The Growing U.K. Economy Isn’t as Strong as It Looks

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One year before the U.K. is to split from the European Union, the economy has avoided the disaster scenarios predicted after the Brexit vote. Don’t get too excited.

True, output has risen every quarter since the Brexit vote, expanding 1.8 percent in 2017. That far outstrips pessimistic estimates from the U.K. Treasury and others made in the immediate aftermath of the referendum.

There’s more good news too: Unemployment is near its lowest since the 1970s, inflation is dropping and Bloomberg’s Brexit Barometer, which tracks 22 U.K. indicators, is at its highest in 17 months.

The risk is that better-than-anticipated results could distract from imbalances within the U.K. economy as well as its relative under-performance in a international context.

The Dangers Ahead:

The U.K.’s resilience over the past 18 months, especially in relation to the labor market, has been extremely welcome. But scratching beneath the surface there are questions about how long it will last—households cannot dis-save indefinitely and at some point global growth will moderate. Productivity growth has failed to re-emerge meaningfully over the past decade and until it does, the economy will go nowhere fast.”

—Dan Hanson, Bloomberg Economics

In fact, the nation’s stronger-than-expected expansion still was close to the bottom of the G-7 charts last year. In the neighboring euro region, growth was the best in a decade and it surpassed forecasts far more than the U.K. did.

The U.S. also saw a year of solid performance, with expectations that President Donald Trump’s tax cuts may support expansion further this year. The IMF said in January that the global recovery was the broadest in seven years, with faster growth in 120 countries accounting for three-quarters of world output.

That hints at the argument, used by the National Institute of Economic and Social Research and others, that the boom on the continent and in the rest of the world has come to the aid of the U.K. just as Britain decided to go it alone. It estimates the buoyant world economy added about 0.6 percentage point to 2017 U.K. GDP.

Domestic demand also gave a helping hand last year, even with the pressure on consumer spending from faster inflation. Despite a slowdown in growth, it was still stronger than anticipated as the solid labor market gave households the confidence to borrow more and save less.

But that’s raised concerns about sustainability and too much debt piling up, which increases vulnerability to interest rate hikes or a turnaround in the 4.3 percent unemployment rate. The U.K. Financial Conduct Authority warned this week that even a gradual increase in interest rates “could have a detrimental impact on consumers who carry high levels of debt.”

Investment, meanwhile, is hampered by uncertainty over Brexit. The Bank of England estimates that business investment is four percentage points below what it would have been had Britain not voted to leave the European Union. Data released Wednesday showed manufacturing shrank in February.

BOE Governor Mark Carney told lawmakers in January that given the health of the world economy, easy financial conditions and strong balance sheets, investment is far below where it should be.

Still, he noted that could change if businesses got more certainty over Brexit, something which came in the form of a transition deal struck March 19. A Deloitte survey this week showed the accord boosted business optimism, with weak growth now supplanting Brexit as the top risk.

This good news-bad news take on the U.K. economy is also evident in Bloomberg’s Brexit Barometer. The gauge stood at 34.5 at the end of March, above where it was the day before the Brexit vote and the day Article 50 was invoked.

While this illustrates an overall robust economy, the intervening months have been a roller-coaster ride, with the barometer as likely to fall as to rise. Unpacking its component parts shows that the employment situation is better and uncertainty is at a post-referendum low, but inflation remains a drag and economic activity is at the weakest since November 2016.

For BOE policy makers, one of the biggest impacts of Brexit, outside of the passthrough of a weaker pound to inflation, is the damage done to potential growth—the so-called “speed limit” which the economy can tolerate without overheating. Officials put that rate at 1.5 percent, meaning that even the current pace has been enough to kickstart interest-rate hikes.

Still, Brexit uncertainty is likely to keep officials on a gradual path for now, especially given the risks to global growth posed by an escalating trade dispute between the U.S. and China.

“Even beyond Brexit there are some very tough questions to grapple with,” said Victoria Clarke, an economist at Investec in London. “I’d be very doubtful that the Bank of England answers them at this point, but if they are there and existing in the background I think that just plays into the case even more strongly for taking a pretty cautious approach to policy.”

©2018 Bloomberg L.P.

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