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Transcript - Episode 25: What's already changed for good?

Emily Khan: Hello and welcome to our latest Beyond Brexit podcast, I am Emily Khan.  Today, we are revisiting one of the big questions; ‘how will Brexit impact the UK economy?’

I am joined once again by two of our senior economists.  Mike Jakeman, who works on our UK Economic Outlook series; and Barret Kupelian, who has been working on economic impact analysis for our own Brexit preparations as well as for our clients.

Mike, I would like to come to you first if I may. When we were last together on this series in January, the main assumption behind your projections was a reasonably smooth exit in March, and a projection of 1.6% GDP growth in 2019.  Now, events have obviously moved on a bit since then. So, take us through what your main scenario is at this point in time.

Mike Jakeman: Hi Emily, nice to talk to you again.

January seems like a very long time ago and indeed so much has happened since then.  I think the best way of thinking about how Brexit has affected the UK economy so far this year is that we actually had a relatively good first quarter for the economy.  Household spending held up as it has done ever since the referendum, people are continuing to spend money, probably in the absence of really knowing what else there is to do.  But what we saw is that business investment, which has been where Brexit has really hit the economy so far, actually did quite well, for the first time in a year or so, but the reasons for that aren’t necessarily all that great.  Businesses saw this March 29th deadline for Brexit and then stepped up their no deal planning as we saw in a good quarter for the manufacturing industry, and a lot of imports as well.  Those two things together meant that businesses spent a lot of money preparing themselves for what they would do if there was a sudden no deal Brexit on March 29th.

Emily: Absolutely, and that would chime with what I was seeing and hearing around that time about people looking at stock piling as one of their priority contingency actions.

Mike: Yeah exactly, and the stock piling component was unusually large for this quarter as well.  So, that combined meant we got a good first quarter, but the trouble is that’s not sustainable, because they did this preparation, in the end they didn’t really need them, because now we have the extension.  Now we are expecting to see business investment continuing to fall again, resuming its previous trend for the second and third quarters and onwards until we get some more clarity.

Emily: Right, so that 1.6% I mentioned then, in the intro, have you moved away from that at all?

Mike: Yeah, it’s going to come down, anything between 1.2% to 1.4% is probably more appropriate.  We will find out more in a couple of weeks when we get an idea of whether household spending - which is a thing that really drives the economy - whether households have remained resilient in the second quarter as well.  They have done so far.  It is possible.  We have seen retail sales possibly soften a little bit in recent months.  That will be a really key data point, but our expectation is that growth can be pretty slow again this year, and probably below 1.4%.

Emily: Okay, and is that still based on the assumption of a smooth exit by the UK from the EU in October or some point thereafter?

Mike: Yes, our base case is still that there will be a Brexit agreement.  It will be a very brave economist to tell you, perhaps very naïve to tell you, exactly when that’s going to occur, but this assumption is still predicated on the UK leaving the EU with a deal, either in October or next year.

Emily: Right, okay. We talked before about the alternative scenarios, the higher growth type scenario and a lower growth type scenario.  Has anything changed in either of those, or do you still see the range of possibilities being broadly similar?

Mike: I would say that the possibilities for higher growth now look a little bit more far fetched than it did in January.  That’s not just because of the UK’s performance, but also about the global economy as a whole.  We have seen that the trade conflict between the US and China has deepened and being more prolonged.  The prospects of that being ended now seem quite remote for political and economic reasons.  We have seen a period where the European economy from growing above trend into 2016 and 2017, having a bad 2018, and now settling back to where it was before, which is growth of around 1.5% to 2% a year.  The global economy is a bit cooler than it was a year ago.  That again makes the prospect of a faster growth scenario in the UK driven by exports, for example, a bit more remote. Now, low growth….

Emily: Yeah, it’s a million dollar question.

