Economics Group. The U.K. Economic Outlook: What About Brexit Uncertainty? Special Commentary. January 26, 2018

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1 Economics Group Special Commentary Jay H. Bryson, Global Economist (704) Abigail Kinnaman, Economic Analyst (704) The U.K. Economic Outlook: What About Brexit Uncertainty? Executive Summary The British economy expanded only modestly in Q4, with real GDP rising 1.5 percent year over year. While overall production increased in the quarter with growth across multiple sectors, real personal consumption expenditures (PCE) and investment spending have remained depressed over the past year in the wake of the Brexit Referendum in In this report, we examine the uncertainties surrounding Brexit negotiations and our outlook for The sharp depreciation of sterling after Brexit led to a rise in inflation that subsequently eroded income growth and led to a drag on consumer spending. Growth in investment spending also slowed over the past year as Brexit uncertainties likely cautioned more expansionary business decisions. While there are still unknowns surrounding Brexit negotiations, the British economy looks poised to regain its momentum over the coming year. A pullback in inflation and strengthening real PCE growth, along with strengthening investment intentions, should be supportive of overall GDP growth. While the Bank of England (BoE) will likely remain on hold in the coming months in the midst of only slowly improving growth and softer inflation, our currency strategy team looks for the value of sterling to increase modestly against the dollar over the coming year amid general greenback weakness. We look for the U.K. economy to slowly return to growth rates closer to 2 percent over the coming quarters. U.K. Economy Expands Modestly in Q4 Preliminary data that were released today showed that real GDP in the United Kingdom rose 0.5 percent (2.0 percent on an annualized basis) in Q relative to the previous quarter (Figure 1). Figure 1 Figure 2 U.K. Real GDP Bars = Compound Annual Rate Line = Yr/Yr % Change Contributions to U.K. GDP Growth Net Exports: 1.9% Government: 0. Inventories: -0. Investment: 0. PCE: 0. GDP: 1. We examine the uncertainties surrounding Brexit negotiations and our outlook for Preliminary data that were released today showed that real GDP in the United Kingdom rose 0.5 percent in Q Compound Annual Rate: 2. : Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul Source: IHS Global Insight and Wells Fargo Securities This report is available on wellsfargo.com/economics and on Bloomberg WFRE.

2 The British economy expanded 1.8 percent in 2017, slightly below the 1.9 percent rate registered in Real GDP growth in the United Kingdom has downshifted over the past few quarters. While the quarterly growth rate came in slightly above consensus, on a year-ago basis real GDP grew 1.5 percent, which was below the 1.7 percent Q3 print. The British economy expanded 1.8 percent in 2017, slightly below the 1.9 percent rate registered in A breakdown of the GDP data into its underlying demand components is not available at this time. However, industry-level data included in today s release showed modest expansion in the service sector, up 0.6 percent for the quarter. On the production side, total production was up a solid 0.6 percent for the quarter, led by the manufacturing sector, up 1.3 percent. The construction and mining sectors were a drag on growth in the quarter, down 1.0 percent and 3.9 percent respectively. While we do not have demand side data at this time, personal consumption as measured by real retail sales has remained lackluster over the past year. Average monthly growth in real retail sales slowed in 2017 to around 2 percent year over year, compared to almost 5 percent in As we discuss in more detail below, the aftermath of Brexit saw a slowdown in overall consumer spending as rising inflation eroded purchasing power. However, inflation is starting to recede, which should lift purchasing power and thereby support growth in personal consumption expenditures in the coming quarters. A disaggregation of the Q4 GDP data into its underlying demand components will be available on February 22. The Shock from Brexit is Starting to Fade As Figure 1 makes clear, real GDP growth in the United Kingdom has downshifted over the past few quarters. Figure 2, which plots the contributions to the overall rate of GDP growth from individual demand components, shows that much of the deceleration in the British economy over the past few quarters stems from slower growth in real personal consumption expenditures (PCE). At the same time, net exports (NX) have helped to shore up the overall rate of GDP growth. These changing fortunes in two demand components of GDP reflect the same catalyst, namely, the sharp depreciation of the British pound in the immediate aftermath of the Brexit referendum in Figure 3 Figure 4 4. Trade Weighted Pound and Inflation U.K. PCE Indicators Core CPI: 2. (Left Axis) Trade Weighted GBP: 1.9% (Right Axis, Inverted) Real PCE: 1. Real Disposable Income: Growth in real disposable income weakened over the course of Source: IHS Global Insight, Bloomberg LP and Wells Fargo Securities As shown in Figure 3, the trade-weighted value of sterling was down nearly 20 percent on a yearago basis in October This sharp depreciation in the value of the British pound has helped to lift U.K. export growth in recent quarters. But by raising import prices, sterling depreciation also contributed to the marked increase in the CPI inflation rate. Because there has been little acceleration in wages, higher inflation eroded growth in real disposable income (i.e., purchasing power). As shown in Figure 4, growth in real disposable income, which has a fair degree of correlation with growth in real consumer spending, weakened over the course of But the dynamics that led to a deceleration in consumer spending are starting to reverse. The trade-weighted value of sterling is now more or less flat on a year-ago basis. Consequently, the inflationary impulses that hit the economy via rising import prices are starting to weaken. 2

