What does Brexit mean for the economy and the UK retail industry?

Uncertainty over the pace, breadth and scale of the Brexit impact could weigh on consumer confidence and the UK’s economic prospects for some time

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The result of the EU Referendum is clear. The implications that this will have on consumer spending, households’ disposable incomes, savings, confidence and the wider retail industry are not. Uncertainty over speed, breadth and magnitude of these changes are likely to weigh on our economic prospects and those of UK households for some time.

The focus on economic data and analysis has never been more important. In a period of heightened uncertainty, it will be critical for businesses to understand how the rapidly changing macroeconomic environment affects the retail industry as the repercussions of Brexit unfold.

In the short-run, households’ disposable incomes are unlikely to change significantly. It will take time for the knock-on effects of the vote to work their way through to the real economy in terms of jobs, higher inflation and lower economic output. Nevertheless, we expect elevated levels of uncertainty to lead to a sharp fall in consumer confidence which will trigger higher levels of saving as consumers rein in their spending.

At-A-Glance

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The near-term outlook for the UK and global economy have both weakened.

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A sharp fall in sterling will push up the price of imports which will inevitably feed through to elevated levels of inflation.

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Retailers should be prepared for further downside in sterling, rising cost of credit, possible disruptions in trade credit insurance (especially for mid-tier retailers) and weaker consumer and business confidence.

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In the immediate aftermath of the decision to leave the EU, households’ disposable incomes are unlikely to change significantly.



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Following the UK’s vote to leave the European Union (EU), we are entering uncharted territory with a prolonged period of heightened uncertainty expected.

The near-term outlook for the UK and global economy have both weakened. We have revised our forecast for UK GDP growth in 2016 from 1.9% to 1.4%, suggesting that there will be little growth in the second half of this year.

Our scenario analysis suggests the possibility of a recession – two consecutive quarters of negative growth – at just under a 50% chance.

A sharp fall in sterling will push up the price of imports which will inevitably feed through to elevated levels of inflation.

GDP

Source: Retail Economics

Retailers should be prepared for further downside in sterling, rising cost of credit, possible disruptions in trade credit insurance (especially for mid-tier retailers) and weaker consumer and business confidence.

When the Bank of England Governor, Mark Carney, addressed the result in a recent press conference, he stressed that the Bank “will not hesitate to take additional measures as required”. He referred to a potential £250bn of additional funds that could be provided through existing facilities to support the functioning of markets if needed.

Although the UK will remain inside the EU for at least two years while an exit is negotiated, considerable uncertainties are likely to persist, not least the unnerving political fallout unravelling for both the Conservative and Labour Parties.

A prolonged period of political and economic uncertainty is likely to ensue which will weaken business and consumer confidence - and ultimately spending.

In the financial markets, risky assets are clearly likely to suffer initially, however, the relief rally has been strong with the FTSE100 returning to pre-Brexit levels at time of writing.

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The main areas of short-term impact include:

Investment – Moody’s, Fitch and S&P, ratings agencies, have already downgraded the credit outlook of the UK to “negative”. This will deter foreign investment in the UK, push up the cost of borrowing, dent business investment in capex and jobs and choke-off confidence. Southeast Asia’s third largest bank has suspended loan applications for London properties as investors assess the uncertainties following the vote to leave the EU.

Sterling and inflation – The initial response from financial markets has been predictably negative, with the pound dropping by c.10%, to a 30-year low of $1.34, with some economists suggesting it could drop as far as $1.20. This will push up the cost of imports which will inevitably feed through to higher inflation. We expect inflation could reach 3% by this time next year. Although equities have proved much more resilient with markets regaining their lost ground, ending the most recent session above pre-Brexit levels, at time of writing.

Inflation

Source: Retail Economics

Monetary policy – The Bank of England’s Monetary Policy Committee is likely to look through the short-term inflationary consequences of the drop in the pound and either keep policy very loose for longer or loosen it further by cutting interest rates or expanding the quantitative easing programme. Markets are currently pricing in a 50% chance of an interest rate cut at the MPC’s meeting in July and a 77% chance of a cut by the end of the year.

