Jim Leaviss considers the economic implications of the UK's withdrawal from the EU, the formal process for which was set in motion this morning
UK Prime Minister Theresa May today set the UK on course to withdraw from the European Union (EU). The first set of negotiations will focus on the UK's exit from the EU, with items to be negotiated including the UK's outstanding financial commitments to the EU, the rights of EU and UK citizens in the UK and EU respectively, and border issues.
The second set of negotiations have been dubbed the "future relationship" deal, which will cover a wide range of areas, including the UK's access to the European Single Market, regulatory standards and dispute settlement mechanisms. This will be the deal that will be the area of focus for financial markets. There is also the possibility of a new referendum on Scotland's place in the UK as a further source of economic uncertainty.
The long-term impact of Brexit will depend on trading relationships. Higher trade barriers, if implemented, will impact growth and productivity. Much, however, will depend on how the negotiations will progress over the next two years, and it is simply too early to speculate on what the impact might be in financial markets.
Clearly the best scenario would be a civilised divorce, where negotiations are constructive and low-key, thereby minimising any potential impact on demand. Any signs of an acrimonious divorce, however, with a hardening in rhetoric on both sides, would likely result in a deeper impact on demand and possibly a recession.
In this scenario, monetary policy would likely remain highly stimulatory, with the possibility of another round of quantitative easing, while the UK government may also seek to stimulate the economy through loosening the fiscal reins.
Unwinding EU membership is unprecedented and the economic implications are highly uncertain. Given this uncertainty, consumers and businesses are likely to be cautious about the future economic outlook as well. Given the UK has access to the single market until 2019, however, businesses will likely react by stockpiling inventories in anticipation of the UK possibly having to trade under WTO rules after being removed from the EU.
Short-term economic boost
Additionally, consumers may bring forward consumption before tariffs are potentially placed on imports coming into the UK. Consequently, short-term economic growth may be boosted over the course of the next 12 to 18 months, provided real incomes are not squeezed too much by rising inflation and stagnant wage growth.
Last month we saw UK inflation rise above the Bank of England's inflation target for the first time since 2013, in part because of the impact of sterling's significant fall since the Brexit vote on import prices.
The uncertainty the Brexit negotiations are likely to bring to hiring and investment intentions in the short term could mean the UK central bank's Monetary Policy Committee faces difficult decisions - does it hike rates to bring inflation down and cool consumption, or will it worry more about weaker underlying growth and investment?
It feels as if the Bank of England will tolerate an inflation overshoot for some time, rather than risk a monetary tightening - especially given its ongoing pessimism about the impact of the UK leaving the EU.
Jim Leaviss is head of retail fixed interest at M&G Investments
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