3 Therefore, CPI inflation should recede in coming months, which should lead to stronger growth in real disposable income and some re-acceleration in consumer spending. Growth in investment spending also slowed in As shown in Figure 5, gross fixed capital formation (GFCF) grew nearly 6 percent on a year-ago basis in Q1-2017, but growth had slowed to about 2 percent by Q Drilling down into the components of GFCF shows that the slowdown was broad-based. Not only did growth in investment spending by the business sector downshift, but public sector investment declined on a year-ago basis in Q Other investment (largely residential investment) also decelerated over the course of But there is some room for optimism going forward. A survey of investment intentions, which has a fair degree of correlation with growth in actual investment spending, edged higher in the fourth quarter (Figure 6). Figure 5 Figure 6 Contributions to U.K. Investment by Sector U.K. Investment Indicators ; Index Investment: 2. (Left Axis) Investment Intentions Index: 1. (Right Axis) Growth in investment spending also slowed in Other: 1. Government: -0. Business: 1. Total: 2. Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul Source: IHS Global Insight and Wells Fargo Securities But Brexit Remains the Elephant in the Room Our forecast looks for the year-over-year rate of real GDP growth in the United Kingdom to pick up from 1.5 percent in Q back toward 2 percent by the end of 2019 (Figure 7). This forecast is predicated on the assumption that uncertainties related to Brexit do not weigh unduly on investment spending decisions. Prime Minister May s decision last year to trigger Article 50 of the Treaty on European Union means that the United Kingdom will formally leave the European Union on March 29, Some of the uncertainty related to Brexit was cleared up in December when U.K. and EU negotiators agreed to the terms of their divorce. 1 It is also likely that the arrangements that currently govern economic and financial transactions between the United Kingdom and the rest of the European Union will remain in place for about two years after March So negotiators will likely have between now and March 2021 to come up with a new framework for their economic and financial transactions. Some of the uncertainty related to Brexit was cleared up in December when U.K. and EU negotiators agreed to the terms of their divorce. 1 The two sides agreed on three terms of their divorce. First, the United Kingdom will continue to pay its commitments to the EU budget in 2019 and 2020 and any contingent liabilities it has accrued. Second, the United Kingdom and the European Union will continue to respect the rights of each other s citizens living in their respective countries. Third, there is to be no hard border between the Republic of Ireland, which is part of the European Union, and Northern Ireland, which is part of the United Kingdom. 3

4 Figure 7 U.K. Real GDP Bars = Compound Annual Rate Line = Yr/Yr % Change Forecast % Compound Annual Rate: 2. : % -1 The risk of an investment-led recession in the United Kingdom in coming quarters is not insignificant. Source: IHS Global Insight and Wells Fargo Securities But there still is significant uncertainty regarding those arrangements. Will trade in goods and services between the United Kingdom and the rest of the European Union remain tariff-free or will tariffs or other trade restrictions be placed on those goods and services? Will the United Kingdom maintain its passport, which allows British financial institutions to freely offer financial products and services in the rest of the European Union? Nobody knows the answer to these and myriad other questions at this time. We are hopeful that this uncertainty will not cause businesses to shelve investment spending plans in the United Kingdom until the uncertainty is cleared up, but we acknowledge the risk that they could. Although it is not our base-case view, the risk of an investment-led recession in the United Kingdom in coming quarters is not insignificant. Bank of England Likely Will Remain on Hold in Coming Months The Bank of England is also mindful of the downside risks posed to the British economy from Brexit uncertainty. In its most recent policy statement the Monetary Policy Committee (MPC) explicitly stated that developments regarding the United Kingdom s withdrawal from the European Union and in particular the reaction of households, businesses and asset prices to them remain the most significant influence on, and source of uncertainty about, the economic outlook. Figure 8 Bank of England Policy Rate Figure U.K. Exchange Rate USD per GBP 2.20 Bank of England: The MPC judged in October 2017 that its insurance rate cut was no longer needed Source: Bloomberg LP, IHS Global Insight and Wells Fargo Securities USD per GBP: The uncertainty that spiked in the immediate aftermath of the Brexit referendum led the MPC to cut its main policy rate by 25 bps in August 2016 (Figure 8). Although the economy decelerated, it did not slip into recession as some had feared immediately after the referendum. Consequently, the MPC judged in October 2017 that its insurance rate cut was no longer needed, and it 4