Mike: Yeah, the prospects of the UK doing significantly worse than we are expecting is of course very closely linked to no deal.  We think a no deal outcome would be bad for the UK economy, we have been saying that for a long time. So if the prospects of political failure and no deal rise, then so does the prospect of a worse outcome for the UK economy.

Emily: One of the things I took away from our conversation in January, you’ve reminded me of again there, is the fact that Brexit isn’t the only show in town in terms of economic projections, and remembering that there are bigger trends around the world that also have real implications for us here in the UK.

Mike: When we talked about things other than Brexit?

Emily: We did, I mean I can’t remember those times!  I want to get back to the point you made around preparations in the run up to March, because we’ve been thinking about it, within the beyond Brexit team, how we move away from looking at Brexit as a one off point in time phenomenon to the prevailing backdrop.  We’ve been using the phrase ‘Brexit as usual,’ because this uncertainty that businesses are operating within at the moment, isn’t even going to end if we get a deal or no deal, kind of, resolution on which scenario is in play.  There is then a prolonged period of uncertainty as that scenario plays out.

How does that impact on your economic projection?  Is that replicated in your forecast?

Mike: I think this is a really valid point, because all the agreement gets us to, is the next stage in the negotiation towards a free-trade agreement.  This isn’t the end of Brexit, it's going to be a multiyear process at best, and could end up being a much longer one.  So the key question for us, when we look at particularly business investment, which is the area where we have seen the strongest impact from Brexit, is to what extent is the investment that hasn’t taken place over the last year or so, to what extent has that been deferred or cancelled altogether.

If we got a deal through and some initial momentum on the possibility of a free-trade agreement and things became much more positive, to what extent where businesses, who haven’t made those investments, decide that the UK is still the right place to make them.

That’s a very big question that I don’t have a single concise answer to.  It depends very much on a sector basis, it depends on prospects elsewhere in the global economy, and it depends also on the level of political debate as well.  One of the UK’s strongest advantages is that, as a destination for investment has been a very stable political environment, and the longer this Brexit as usual phase goes on, or the Brexit limbo, or whatever you want to call it, the greater the risk is that some significant damage is done to the UKs reputation as a stable place to do business.

Emily: Okay, and what does that mean for our global standings?  So, where are we in the overall global picture and global economy at the moment?

Mike: One of the tragedies of Brexit so far is that the UK has grown quite slowly and well below its potential rate at a time when the global economy has been doing quite well.  We have seen in the last, particularly since 2016, the global economy has grown in a more synchronised and faster rate than any point since the global financial crisis.  This really was a time when the UK could have cashed in, if you like, on the fact that lots of its neighbours had greater export demand, etc., but it hasn’t quite happened.  The economy has grown at 1.5% for the last three years or so at a time when the global economy is much more vital.

It is disappointing that this has occurred at a time when there were genuine opportunities to be seized by the UK.  If there is a league table of the largest economies in the world, and one of our predictions we made at the beginning of this year is that the UK would slip in that from fifth to seventh.  The countries that would have overtaken it will be India, which is a permanent transition, you would imagine, given the amount of catch up growth in India, and also France.

Now, the UK and France have swapped positions.

Emily: Yes, I was going to say some great rivalry there. 

Mike: Yes, many times, and will continue to do so.  This is based on both exchange rate movement and economic growth, and we think France had put up a better year in both of those aspects, but because there is plenty of potential for the UK to take that sixth place back over the next decade or so.

Emily: Thanks Mike.

Barret, I would like to bring you in now, if I may.  How does everything that Mike has just been talking about chime with what you are hearing from clients who are planning for these different scenarios?

Barret Kupelian: Well Emily, I think for businesses, what has really changed is the type of uncertainty that they are facing.  In the first few quarters after the referendum, uncertainty levels were running high, but they were centred around the nature of the deal that the UK would strike with the EU, and the classic question back then was, is it going to be a soft Brexit or a hard Brexit.  But now we are three years down the line since the referendum, uncertainty levels still remain high, but it’s the type of uncertainty that’s changed, particularly in the last 6 to 12 months.

