More than a year has passed since the UK electorate voted to leave the European Union (EU) and there is a very long way to go before an agreement over the terms of the UK’s departure is likely to be reached – if there is an agreement at all.
In our view, the UK faces a very challenging few years as the country deals with its departure from the EU. We believe the economic impact of Brexit has been delayed rather than avoided and will probably begin to be felt later this year. Our concern is that, having largely exhausted its monetary policy options, the UK government will have limited ability to protect the economy from a significant slowdown.
Our base case is that, barring a major political change of course in the UK during the next year or so – which is possible given the vulnerability of the government – a ‘hardish’ Brexit is still the most likely outcome, meaning the country falls upon WTO terms soon after March 2019, if not immediately.
It is almost certain the UK’s economy will suffer a slowdown if it falls suddenly upon WTO terms in March 2019. Less clear is how severe that slowdown will be and how long it will last. Given the complications associated with re-joining the WTO as an independent member, however, it is reasonable to assume a prolonged period of economic uncertainty would follow the UK’s exit from the EU, possibly exacerbated by a wider global economic slowdown.
‘The monetary cupboard is almost bare’
In the event of a sharp economic slowdown, what tools would the UK have at its disposal to stimulate growth? In line with many other central banks, the Bank of England is edging toward tightening measures, meaning that rate cuts or further quantitative easing are highly unlikely.
Given this, the next viable option would be to explore fiscal measures, such as arranging for the BoE to underwrite government debt. In other words, the government could fund major infrastructure programs such as the High Speed 2 rail link by issuing zero-coupon bonds directly to the central bank, which would pay for them with newly printed money. The BoE would likely promise never to sell the bonds or withdraw the money it created from circulation and, instead, create a permanent loss by expanding its liabilities without receiving an offsetting asset.
This would be helicopter money in all but name – and it could become reality in the UK if the economic aftershocks of Brexit are severe enough. But helicopter money carries its own risks, including uncontrolled inflation, political instability, and the erosion of central bank independence. Therefore, it would only likely be used as a last resort.
‘We remain cautious on gilts and sterling’
It is difficult to predict with confidence the likely direction of talks between the UK and the EU over Brexit – media reports tell a different story every day. What can be predicted with more confidence is that the UK economy will take a hit when the country leaves the EU, especially if this coincides with a global economic slowdown.
A transitional deal may ease the pain for businesses, but as things stand, it seems more likely that the UK will leave the EU with either a deal that provides the UK with significantly reduced access to the single market or, in the worst-case scenario, no deal at all.
We, therefore, remain defensively positioned in both gilts and sterling. Volatile price movements may mean that short-term buying opportunities may arise, but the possibility of a hard Brexit, and the headwinds to consumption it will create, means that the environment for UK investment is likely to be uncertain. Accordingly, it should pay to approach the UK with caution – while retaining the flexibility to buy into weakness when opportunities occur.
Quentin Fitzsimmons, portfolio manager of the T. Rowe Price Dynamic Global Bond Fund