Recent economic data have shown further weakness in manufacturing sectors in most of the major economies, including Germany where growth is now negative. Amid this generally sluggish global backdrop, one big advanced economy looks in more danger of recession than most others. That country is the UK, where economic activity data have been plummeting as the next Brexit deadline approaches on October 31.
According to the latest Fulcrum nowcasts, UK activity growth has fallen to minus 0.8 per cent, compared with plus 1.0 per cent as recently as mid May (see box). Since then, economic data have revealed downward steps in the annualised growth rate on five successive occasions.
As in other countries, some of these drops have come from the industrial sector, with business surveys and official industrial production releases both contributing towards significant declines in estimated activity growth. However, two Brexit-related developments have hit UK industry particularly hard.
First, business sector investment in equipment and new building has strongly underperformed in Britain since the EU referendum result. Mark Carney, governor of the Bank of England, last week said UK investment has fallen about 12 per cent below the path that would have been expected from previous UK cyclical behaviour, and from the experience in other economies since 2016. This gap may continue to widen as Brexit uncertainties persist.
Second, there was an increase in precautionary stockbuilding ahead of the first Brexit deadline on March 29, and some of these stocks have probably been shed by cutting output subsequently. There was also a temporary hit to industrial production data for May as car factories brought forward their closures for annual maintenance.
It is unclear how far these “temporary” Brexit-related factors will unwind before the end of October, but there seems little doubt that the industrial sector has already travelled into recession.
What about the rest of the economy?
Here the evidence is less clear cut but is becoming more concerning. According to the nowcast model, the past two CBI distributive surveys have both contributed towards large downgrades to estimated activity growth. The most recent services purchasing managers’ index for June fell to a level just above stagnation in that sector.
Furthermore, the June PMI for construction was exceptionally weak, taking the economy-wide composite PMI for June down to 49.2, compared with 50.7 in May. This signalled the first contraction in activity for the private business sector since the temporary collapse in business sentiment that followed the Brexit referendum in June 2016.
The one bright spot amid all this gloom is the buoyant state of the labour market. The unemployment rate is at cyclical lows and official data for employment growth remain robust.
This resilience in hiring new employees may seem surprising, given the extent of the contraction in business investment.
The explanation is probably that businesses believe it is less difficult to reverse mistaken decisions on hiring new staff than it is to unwind expensive long-term capital investment plans. But if the conditions continue to deteriorate with contractionary trade and Brexit shocks, the effect on employment could be seen quickly.
The policy response
UK policymakers have not yet fully adjusted to the recent deterioration in economic activity. As recently as May 2, the Bank of England’s Monetary Policy Committee maintained its warning that, assuming a “smooth Brexit”, policy would be tightened at a gradual pace and to a limited extent in coming years. At its next meeting on June 20, the MPC recognised that downside risks from global trade policy and Brexit had increased, but still said that “the monetary policy response to Brexit, whatever form it takes, will not be automatic and could be in either direction”.
Mr Carney in his speech last week maintained this broad stance, but appeared to shift slightly in a dovish direction, admitting that there had been a “sea change” in global trade and Brexit risks. That is a significant choice of words for a cautious central banker.
He added that the decline in market interest rates was “unsurprising”, since investors place a significant weight on the probability of a no-deal Brexit. In that event, he said, the BoE would support the economy’s transition “as much as possible”. Finally, he said that precautionary “insurance” cuts in interest rates may be warranted “in some jurisdictions”, though he suggested that the UK may not be the first among them.
The market has now decided that the chance of an insurance cut in UK rates in 2019 is above 50 per cent. Even in the case of a smooth Brexit, that would be a wise move, in view of the danger that the likely mild recession could develop into a more painful breakdown in the labour market.
That leaves the extremely worrying possibility of a disruptive — as distinct from a planned — no-deal Brexit. Mr Carney hinted last week that fiscal policy would then be needed to support the economy. The UK chancellor Philip Hammond thinks this eventuality will be blocked by parliament. But he warned that if it happened, inflation and the budget deficit would both rise substantially, making any policy response extremely problematic. That seems a fair assessment.
