Four years after the June 2016 referendum, the U.K. finally struck a deal to exit the European Union (EU). Despite all the attention, controversy, and volatility that Brexit has brought, we don’t expect any meaningful effects on near-term economic activity. Firms are generally well prepared and the government has already rolled over most non-EU trade deals. And while there may be some temporary frictions at the border, they pale in comparison to the near-term uncertainty around the economic effects of COVID-19 and the speed of the vaccination distribution.
Productivity is key
In the long term, Brexit certainly raises many questions, but most areas of the economy will likely be largely unaffected. Labour supply is one example. While the U.K. will now control its own border, it is far from clear whether Brexit will lower net migration. Since the referendum, net inward migration has been mostly unchanged – lower EU migration has been offset by higher non-EU migration – and we see no strong reason for that to change going forward.
One key uncertainty is productivity. It is possible the new trading relationship lowers productivity growth at the margin, with more barriers to trade diluting the benefits from specialising in areas of comparable advantage. This will in part depend on the precise nature of the future U.K.–EU relationship. Negotiations will continue in coming years, especially on services, which were not part of the 31 December 2020 deal and account for the bulk of the U.K. economy. While these discussions may lead to some divergence between the two regions, in our baseline outlook we expect few differences in regulatory frameworks and frictions to services trade. Significant change in trade in services is a key risk, but frictions aside, we do not expect anything too radical.
Putting Brexit in context, however, there are much bigger questions around future productivity growth, which has been on a secular decline in the U.K. for many decades. While this has been a global phenomenon, the slowdown has been particularly pronounced in Britain since the 2008–2009 financial crisis. There are many possible drivers – measurement error, diminishing returns to innovation, scarring from the financial crisis, and anti-competitive regulation, to name a few. There are reasons to believe productivity will pick up in coming years as new technology improves efficiency. But other factors, including potential scarring effects from COVID-19, could depress productivity further. The impact of Brexit on productivity is likely marginal relative to these bigger questions.
As highlighted in our recent Cyclical Outlook, we expect global output and demand to rebound strongly this year. For the U.K., following a stop-and-go winter and early spring, we expect economic activity to accelerate from the second quarter of 2021 onwards, driven by broadening rollout of vaccines and continued fiscal and monetary support. Activity, however, is unlikely to return to its pre-pandemic peak until 2022.
Brexit presents a few risks to that outlook. As mentioned above, one would be a “services trade war” in future negotiations between the U.K. and EU, leading to more significant barriers to trade. Another risk is political, with Brexit potentially increasing nationalist pressures in Scotland. For now, we see both of these risks as contained.
Fiscal policy is a key swing factor. So far, it has been a crucial automatic stabiliser during the pandemic, backstopped by monetary support from the Bank of England. We still see some upside potential for fiscal policy to continue to stimulate the U.K. economy in coming years – maybe more so than in the rest of Europe but less so than in the U.S. – as the government returns to infrastructure investments and other projects designed to benefit the northern Conservative constituencies. While there are some tentative signs of fiscal fatigue following the large fiscal cost of the emergency pandemic-related support measures, we think the U.K. is unlikely to return to the austerity measures introduced after the 2008–2009 financial crisis.
Far from the major market swings seen right after the 2016 referendum, we have seen only a moderate repricing of assets following the exit deal. While most of the Brexit risk premia is now largely gone, we still see a few pockets of opportunities.
We continue to favour housing-related exposures, including U.K. residential mortgage-backed securities (RMBS), and U.K. banks, which have strengthened their balance sheets over the past few years. We also think there is some medium-term upside for sterling to strengthen further. On duration, we expect a fairly range-bound environment for U.K. government yields over the next few years. More broadly, non-Brexit-related issues such as the COVID-19 recovery, fiscal policy, productivity performance, and the global market backdrop will be more important for markets and investors than any ongoing discussion on Brexit counterfactuals.
For further insights on the global outlook and implications for investors, please read our January 2021 Cyclical Outlook, “Bounded Optimism on the Global Economy.”
Peder Beck-Friis is a portfolio manager focusing on global macroeconomic trends, and Ketish Pothalingam is a portfolio manager focusing on U.K. credit. They are regular contributors to the PIMCO Blog.