UK Economic Outlook for Sterling as Brexit negotiations start

The weaker UK Services Purchasing Managers’ data for August, at a 11-month low, confirm the on-going slowdown in UK economic growth.

This follows similar falls in year on year growth in each of the first two quarters of 2017. However, this recent report on the largest segment of the UK economy still continues to indicate positive, albeit very modest, expansion. 

Conversely, manufacturing exports remain one bright spot in the UK economy, helped by a lower sterling exchange rate against the euro and, to a lesser extent, against a weak US dollar. UK manufacturing growth unexpectedly picked up between July and August bolstered by the strongest jump in export orders since the first quarter of 2012. UK manufactured exports have also benefitted from a recent upturn in the economic activity of its major export markets, namely the EU, North America and the Asia-Pacific region. 

With regards to domestic manufacturing activity, UK firms have been helped by an easing of input costs which are rising at the slowest pace in over a year; this would imply that last year’s inflationary effect of imported costs, as a direct result of the pound’s weakness, is now beginning to fade from year-on-year statistics.

Unlike manufacturing, construction has continued to decline over the course of this year. Economists believe that this steady decline in activity is down to a lack of confidence by companies to invest in new facilities until the outcome for Brexit is more certain. They also attribute the downturn to a significant fall in new government projects as well as new commercial builds. On a more positive note, residential building activity remains robust; perhaps not surprising given the ongoing shortage of affordable housing in most regions of the UK.

Retail sales have also remained fairly resilient, especially in the face of more expensive imports and negative real wage growth as earnings continue to trail a persistently high level of consumer price inflation. However, the average monthly volume of goods sold has decreased from 0.6% in the second quarter of 2017 to 0.3% in both June and July; this reflects recent data showing that real incomes declined by 0.3% as wages continued to fail to keep pace with inflation. Consumer confidence has also been steadily  weakening this year as shoppers change their spending habits to combat higher price inflation. This was particularly noticeable in the July retail sales report which posted the biggest jump in purchases of food items in almost two years.

Two areas of concern for the UK economy, as the Brexit negotiations look to begin in earnest, are the burgeoning budget deficit and the widening bias of the trade deficit. The increasing budget deficit, which has deteriorated markedly over the past couple of months, is likely to limit the scope for any easing of government austerity policies; as a result, ongoing budget deficits could provide a significant drag on GDP for the foreseeable future. Likewise, the recent fall in both the value and volume of exports (despite the fall in the value of sterling since last year’s referendum result) and the continuing rise in imports is likely to result in no perceptible narrowing of the trade deficit and, by implication, no positive contribution to UK GDP leading up to the Brexit deadline in 2019.

The Bank of England now has a difficult decision to make as regards setting an appropriate level of interest rates to account for a slowing economy with a persistently high level of cost price inflation already built in. Given that global growth is showing positive signs of modest acceleration and that domestic consumer price inflation has remained at 2.6% in both June and July, a 0.25% rise in the bank rate seems unwarranted at this juncture. I would prefer that the MPC continue to hold rates at current levels to see if the economy reacts positively to rising global growth during the remainder of this year. Similarly, I would want to see if consumer price inflation is likely to continue on a downward trajectory without having to risk adding to household costs or undermining already strained consumer confidence. In the absence of obvious stagflation, I think the MPC has time to watch and wait for the respective UK growth and inflation stories to unfold.   

Finally, where does the sterling exchange rate go from here? As with the level of domestic interest rates, the answer is likely to be data dependent. If the inflation, caused by sterling’s effective devaluation last year, were to subside / unwind as households and corporates continue to reduce their spending and economic growth were to uptick modestly, sterling could potentially strengthen against the US dollar and, more importantly, against the euro. However, should the present ‘softness’ in key areas of the UK economy continue and / or be combined with an unsatisfactory Brexit deal with the EU, sterling could potentially decline, perhaps to sub-$1.20 or 0.95 Euros, which could act as a brake on economic growth.


Please note, our Investment Commentary is our view of markets and does not constitute investment advice. Past performance is not necessarily an indication of future returns; the value of investments and any income from them is not guaranteed and can fall as well as rise. Overseas investments are affected by currency movements and exchange rates. If you would like investment advice on your individual circumstances, please do not hesitate to get in touch.

Found this useful?

Please feel free to share it with your contacts and friends through social media.