Confidence – Expectations of weaker growth, uncertainty over trade agreements, the impact of weaker sterling, rising living costs, a fragile labour market and a slowing property market will all impact business and consumer confidence.

Sourcing – The sharp drop in sterling will have implications for practically all sectors in UK retail. The dollar rate is likely to impact non-food retailers to a greater extent given it is the trade currency of choice in the Far East, while food retailers are likely to be more sensitive to changes in the euro. Nevertheless, typical hedging strategies will ensure limited foreign exchange impact for the next 6-9 months which suggests inflationary pressure building in Spring 2017. Although, with shorter supply chains in food, inflationary impacts are likely to manifest over the next quarter.

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The political fall out

David Cameron has announced that he will be resigning and a new Prime Minister should be in place by the start of the Conservative Party Conference in October. He has said that it will be for the new Prime Minister to invoke Article 50.

We believe there is a realistic possibility of a general election as early as the autumn although early 2017 is more likely. Further, the prospect of another referendum in Scotland is growing in strength.

Meanwhile, George Osborne has reneged on his post-Brexit emergency budget.

During negotiations it is crucial for the retail industry that goods should be able to move freely and easily across borders and a clear regulatory framework should be defined. Food retailers require a simple framework in order to ensure demand can be met.

It is important to remember that it is in the hands of the UK Government to trigger Article 50 when it is ready to start negotiations. Even if the government was to serve notice to leave the EU today, the process of leaving will take a couple of years, during which time the UK remains a member and EU rules over free movement will continue to apply. In addition to goods traded with the EU, the Government will need to define the rules that will apply to goods traded with other countries.

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Outlook for UK Retail – Short-term impact

In the immediate aftermath of the decision to leave the EU, households’ disposable incomes are unlikely to change significantly. It will take time for the repercussions of the vote to work their way through to the real economy in terms of jobs, higher inflation and lower economic output. Nevertheless, we expect heightened uncertainty to lead to a sharp fall in consumer confidence which will trigger elevated levels of saving as consumers rein in their spending.

Indeed, our Consumer Attitudes Survey of c.2,000 respondents (conducted 24 hours after the EU Referendum result) revealed that 60% of consumers were concerned about the outlook for the UK economy and thought that Brexit would have a negative impact on their personal finances. Around half of consumers said that they were likely to save more in light of the result with 60% suggesting they would cut back on discretionary spending.

Consumer Confidence

Source: ONS, GfK

Importantly, there is a close correlation between consumer confidence and retail sales growth. The contraction in consumer confidence which ensued the financial crisis in 2008 was followed by a sharp rise in the savings rate and a subsequent fall in retail sales growth. This is not too dissimilar to conditions we are faced with today.

Household Savings

Source: ONS

Given that consumers have exhibited a higher degree of confidence over the last couple of years, the savings rate has returned to pre-crisis levels and unsecured borrowing is growing at its fastest rate for over 10 years. There is significant scope for both these measures to head in the opposite direction from their current elevated levels.

While it is impossible to accurately quantify the immediate impact on consumer spending, we expect the short-term impact will be considerable. Our research showed that the retail sectors most likely to be hit are electricals, DIY and clothing and footwear which are typically more income sensitive than other areas. Food and health and beauty will be more defensive.

Net lending to individuals

Source: Bank of England

Following the news that the UK has voted to leave the EU, please indicate the strength of your opinion on the following statement.

I think it will have a negative impact on my spending of non-essential items

Non-essential items

Source: Retail Economics. *sample size of 2,000

If you had to cut back on spending, which areas do you think you will cut back on the most

Cut back on spending

Source: Retail Economics. *sample size of 2,000

However, the overall impact of a slowdown in spending will be felt across the entire sector. In the coming months, there will be wider implications on households through pressures on disposable incomes, credit and borrowing, the performance of assets, savings, job security and long term confidence.

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Drivers of consumer spending

Drivers of consumer spending

Disposable income

Inflation is expected to gather pace in Spring 2017 as the impact of a weaker pound filters through supply chains. We forecast inflation to reach 3% by mid-2017.

The main short-term pressures will be on food prices, recreation and culture and transport given the shorter supply chains. A 10% drop in sterling equates to a c.3% rise in fuel prices.

