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As Brexit uncertainty fades, how will the UK economy fare in 2021?

Market update
Brexit
Jonathan Sparks
UK economy

As Brexit uncertainty fades, how will the UK economy fare in 2021?

Jan 18, 2021

What does the last-minute Brexit deal mean for the UK economy and how will that and other factors impact investment strategies in 2021?

Trade negotiations between the UK and the EU went down to the wire, but an agreement was finally reached on Christmas Eve. Whilst still a fairly hard Brexit, there are some important wins around tariff-free trade, rules of origin and no dynamic alignment, which pave the way for further liberalisation.

What does it mean for the UK economy? Liz Martins, Senior UK Economist at HSBC, explains more: "Our central case has always been that there would be a Brexit trade deal, so our forecast of 4.3 per cent growth in UK GDP in 2021 remains the same. Although that looks good on the surface, against a fall of 11 per cent in GDP in 2020, it suggests a pretty lacklustre recovery."

With rates so low, the cost of servicing debt is also low so there’s no real pressure on government. Even the IMF is warning against premature tightening.

A mixed picture

Explaining the reasons for a forecast somewhat lower than others have predicted, including the Bank of England (7.25 per cent), Liz points to a number of factors. "While there is good news – in terms of reaching a Brexit deal, the vaccination programme and increased household savings – the bad news is coming thick and fast. COVID-19 case numbers are rapidly rising, a national lockdown is in force, there's new potential political risk with a resurgence in calls for Scottish independence. Brexit has also created trade friction despite the deal."

On this latter point, Liz describes the paradox of the UK/EU agreement which, despite going further than many other deals that liberalise trade, has actually introduced frictions and still leaves uncertainty, for example around financial services and future plans to address equivalence. "Its effect on growth is hard to quantify," she says, "but we forecast that UK GDP at the end of 2022 will be 5.4 per cent lower that it was at the end of Q4 2019. That compares to just 2 per cent in our Eurozone forecasts, so 3.4 per cent as a Brexit hit."

Factors playing on the economy

More broadly, Liz explains that there are expectations of a further EUR100bn of quantitative easing to come through in May as part of a tapered easing of stimulus. "Our central case is that interest rates will remain on hold at 0.1 per cent, though if things get worse, then we could see a cut to 0 per cent and even beyond into negative territory," she adds. 

Forecasting other economic indicators, the housing market and retail sales are holding up well and the latest PMI shows a resilient manufacturing sector. 

"We see unemployment peaking at 6.7 per cent in Q2 before beginning to fall – which is a lot better than it might otherwise have been thanks to the level and extent of government support," Liz continues. 

The scale of support, however, has seen government debt levels rising to 100 per cent of GDP, with questions over how that debt is repaid. Liz points out that moves to address it are unlikely in the short-term due to the risk of quashing early signs of recovery. "With rates so low, the cost of servicing that debt is also low so there's no real pressure on government. Even the IMF is warning against premature tightening. So, we're unlikely to see any significant moves in the March Budget, for instance. The Conservatives are also, of course, committed not to increase income tax, VAT or national insurance, and I think it's unlikely we'll see taxation on areas that might impede recovery, like household spending, or corporation tax. There may be some tinkering around wealth, capital gains, property, the pension sector, but with an eye on potential impact on capital inflows and inward investment."

Whilst a meaningful rise in inflation isn't included in our central case, Liz says that there are inflationary pressures to be aware of. "One of the ways to get out of a spiralling debt situation is to inflate your way out. A crisis that hits supply, production and productivity is also potentially inflationary, so despite not being included, it's something we should all have on our radars."

Impact on investment strategy

From an investment strategy viewpoint, Jonathan Sparks, Chief Market Strategist, UK & CI, HSBC Private Banking, says that these barriers to trade and the economic headwinds are weighing heavily on sterling, although some weakness in the US dollar has seen our previous forecast of sterling against the dollar of 1.25 revised up to 1.34 for the year.

Feeding that through to our investment strategy, we see a reduction in volatility – less political risk compared to no deal and a more stable outlook for currency. "Looking at the fundamentals, at valuations in particular, there's a clear differential that's opened up between UK equities and global equities," says Jonathan. "The FTSE 100 is cheaper than the rest of the world and our preference for that over the FTSE 250 is because these companies are more tied to a global recovery; so we've got more of a rebound globally that we're playing alongside some selective cyclicality.

"As a result, we have recently moved from being neutral on the advisory proposition to being overweight on the equity side."

From a sector perspective, Jonathan says there's a clear preference for the industrial and materials sectors with manufacturing recovery clearer than that of domestic services, for example. In global recovery terms, meanwhile, Jonathan points to Asia. "We are marking a preference for Asia, particularly China, where growth of 8.5 per cent is forecast this year, against  2.3 per cent in 2020."

Clearly the New Year has brought some degree of certainty – an agreement reached between the UK and the EU and confirmation of Biden's presidency. However, there are strong headwinds facing many of the world's economies, not least as the COVID-19 pandemic continues to play out. The key this year is cautious optimism as we see some economic indicators displaying remarkable resilience and the recovery gather pace, especially in countries such as China.

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