisation and the financial crisis, we’ve had a decade and a half or so of really abundant, quite cheap labour, and that has persuaded firms to hire people rather than build and invest in robots and machines, which may be more efficient, but it has just been easier to find people to do outsourcing or people on your own doorstep.  As in the next few years, we think these labour markets are going to tighten, we’ve got very low unemployment now in the UK, labour is going to become more expensive. And we might see firms beginning to invest in in more efficient machines, which may help to drive up productivity growth a bit. 

Again, if you take all of that in sum, we’ve got this growth of between 1.5% and 2% a year over the next 10 years, which is a little better than we’ve seen in the recent years, but it’s way off the growth between 2% and 3% that we saw in the 60s, 70s, 80s, and the 90s.

Emily: Okay, thank you for that. Really interested in the point you made there around investing in machines, and certainly we are starting to see clients dusting off business cases that maybe didn’t make sense five years ago in Brexit terms, now making a bit more sense today.  So, interesting to hear you reinforcing that point.

Just a note to listeners, you can find our UK Economic Outlook report and subscribe for updates on our Beyond Brexit website pwc.co.uk/brexit.

Barret, I would like to draw you in a bit more.  I know, you and I’ve been working together on PwC’s own Brexit planning, and you are working with a number of clients in this space.  Let’s talk a little bit about different sectors, so, Mike painted a really good general picture there, which sectors are going to most impacted by those different economic scenarios?

Barret Kupelian:  Hi Emily.  I think, it is worth saying that is difficult to answer that question with certainty, because there is quite a few layers you need to consider to answer that question.  So, if you do a bottom up analysis of which of the sectors you’ve to consider, the trading linkages of all those sectors, the supply chain, the EU regulations that pertain to that sector, but a simpler way to think about it is from a top down perspective and in terms of factors of production, which might actually allude it to. 

If you think of what drives the productive capacity of a business, there is three main elements, productivity, capitals, stuff like computers, labour, buildings, and also your workers as well.  So, focusing on that latter element, labour, we’ve got relatively good data from the ONS, which shows the reliance of different sectors with the UK economy on labour from the European Union.

Actually, the top three sectors in the UK that are reliant on EU labour in descending order are the manufacturing sector, the distribution hotels and restaurant sector, and the construction sector.

If I can just make a couple of quick points on the first two sectors.  In manufacturing about 10% of the labour force employed in manufacturing is from the EU.  In absolute terms that is 300,000 people.  The manufacturing sector has been particularly vocal about Brexit and the ramifications it has on its sector, partly because of the reliance on EU staff, but also because they are quite reliant on the EU market as a significant source of demand for the products they produce.  More than half of total manufactured exports by value that we produce in the UK goes to the EU.

I think it is also worth saying one more point about manufacturing here, which is this, when I have conversations with clients, the impression most clients have about with the manufacturing sector in the UK is akin to the image of a dirty old polluting factory that is not very efficient. But actually that’s far from the truth for British manufacturing nowadays, because nowadays they seem to be much more hi-tech and productive than they were in the past.  So, more than one-third of UK manufacturing is either in the car sector or in complicated machinery like airplanes turbines, and in chemical goods.

These are very competitive and complex industries, which require very specialised and high value adding skills, some of which are in low supply in the UK, and that’s where the EU sort of stuff comes into play.  That’s why it is quite important for the manufacturing sector.

The second point is the distribution, hotels and restaurants sector, which employs about a quarter of a million people from the EU.  Now, this sector is particularly worried about Brexit simply because the UK is now experiencing record low unemployment rates, which basically means they have to look for labour elsewhere to grow their businesses, and if restrictions are put on that channel potentially then that could impact the scale of which they expand their businesses.

Let me just say one more final thing, which is actually surprising when I looked at the data coming out from the ONS, which is about the banking and financial sector, which in absolute terms absorbs the most EU migrants.  About almost half a million Europeans are employed in this sector, and this can be seen as you walk down Liverpool street where you hear different mix of languages.  As an economics team, we’ve done some work in this sector as well to understand the impact of different forms of Brexit on the FS sector, which our listeners can find on the PwC website as well.

Emily: Right.  You’ve reminded me actually one of the most frequently asked questions I get is around what’s the impact going to be on jobs.  Mike, you and I were discussing this the other day, share with the listeners your answer to that question, how is Brexit going to impact jobs?

Mike: I think the reason that it’s a very familiar question, because it is very difficult to answer given the number of potential outcomes still on the table for Brexit, giving precise net job gains or losses is very difficult.  What we can do is flesh out some of the context through which this disruption to labour market is going to occur.  Barret mentioned the unemployment rate in the UK is now coming to the lowest since the mid-1970s, but at that point the economy looked very different from how it is now.

The employment rate as a proportion of labour force is at a record high, job creation is still pretty rapid in terms of number of new jobs being created by the economy each month, and wage growth is starting to accelerate as well.  So, all of these things together, I think, suggests that unemployment, which is 4.1% at the moment, could go a little bit further down, to three point something, but after that the market is going to look quite seriously tight.

Were a considerable number of EU nationals to leave, and they weren’t replaced by economic migrants from the rest of the world, employers would struggle to find workers, Barrett mentioned a couple of sectors that we think will be particularly affected by that, and they may be forced to either increase wages and the increase risk of higher inflation as a result.

Alternatively, we may get a less smooth Brexit then we hope and are currently projecting, where we could see an economic down turn that results in firms laying off work, and unemployment rising.  Most likely we will see different groups of workers within the labour market behaving in different ways in response to exactly the precise kind of Brexit we get depending also on the sector they are in and the particular nationality and access to the market.

I guess the best answer is to say, if disruption is coming, the precise shape of that is going to be very different for different kinds of worker in different places, and the scale of that disruption depends almost entirely on the precise sort of Brexit that we get.

Emily: Okay, thank you Mike. I would like to get in to another specific area that I get lot of questions about, and Barret, I know you and I’ve been looking at this closely together, which is around investor sentiment.  Maybe you could just talk through that work and what we’ve concluded about what may happen to investor sentiment as we move to 2019?

Barret: What we did as a part of our internal workings is to look at how uncertainty and slower UK economic growth or GDP growth effect investment levels in the UK economy.  Just to contextualise some of the numbers, real investment growth in the UK economy grew by an average of 1.5% in the two years after the referendum, compared to an average rate of 3.5% in the six years preceding the referendum.  So, what we did is, we built this model, econometric model, which linked investment growth rates in the UK economy with economic activity rates and uncertainty levels, and we found that statistically both of these drivers were significant in explaining investment growth rates.

A couple of the key conclusions we came down to was, well the first one was, we deduced the impact of the result of the referendum on investment levels in the UK economy.  To do this, we compared the actual investment levels that we were experiencing the UK economy after the referendum.  With estimates of what investment levels would have been had the UK economy grown at long term growth rate, and had uncertainty levels remained broadly constant.

What we found was the cumulative investment post the referendum was about 3.5% lower than what it would have been in the absence of Brexit.

Then, what we also did is, we projected forward the investment growth rates based on a spectrum of different Brexit scenarios and the key conclusion we came down to was that a deal, which led to high alignment of rules, regulations, product standards with that of the EU was associated with much faster investment growth compared to stagnant investment growth climate in a no deal situation.

I suppose, this piece of work is a great example of how we generally help our clients by bringing in or bridging that gap between the big macro picture and the more business implication side of things.

Emily: That’s interesting actually and that was one of things that I wanted to ask you both about today, because this is absolutely fascinating, there is no getting away from that. But what can a business do with this type of analysis as well as being interested and intrigued, what kind of decisions to businesses that you are working with make armed with the type of analysis that you are talking about?

Barret: I can give you a couple of examples of what types of works that we’ve done and how clients are responded?

Emily: Great, thank you.

Barret: So, the one area that we do quite a lot of work is developing different scenarios about the future state of the world, that may involve Brexit or may involve other sort of situations, and revenue or cost forecasting based on those scenarios is what that is really popular with our clients.  So, what we do is build models that link the economic climate to the business climate, and then we project those forward, and give an indication to our clients of how their revenues or cost might develop in the future.

Now, we found that clients’ use that to adjust their corporate strategy or their operational readiness about these different scenarios, or they adjust some of their supply chain arrangements that they have to reflect these different states of the world that might occur in the future.  So, that’s one area that we do a quite a lot of work with on business level.

The other one that tends to be quite popular with our clients is the impact assessment area, where we measure the change of a big policy change or of a structural change such as Brexit on the sector as a whole.  That gives some indication to particularly trade associations, for example, for them to understand better on the ramifications of that policy change on their sector, and they then feed that to their members and then their members take action according to the conclusions of those type of analysis.

Emily: Mike, anything you would add to that?

Mike: I think, we serve a purpose as a, kind of, filtering service as well, because there are so many, we’ve obviously been talking about Brexit today, lots of Brexit impact assessments, a lot of constant stream of economic data that’s coming out and the role we play for lots of clients is taking all of that information in, doing the modelling that we do, looking at the conclusions and then trying to put that into sometimes numbers, sometimes scenarios, this is what it means for your business.

Emily: Okay.  So, filtering out the noise in essence.

Mike: Yes.

Emily: Great.  Thank you both. It has been really interesting for me.  I’ve certainly learnt a lot today.  Now, regular listeners will know I would like to finish with a bit of myth busting.  So, what are some common economic myths that you hear a lot in the Brexit debate?  Mike, perhaps you would like to go first.

Mike: I think, there is one about slow growth versus recessions.  This is a very common economic trap to fall into.  We’ve seen lots of Brexit impact studies that say the economy will be lower in the long-term then if we’d voted to remain, including those done by PwC.

So, they often conclude by saying something like the economy will be 5% smaller in 10 years.  This doesn’t mean the economy shrinking by 5% or recession that lasts 10 years, it just means the economy will be growing at a slower pace over time and it means that by the end of the horizon it is 5% smaller than it would have been under the previous scenario.

There may be a recession in there, there may not, but this is the difference between slower growth and the economy actually shrinking which we get in the recession.

Emily: Okay and I definitely hear that a lot.  Thanks for busting that one today.   Barret, how about you?

Barret: I want to reiterate Mike’s point there, and the key point for me is that, all of these impact assessments are basically comparative exercises.  They compare different states of the world amongst themselves, they are not forecasting exercises.

So, for me, the moral of the story is to go beyond the headlines of some of these stories that are written, and I would like to think that us economists are relatively good at making projections about the future state of the world, subject to assumptions that are clear and transparent, but we never claimed, and I don’t think we will ever claim that we can forecast the future with absolute certainty.

Emily: I think, it’s fair to say, you talked about the headline there, often those pickup on the worst case, don’t they, so get behind those headlines in to the detail behind and you will see a rich picture of different scenarios and to understand.

Barret: And they are scenarios and not forecasts.

Emily: Okay.  So, that’s all we have time for today. I hope you have all found this economic special edition as interesting and useful as I have. If so, why not subscribe to our Economics and Business Podcast and remember to visit pwc.co.uk/brexit for our most up-to-date insights and get in touch with any questions you might have. Bye for now.

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