Around 40% of food consumed in the UK is imported with around 27% from the EU.

The average household spends 11.1% of expenditure on food which rises to 16.0% for the least affluent households. Rising food prices will have a disproportionate effect on the least affluent households, eroding disposable income growth and dampening discretionary spending.

Expenditure by category

Source: ONS

Meanwhile, wage growth is expected to remain at modest levels and may even weaken as firms cut back on hiring and potentially reduce head count.

We estimate that even a modest rise in inflation across food, transport, recreation and culture and clothing and footwear would shrink disposable income growth to around 1.8% compared to our pre-Brexit forecast of 2.8% in the second half of 2016.

Another important component of disposable income growth are interest rates. As mentioned previously, in the short-term, we expect the Bank of England to look through the inflationary consequences of the drop in the pound and keep policy very loose with the markets currently pricing in a 50% chance of an interest rate cut at the MPC’s meeting in July and a 77% chance of a cut by the end of the year. However, should economic growth prove to be more resilient than we expect, higher inflation may force the Bank of England’s hand on a rate hike sooner than expected.

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Credit and borrowing

The UK has lost its top AAA credit rating from ratings agencies S&P, Fitch and Moody’s following the country's Brexit vote.

In theory, the cost of borrowing for governments on international markets will rise, pushing up interbank lending rates and ultimately the cost of loans and mortgages. The Treasury predicted a vote to leave would push up the cost of borrowing by 0.7-1.1% meaning mortgages would rise, on average, by £1,000 per year.

However, if a period of low growth ensues, the Bank of England could ease monetary policy further which would lower the cost of borrowing. This is more likely in the short-term but impossible to judge in the long-term.

Nevertheless, consumer confidence is a key driver of borrowing and so, irrespective of the cost, we expect growth of borrowing to slow sharply, especially for mortgages, as consumers hold-off purchases in expectations of a house price readjustment and greater certainty.

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Assets

The cost of mortgages, especially for first time buyers, is likely to rise given a more negative outlook for the economy will increase the risk profile of many borrowers.

The Treasury has estimated house prices could be hit by between 10% and 18% over the next two years, compared to where they otherwise would have been.

The National Association of Estate Agents (NAEA) believes house prices in London could see the biggest change, losing up to £7,500 on average over the next three years, compared to where they otherwise would have been.

Lower house prices, falling stock prices and shrinking pension pots will create a negative wealth effect which will damage confidence and spending.

A record $3tn was wiped off global equities in the two session that followed the decision to leave the EU. Although the FTSE100 has regained much of its lost ground, sterling remains considerably lower than pre-Brexit levels while the flight for safer assets has pushed down bond yields.

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Savings

Heightened uncertainty will cause many households to save a higher proportion of their income. Our Consumer Attitudes Survey showed that 50% of consumers will save more in light of Brexit.

Following the news that the UK has voted to leave the EU, please indicate the strength of your opinion on the following statement.

I am likely to save a higher proportion of my wages

Save wages

Source: Retail Economics. *sample size of 2,000

In the aftermath of the financial crisis in 2008, the household savings ratio peaked at 11.5% having risen from 4.3% before the recession. The ratio currently resides at a 5.9% and we expect it to rise sharply in the coming months.

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Confidence and job security

Our survey revealed three in five Britons are worried about the outlook for the UK economy and believe that Brexit will have a negative impact on their personal finances.

Following the news that the UK has voted to leave the EU, please indicate the strength of your opinion on the following statement.

I am concerned about the future of the UK economy and I feel this will have a negative impact on my personal finances

Personal finances

Source: Retail Economics. *sample size of 2,000

A further 58% said they would now hold back spending on non-essential items with our analysis suggesting that electricals and DIY would be the areas hardest hit.

With the consumer sector the driving force behind the economic recovery so far, it is difficult to see what can compensate should a more widespread slowdown materialise.

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Initial thoughts on long-term implications

While it is still too early to be sure of the wider long-term implications for the retail industry, we believe that there are four main areas which are worthy of consideration.

