23 May 2016

With the purdah period just days away, the Treasury is firing the last bullet from its big economic gun – the short term impact of Brexit.

The first thing to note is that there is actually quite a wide consensus – including many economists from the Leave side and a majority of the British public – that there would be a short term shock from Brexit to the UK economy. Any transition of this size will involve uncertainty, even more so when there is no clear succession plan in place (at least publicly) – this means market volatility and uncertainty over investment/spending decisions. So the overall premise of the Treasury report is hard to question.

That said it is nigh on impossible to make any credible predictions about how this uncertainty will manifest itself in the short term – especially for such an unprecedented event. So while, the direction of the moves in some prices/economic indicators might be correct, I don’t think the actual size of the moves can be credibly estimated.

The final opening point to make is that, whatever the short term impact, a decision on whether to stay in the EU or not should not be made on this alone (if at all) but on the bigger picture, long term issues.

Below I look at a few of the specific predictions in more detail.

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Short term forecast harder than longer term: One mistake which is often made is to assume that because this is a short term forecast over a couple of years it will inevitably be more accurate than the other forecasts up to 2030. However, I think the reverse is probably true. It is easier (albeit still very difficult) to look at how certain policy changes might impact rational long term economic decisions and shift an economy from its baseline growth. This short term estimate is trying to encompass the impact of uncertainty as well as predict movements in financial markets without any historical precedent. Of course, both cases are heavily dependent on assumptions and inputs but I would hazard a guess it’s slight easier to make reasonable assumptions about broad long term policy choices than about short term market movements (see here and here for my take on the longer terms predictions).

All relative to a growing economy: An important point to keep in mind is that all the figures put forward are relative to a baseline where the economy and asset prices continue to grow. So the recession forecast is actually very mild with four quarters of -0.1% growth (see table below), while the forecast for house prices is actually that they stay flat rather than growing (h/t @EdConwaySky).

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GDP impact: UK GDP is seen to be between 3.6% and 6% lower after two years. These figures seem on the high end given that nothing actually changes after two years since this is the minimum transition time allowed by Article 50 (the process for leaving the EU).

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Transition effect: Linked to the above point, the Treasury assumes that in these two years businesses and investors start positioning for a “less open, less productive and poorer” UK. This is based on the results of its long term analysis. But as we have pointed out before, ultimately whether the UK is open and productive in the longer run depends on policy choices and the Treasury’s assumptions/scenarios fall short on this issue. As such, much of the transition effect could well be overstated and the actual size will depend on what businesses believe the outcome of the UK’s exit negotiations will be and what the UK government’s ensuing approach to trade, immigration and regulation might be. Ultimately, this has a reversed engineered feeling to it – it’s basically based on the idea that the Treasury’s long term Brexit estimate is correct and everyone buys into and responds to it earlier – all of which seems quite unlikely.

Uncertainty effect: This is a more valid driver in our view. Clearly there will be a significant amount of uncertainty around, particularly as the negotiations get underway. This could well hamper business investment and consumer spending. Whether the composite indicators used by the Treasury is a good approximation of this is unclear (remember there is no historical precedent for Brexit), but it is not beyond the standards realms of assessment.

Financial conditions effect: This also seems to be a valid channel since such a shock would create financial market volatility. The report is correct that this is already showing up in certain areas notably certain investments and the cost of insuring against a UK default. However, it is not showing up yet in the cost of borrowing for the UK and this is seen as one of the chief drivers of the impact in the report. The impact on equities is mixed so far – headline indexes are performing quite well but there is evidence of underlying churn with certain equities exposed to a potential shock struggling.

Unemployment: Increases between 1.6% and 2.4% also sound high to us. Especially given that, following the financial crisis, unemployment in the UK only rose by 2.9%, it seems unrealistic to expect such a large jump from a smaller shock (as measured in GDP and currency terms). Given the flexibility of the UK labour market, it has proven adept at mitigating short term demand shocks via other avenues than employment (wages or working time for example).

House prices: The logic here is that the economic shock will feed through to spending and investment as well as possibly making banks more risk averse, thereby hampering lending, all of which reduces demand for housing. Again, in broad terms this is entirely possible, but it’s difficult to be precise about how this will manifest in prices. A fall of between 10% and 18% is of the same magnitude of the 18.7% fall in house prices seen following the financial crisis. Given the size of that crisis in the financial sector and its link to the housing market, it again seems unlikely the falls would be as large from the uncertainty around Brexit. There are other points to keep in mind as well. In particular, that UK and more specifically London property remain a safe haven (suggesting demand could increase if there was a serious shock) but also that the devaluation (combined with a price drop) could make property look very attractive to foreign investors. Furthermore, one has to question how concerned people will be by a price drop given the recent rise in prices and the structural shortage of housing in certain areas, which suggests prices would rebound in the longer term.

Currency devaluation: As we noted in our recent piece on Bank of England policy post Brexit, predictions of a devaluation following a vote to Leave range from 10% to 20%. As such the Treasury’s assumption of between 12% and 15% decline is not unprecedented. However, it’s not clear to what extent the wider range of estimates has taken into account the 7% fall in the pound since November – how much is priced in and how much further is there to go? As the chart below shows (via the CFTC) shows, net shorts on sterling are still at high levels – suggesting investors are positioning for a potential further weakening but without much indication of how large a devaluation is expected. But more importantly, as we also noted, it’s very hard to know to what extent and when this might pass through to prices (especially since a large majority of businesses have already hedged their currency risk and internalised some of the cost). Pass through is always partial and can take a couple of years. The Treasury technical doc on this issue states that it assumes devaluation is “fully passed onto” food and clothing. But the Bank of England has previously estimated that the pass through of currency shifts to the broader price level  is far from complete (even for import prices). Furthermore, this is also dependent on whether the devaluation is temporary of more permanent – again near impossible to say. So, it’s fair to say we will likely face a weaker pound, which may impact consumers and those traveling abroad, but it’s a very big stretch to predict how exactly this will feed through to prices for food and clothing.

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No policy response: As with its long term estimate, one of the big shortcomings is that the Treasury assumes that there will not be any policy response from the Government or the Bank of England to try to mitigate the short term shock. This is unrealistic. Particularly since this would likely be a standard demand shock, which both organisations have tools to use in response to. The document does rightly note, as we have, that there would be opposing forces to deal with (economic shock and devaluation) but this calls for a nuanced response not no response. Of course, this might tie up resources which could have been deployed elsewhere but it is not realistic to assume nothing would happen. Let’s not forget that if you apply any negative shock to the UK economy it would likely cause lower growth if there were no policy response. The shorter term uncertainty is likely to be slightly easier to manage since it is around confidence/uncertainty/demand while longer term problems could down to structural supply side and economic structure issues which will be tougher (though not impossible as we set out here).

Overall, it is fair to say there will be a short term shock but going much beyond that is ultimately speculation. There are also a number of particularly pessimistic assumptions in the Treasury report which do not seem entirely realistic, especially around the policy response and the impact of the transitional effect which means buying into the Treasury’s longer term predictions and basing business decisions on them.