Brecession Watch #1

Could there be a recession?

The Bank of England (“BoE”) has sought to calm financial markets and the UK economy by stating that there won’t be a financial crisis. They have also mentioned that UK banks are in much better health compared to the credit crisis of 2007-08 due to the new FCA/PRA regulations and increased capital and liquidity requirements. The BoE has also committed to providing £250bn liquidity (possibly supported by the ECB) to banks who require facilities to cope with foreign exchange liquidity, to continue providing credit (unlike in the credit crisis) and to supply other financial services to the real economy.

In the worst case scenario a number of commentators are predicting that the volatility in markets could potentially last for years whilst new trade agreements are drawn up and that there could be a lasting recession.

However, others consider Brexit to be a political event and the market volatility due to uncertainty rather than underlying economic reasons such as in the credit crisis of 2007-08.

Foreign exchange rates

GBP has depreciated significantly against foreign currencies. It was down by 8% against US$, which is double the loss of 4% during the ERM exit in 1992.

 

It is not clear whether or not this is a temporary fall or the start of a permanent devaluation, but the fall could potentially have the following significant effects in the short term:

  • The cost of imports could increase due to the higher cost of goods and also energy prices if the reductions in the US$ price of oil are less than the GBP depreciation. This could then put pressure on inflation.
  • Although the UK’s exports would become cheaper and more competitive, the UK already has a significant current account deficit and this could worsen due to an unbalanced company relying on consumer spending, funded by debt. Many of the UK’s exports are also made up by services which may not necessarily benefit from a fall in GBP.

Interest rates 

Whilst many commentators suggested pre-Brexit that interest rates could rise, early indications are that the Bank of England will either hold interest rates at 0.5% or reduce them to 0.25% in an effort to stimulate the economy.

Government bonds could potentially suffer from a cut in credit ratings in future, however yields have fallen due to increased demand.

Investment

Foreign investment in the UK could fall. We have already seen a fall in the UK stock market, and whilst the FTSE 100 has partially recovered, the FTSE 250 has fallen significantly. This could indicate a flight of capital from UK stock markets (as well as global stock markets). This would make it much more difficult for firms looking to raise equity.

UK companies may also find it difficult to issue corporate bonds to borrow from foreign investors due to the economic uncertainty.

Businesses are also likely to avoid making significant investment decisions until the situation clears.

Consumption

The increase in prices from a weaker GBP could reduce consumption. However, the psychology and sentiment of consumers may be the most important factor in avoiding recession. It is clear that Brexit is a completely different scenario to the credit crisis when there were bank runs and financial meltdown appeared to be imminent. However, if consumers are worried (rightly or wrongly) about job security or believe their mortgage interest payments could increase this will weaken private UK demand.

Global economy

Global stock markets have suffered with European indices falling more than in the UK and there could potentially be risks of global contagion. Although the UK’s GDP was only 4% of the world GDP and imports in 2015 the UK is a major global financial hub with the UK financial sector assets accounting for more than 8 times its GDP. This means that the rest of the EU is much more exposed to the UK due to financial and investment linkages.

Conclusion: Brecession?

The uncertainty could reduce consumption and investment. Although BoE could cut base rates and provide liquidity to banks this doesn’t necessarily mean that banks will lend to businesses and consumers, and could hold onto capital to boost their own balance sheets. This could result in falls in the growth rate, which was only 0.4% in Q1 2016 so a contraction in GDP could be possible.

Although, it is too early to say with any uncertainty but businesses should definitely consider the possibility that the UK could be in a recession as a result of Brexit in the near future. Important business decisions may need to be delayed in the near future until there is further clarity for example, hiring staff, moving premises or committing to large R&D projects or capital expenditure.

 

Unemployment?

A number of UK employers have made statements that they could have to cut staff levels whilst others have stated that they won’t need to. Historically, however, a recession is normally followed by increases in unemployment. We could also be in the unusual situation of low/negative growth and inflation at the same time.