1. Sourcing

The impact of sterling’s sharp depreciation will be varied depending on the currency used for sourcing, the length of supply chains and hedging and contract strategies. With the majority of clothing and footwear imports originating from China, but increasingly from the Indian subcontinent, the relative strength of sterling versus the dollar is most important. We estimate that approximately 75% of the £25 billion worth of clothing and footwear imported into the UK in 2015 was sourced in dollars.

Total Non-Food Imports

Source: UK Trade Info/ Retail Economics analysis. Export – UK exports outside the EU. Dispatches – UK Exports within the EU. Imports – UK Imports from outside the EU. Arrivals – UK Imports from within the EU

On the contrary, around 40% of the food consumed in the UK is sourced internationally with approximately 27% coming from the EU. Hence, the euro exchange rate matters much more for food retailers. Given that food retailers work on much tighter profit margins than non-food retailers, the impact of rising sourcing costs is likely to be felt more quickly and to a greater extent.

Total Food Imports

Source: UK Trade Info/ Retail Economics analysis. Export – UK exports outside the EU. Dispatches – UK Exports within the EU. Imports – UK Imports from outside the EU. Arrivals – UK Imports from within the EU

Notwithstanding the sharp drop in sterling and the knock-on implications this will have on import costs, there is considerable uncertainty on what the UK’s terms of trade will look like following disentanglement from the EU.

2. Trade

When the UK joined the European Economic Community in 1973, just over 30% of UK exports went to the EU. By 2014, this had increased to 44%. For retail this is even higher, with 64% of exports dispatched to the EU.

The effects on trade are dependent on the renegotiation of trade agreements. If the UK were able to negotiate a Swiss style agreement, then free trade with EU states would still be possible, although the EU would still require funding and the free movement of labour would remain in place. This is unlikely, therefore, but if tariffs and quotas did remain broadly consistent with current levels then prices in the UK are unlikely to be impacted.

If the UK were to make a total break from the EU and use the WTO default, Most Favourable Nation (MFN) based approach, then imports from the EU would also be subject to MFN tariffs. The scale of the increase in prices would vary from product to product but it could be up to 11.5% for clothing as certain non-food products have high tariffs. However, it is likely to be even higher for food products though. Whether these costs will be passed on to consumers remains to be seen. Imports from outside the EU would be largely unaffected. The real opportunities would come from the UK’s ability to source food products, particularly, from outside the EU, and take advantage of not having to comply with EU regulation – for example, the possibility of sourcing more cost-effective Genetically Modified foods from the US.

Average MFN Tariffs

Source: WTO

3. Labour Costs

EU migrants became a key source of labour supply after the UK labour market opened to Eastern Europeans with the 2004 enlargement. Brexit would end the free movement of labour from the EU to the UK. People would still come into the UK, but without free access and permanent residency rights. All migrants would need a valid visa/work permit to work in the UK or stay for long periods. This would make it harder for many retailers to recruit, in particular, entry level jobs in major cities, particularly those who depend on large numbers of Eastern European staff in, typically, lower skilled positions.

In the long run, tighter controls on immigration will mean that the migrant labour pool will be less accessible and so push up labour costs. A reduction in the labour supply of people prepared to work at or near the statutory minimum wage may force retailers to increase their pay rates in order to attract the quality and number of staff required to run their businesses.

Nonetheless, the implementation of the National Living Wage has already put significant upward pressure on retail wages and so it is difficult to see how tighter immigration controls will apply incremental pressure on wages above and beyond their future trajectory.

Currently, wage bills are expected to rise by around 5% per annum until 2020 when they’ll reach c.£9 per hour. However, we think it is important to note that the future path of the National Living Wage was subject to “sustained economic growth” which is now clearly uncertain.

4. Population

Restrictions on immigration will almost certainly mean a slowdown in population growth in the UK. Over the last decade, the number of people living in the UK has grown by approximately 0.75% per year. This compared with growth of just 0.4% from 1995 to 2005. It seems a sensible assumption that the enlargement of the EU in 2004, which entitled more European citizens with the right to live in the UK, was a key driver behind population growth, amongst other factors.

UK Population

Source: ONS

Put simply, in due course, lower levels of immigration will slow the rate of growth of the UK population which will weaken growth prospects for the UK retail sector.