Let me just break that down.  I think the first source of uncertainty now the businesses are facing is, first of all, whether the deal will be struck with the EU or not.  Now right after the referendum, I think it’s fair to say that was a remote possibility, but that has now changed.  The second question is more about the future relationship between the EU and UK, so that’s more the hard versus soft Brexit sort of uncertainty.  The third one is also, businesses now have to start considering about the domestic political angle.  So, what different forms of Brexit could mean for Scotland and Northern Ireland, for example, which wasn’t, I think, one of the issues that the businesses were thinking right after the referendum.

Finally, I think there is an international context here as well, one needs to consider, particularly for businesses, who have got exposures in different economies.  The one thing now they have to deal with is tariffs, particularly with the US and China, and the tensions between those two economies.

Some businesses have had to start figuring out ways to change, modify, or tweak their supply chains much faster than they originally thought. So, all in all, if you think of the job description of CEOs and strategy directors pre and post the referendum, I think that’s changed quite significantly from carrying out a more of vanilla type of function, leading an organisation, ensuring costs are contained and revenues grow so that your bottom line grows, to much more defensive function, where CEOs and strategy directors make sure that their organisation is prepared to be operationally viable under different states of the world.

Emily: I absolutely recognise what you were just saying there.  There is one other uncertainty I would add to your list, actually, that I am picking up on, is the timing of it all.  Those are all big questions, but we also don’t know when any of those different states will come into effect.  I am not sure many of us were expecting the flextension when we were modelling scenarios even a year ago, and certainly there is a big question over whether or not there will be a further extension in October, I know is troubling many of the clients that I speak to.

You picked up on the supply chain, which obviously is relevant to a lot of sectors.  Are there any sectors that really stand out from the conversations you are having of where this is being followed more keenly than others?

Barret: Well, if you look at the UK economy and look at the two main production side sectors, so services and manufacturing.

I think manufacturing, if you just focus on that for a second, it has done relatively well, and that’s driven by the fact that we export quite a lot of our manufactured goods and the cheapest earning has helped.  That affect is dissipating now, and if you look at some of the forward looking surveys for the sector, they are looking more gloomy than in the past.

Well, manufacturing is about 20% of the UK economy, what really matters is services.

Now the picture there is much more nuanced, particularly when you start zooming into the services sector.  Some sub-sectors that haven’t done relatively well is, for example, financial services.  That sentiment is reflected in PwC CBI survey we carry out every quarter; where banks seem to be less confident about how their customers will react to potential Brexit developments, but they are more confident about how they will themselves react to Brexit.

Then on the positive side, other sub-sectors have been doing well.  Stuff like, motion pictures, for example, has been doing well, because people are staying home and watching their streaming services.  Other big sectors that have been doing well is technology, information technology I should say, and there are a couple of reasons for that, but the obvious one is Brexit and the fact that our clients would advise about what Brexit means for them, and how they could mitigate those risks.

The second point is that the business agenda is moving on.  Digitalisation, for example, is happening irrespective of Brexit, and clients need help on that.  That seems to be a sector agnostic issue.  It’s the case in retail, finance, manufacturing, or even in government, where personally I’ve been working on a digital transformation project in the Middle East for the past three months, so digitalisation is spearing ahead.

Emily: Right, okay. Brilliant.

Mike, you talked about the pattern on investment, and I will be interested, Barret, in your take on some of the factors behind businesses making investment decisions, and how that uncertainty is playing out at a very client by client level of making a decision whether to invest in the UK or not, what do you see?

Barret: The first victim of Brexit has been business investment in the UK, and the typical comparisons we economist carry out is, we compare business investment levels in the UK against its major competitors, the G-7 economies.  If you look at how that’s been evolving ever since the referendum, so on average all of the G-7 economies, excluding the UK, they have been growing their business investment levels all the time, whereas in the UK, it sort of stayed relatively stable, and now for the past four quarters it’s on a slight decrease.  You can clearly see the effect of uncertainty on business investment, but the interesting thing is actually, when you zoom in to the business investment levels, and see how that composition of business investment has changed.

So in the UK, for example, you will find that businesses have been cutting spending on transport equipment. That’s lorries and vans, and on ICT spending, but they’ve been increasing their spending on building and warehouses, and I think that’s where Mike’s point comes around, the stock building that we saw in the first quarter of the UK economy and that is being recorded as a business investment input.  Clearly, that’s not big enough to offset the overall negative decline of business investment.

Emily: Picking up on the point you made there about stockpiling the business readiness, I know one of the things that you and I often talk about is the data, what the data is telling us about business readiness more generally, has there been any change in the data that we can see about preparations, and who is ready and who is not, and the general state?

Barret: Usually what happens in these sorts of cases is, the Bank of England, for example, might go out and through its business agent network to carry out a survey and assess business’ preparedness for Brexit.  They did exactly that in their latest May inflation report.

Now there are a few interesting trends they found.  Well first of all, three quarters of the business, who responded to the survey, did some sort of contingency planning for Brexit, or they are in the process of developing one, so that’s one clear picture that emerges.

The other quarter of businesses said that they were not making contingency plans.  Now, of those businesses that are not making contingency plans, 50% said they were not affected by Brexit; a third said they were waiting for more information and clarity until they decide when to carry out Brexit.  Now the other point as well is the complication as to the clarity as to the timing of when Brexit will happen.  We’ve seen it come through the economic data, through inventory accumulation in the first quarter of the year.  If we expect Brexit to actually materialise at the end of October, then we might see that accumulation of inventory yet again, which is the manifestation of all these contingency plans.

Emily: One of the points that quite often comes up in conversations I have with clients is not overlooking the stock that was appropriate and relevant at the end of March won’t necessarily be appropriate and relevant for the end of October, particularly noticeable in retail that are preparing for Christmas at that point in the year as well.

That’s not as simple as the data alludes to, and Andrew Gray actually mentioned the other day, or reminded me, that the 31st of October is a Thursday, whereas the 29th of March was a Friday, which particularly in financial services, Friday; end of a period, you’ve got two days then before trading on the Monday. Whereas the 31st of October, the next trading day will be the very next day.  Some of the activity we might see, as you said, an increased focus in the run up.

Mike: We could easily see another bump, in fact you’d want to see another bump in business investment in no deal preparations should we get that far by 31st October.  It is a little bit reassuring to see that is actually materialising into something, because having a contingency plan for Brexit, feels like a fairly low bar, to have to clear.  We still don’t know, of course, how effective any of those plans are going to be, we may never know, so we will see what happens again.

Emily: Question I would like to put to you both actually, is around the labour market, and I know we talked about this when we last spoke in January, but a few different data sources about this being of most pressing importance for clients, it is not least our own global CEO survey, where access to skills was one of the concerns the world over of CEOs, and we talked about the increasingly tight labour market in the UK back in January.

How have you seen those trends unfold since then?

Mike: Largely, as you would expect, the UK still has very low unemployment.  The number of jobs that are being created each month has slowed ever so slightly, and likewise nominal wage growth has slowed down ever so slightly, which you wouldn’t necessarily expect.  As unemployment falls, you tend to expect wage growth to pick up, because people are becoming that much more scarce, and therefore have greater bargain with potential employers.

Is that significant or is it just month to month noise in the data, it is a little bit early to tell.  If you are being very pessimistic, you would say that actually this sort of softening occurred exactly the same time as the potential no deal at the end of March and then continued in April.  You would say that this is evidence that firms are worried about Brexit and they are trying not to take on any additional cost at all.

Alternatively, it might be month-to-month noise.  So, it is too soon to really have a firm view on that.  All the labour market trends that we’ve seen, labour markets tend to move in quite long-term cycles any way.  UK has relatively low unemployment, high employment, and decent wage growth.  The labour market is still one of the strongest aspects of the UK economy.

If I’ve got another minute or two to explain this, one of the key interesting things to understand at the moment about how labour markets work, is, how come if you’ve got falling business investment, people are still being hired quite quickly, and there is no one answer to this, but my suspicion is that firms are saying, ‘okay, well if we need to expand, we can either do this through making a major capital investment into equipment or automation, or something expensive in the long term, or we can simply hire some more people.’

Although, wage growth is a bit faster than it was 18 months ago, it is still not especially quick in historic terms, so people are still relatively cheap.  I think that we’ve been able to sustain this rate of quite rapid hiring, because it’s cheaper to hire people than it is capital at the moment, because of that uncertainty around Brexit, firms are less willing to commit to major expansions.

There are still lots of good things around the labour market in the UK in spite of Brexit gloom, but the longer this limbo goes on, the more we might start to see that effect creeping into the labour market too.

Emily: Obviously, you are nodding at that Barrett, does that chime with what you are seeing in your area?

Barret: It does, and one of the positive surprises, especially in the past five years in advanced economies has precisely been this resurgence in employment rates or the decrease in the unemployment rates.  We have seen the same story unfold in the US, for example.  I think they have one of the lowest unemployment rates for about 40 years.  We have also seen in some European economies, for different reasons, actually, in some of the peripheral European economies or Eurozone economies, it more has to do with the fact that some of the wages were cut back during the financial crisis that they faced.  Now labour is much cheaper compared to history.

Then you’ve also got another trend developing, whereby most of the Eastern bloc that got admitted into the EU in 2004 mostly, so they are reaping the benefits of the freedom of movement of businesses across the EU, and they’ve got relatively cheaper labour forces compared to the Western European countries, so they are taking advantage of that.

Emily: We are almost out of time here, and we haven’t had a Brexit myth buster in a while, so I hope you are going to indulge me.  What Brexit - and I’ll allow you to have economic myths – what Brexit economics myths would you like to bust for our listeners today?

Barret: Let me go with the one that’s been annoying me lately, it’s the fascination with tariffs.  There seems to be this perception that tariffs are the be all in the trading system, but actually its non-tariff barriers that really matter, particularly for the UK economy, which is the second largest services exporter in the world.  Non-tariff barriers are much more important for advanced economies, and for some reason the debate seems to have shifted completely on to tariffs, which I think is potentially easier to understand, and it relates to tangible goods, but what is equally important, if not more important, is non-tariff barriers and they need to be brought into the debate about Brexit.

Emily: It’s almost like you’ve listened to our last podcast in this series, Barret, which was all about non-tariff barriers for services!

Mike, how about you?

Mike: That’s actually inspired me, because my single biggest bugbear is, if you look on the global perspective, is when a journalist writes about China.  So, China is in the middle of a very long-term slowdown in the growth of its economy.  15 years ago it was growing by 15%, now it’s growing by just over 6%, and every single quarter, when they get a new data point, you will get journalist writing about how China is growing at the slowest rate for 25 years, as if it’s on the edge of a crisis, and that is a fundamental misunderstanding on how economies work.  China is growing at the slowest rate, yes that’s true, but that doesn’t matter, because it is simply a more advanced developed economy, that’s what they do, they slow down as they mature.  What matters is the change in the rate of growth one quarter to another.  If China suddenly, the growth rate has fallen off a cliff, we all need to know about it.  If it is merely slowing down at exactly the rate that the government is desiring, then that’s of no concern to anybody.  That’s a particular pet peeve, and next time we see some growth data on China, I guarantee you, some ill-informed journalist, who are talking about how it’s the slowest rate in X number of years.

Emily: Okay, absolutely noted, thank you very much.

Right, that’s all we’ve got time for today.  Thank you listeners for joining us.  I hope you have all found this economic special edition as interesting and useful as I have, and thank you Mike and Barret for coming back.  We look forward to having you, maybe, a third time later on in the year.

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