5 returned its Bank Rate to 0.50 percent where it remains today. In our view, growth will remain slow enough over the next few quarters to keep the MPC on hold. By the end of the year, however, real GDP growth should be showing signs of strengthening anew. We forecast that the MPC will tighten by 25 bps in Q4-2018, and we look for two more 25 bps rate hikes over the course of As shown in Figure 9, the British pound rose about 10 percent on balance in 2017 vis-à-vis the U.S. dollar following its marked decline from 2014 through Looking forward, Wells Fargo s currency strategy team expects that sterling will continue to trend slowly higher against the greenback in the context of broad-based dollar weakness. That said, our strategists look for the British pound to weaken modestly versus the euro in coming quarters. Conclusion Real GDP in the United Kingdom rose 1.5 percent in Q4 year over year, led by a solid increase in overall production, yet likely only modest growth in consumer spending. In the wake of the Brexit referendum in 2016, sterling depreciation and subsequent increases in inflation led to a pullback in real PCE and investment spending over the past year. However, the slowdown is likely starting to reverse as inflation begins to recede, wage growth slowly begins to pick up and investment intentions strengthen. A relatively stable trade-weighted value of sterling should also support a softening in inflation. In the midst of an improving outlook, Brexit negotiations still present uncertainties for the British economy, as the U.K. and European Union must determine the future of economic and financial relationships currently in place. The BoE will also likely maintain a cautious approach to tightening policy as Brexit negotiations continue, inflation slows and growth gradually picks up. Our currency strategy team looks for the value of sterling to gradually appreciate against the dollar in the coming quarters in the midst of general greenback weakness. We look for the British economy to return to growth rates closer to 2 percent by the end of 2019, assuming Brexit negotiations do not reverse the gradual improvement in consumer and investment spending in the meantime. Wells Fargo s currency strategy team expects that sterling will continue to trend slowly higher against the greenback. We look for the British economy to return to growth rates closer to 2 percent by the end of

6 Wells Fargo Securities Economics Group Diane Schumaker-Krieg Global Head of Research, Economics & Strategy (704) (212) John E. Silvia, Ph.D. Chief Economist (704) Mark Vitner Senior Economist (704) Jay H. Bryson, Ph.D. Global Economist (704) Sam Bullard Senior Economist (704) Nick Bennenbroek Currency Strategist (212) Eugenio J. Alemán, Ph.D. Senior Economist (704) Azhar Iqbal Econometrician (704) Tim Quinlan Senior Economist (704) Eric Viloria, CFA Currency Strategist (212) Sarah House Economist (704) Michael A. Brown Economist (704) Jamie Feik Economist (704) Erik Nelson Currency Strategist (212) Michael Pugliese Economic Analyst (704) Harry Pershing Economic Analyst (704) Hank Carmichael Economic Analyst (704) Ariana Vaisey Economic Analyst (704) Abigail Kinnaman Economic Analyst (704) Shannon Seery Economic Analyst (704) Donna LaFleur Executive Assistant (704) Dawne Howes Administrative Assistant (704) Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A., Wells Fargo Clearing Services, LLC, Wells Fargo Securities International Limited, Wells Fargo Securities Asia Limited and Wells Fargo Securities (Japan) Co. Limited. Wells Fargo Securities, LLC. is registered with the Commodities Futures Trading Commission as a futures commission merchant and is a member in good standing of the National Futures Association. Wells Fargo Bank, N.A. is registered with the Commodities Futures Trading Commission as a swap dealer and is a member in good standing of the National Futures Association. Wells Fargo Securities, LLC. and Wells Fargo Bank, N.A. are generally engaged in the trading of futures and derivative products, any of which may be discussed within this publication. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm which includes, but is not limited to investment banking revenue. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company 2018 Wells Fargo Securities, LLC. Important Information for Non-U.S. Recipients For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ("WFSIL"). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. The content of this report has been approved by WFSIL a regulated person under the Act. For purposes of the U.K. Financial Conduct Authority s rules, this report constitutes impartial investment research. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. This document and any other materials accompanying this document (collectively, the "Materials") are provided for general informational purposes only. SECURITIES: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE