Uncertainty filters into UK economy as nation holds its breath

As 23 June, the date of the UK's upcoming referendum on EU membership, nears, the attendant debate has intensified and fractured into two broad camps.

Those that want to 'Leave' argue the UK would have a stronger economy, and retain more national sovereignty outside of the EU. Those in the 'Remain' camp say trade with the EU makes the UK much stronger economically, and its voice within the Union makes it much more politically important. Although many have chosen their respective side, the Institute of Directors (IoD) remains neutral in the discussion: 63% of IoD members wish to remain in the EU, but 50% think that the UK could be economically successful outside of it.

Much of the debate has focused on the economic implications of a possible Brexit, with the Leave side arguing that, although there would probably be a short-term negative shock, outside of the EU the UK would be best placed to strike trade deals with the rest of the world, notably the US, India, Australia and Canada (although some, like the US, have mentioned that the UK would be at the 'back of the queue'). They also argue that a Brexit would also reduce EU-inspired regulation and save the UK the roughly £150 million (the Vote Leave website inaccurately says £350 million) net contribution sent to Brussels every week in the form the UK's contribution to the EU Budget as a price of membership (the lowest of any EU member as a proportion of the economy). The Remain side has focused much more on the economic costs of Brexit, highlighting the negative forecasts from the IMF, the Bank of England (BoE), the UK's Treasury and the OECD, all of which say that in the short- and long-term, the UK will be economically worse off, albeit to differing degrees.

As ever, the future is a bit tricky to predict, and the Vote Leave campaign's seeming lack of a detailed plan about the UK's future relationship with the EU is not making it any easier: various relationships have been discussed and then rescinded, notably the Norwegian model (so-called fax machine diplomacy), the Swiss model (a series of bilateral trade agreements that require free movement of people, among other things), the Albanian model (which liberalises trade in goods but not services), and WTO membership (which would see tariffs and 'rules of origin' principles re-imposed).

This does not even factor in the EU side of the negotiations where there is potential for at least one of 27 member states to not be disposed to express kindness to a departing member. That being said, given the sheer number of arrangements, it is possible that a new 'British' model may be developed, although what this may look like is anyone's guess (especially if there is a new British government in the wake of the 23 June vote). [fold]

The IoD will not be wading into the relationship prediction game, but we note that referendum-prompted uncertainty about the future has begun to filter into the UK's economy. The BoE recently revised down growth expectations and several recent statistical releases from the Office for National Statistics have shown how uncertainty has begun to feed into the economy.

Firms have begun to hold off on increasing future employment (vacancies shrank by 2.4% in the first three months of 2016, the largest fall since 2011), and businesses have stopped investments in further capital expansions: business investment decreased 1.1% in the last quarter of 2015 when the EU referendum was certain but its date was not. The manufacturing sector helps to highlight how uncertainty is affecting business decisions because its time horizons are longer and its sunk costs higher. When uncertainty prevails, manufacturing firms are usually the first to signal a slowdown. Output in the sector shrank by 1.9% in the first three months of 2016 compared to the year prior.

At the moment, the UK's service sector, which makes up 80% of economic output and 83% of the labour force, remains stable. Employment grew by 64,000 over the past three months and wages increased by 1.9% over the same period last year. The percentage of part-time employees that want full-time work is near a post-crisis low of 14.3%, almost a quarter lower than its high of 18.4% a little over three years ago. The economy's stability is likely due to its labour market's flexibility. Firms can shed employment during downturns relatively easily, so it makes sense to maintain employment until a downturn is certain (rehiring and retraining new workers can get a bit pricey).

If, however, uncertainty spreads or a slump takes hold, the downturn could be quick and severe. Consumers have already started holding off on purchases of high-cost goods: prices of furniture fell by 2.5% compared to the month before (although they had grown by 1% on average over the past 10 months), major household appliances saw a fall of 2% after six months of continuous growth, and the purchases of new cars grew by 0.3% compared to an average growth rate of 1.6% over the previous eight months. The same pattern was seen during the build up to the 2015 general election.

The last three years of the economic recovery have been notably labour intensive which, although causing record high levels of employment and low levels of unemployment, has also led to lower investment in capital such as computers, both of which have dampened the UK's productivity and nominal wage growth. The latter has averaged under 2% growth over the past two years. Disposable income growth has been low, too, increasing at a quarterly average rate of 1.1% over the past 8 years, contributing to a saving rate below 4%.

This should be coupled with the fact that two of the three main sectors of recent employment growth are counter-cyclical: restaurants and pubs and the creative industries have 4% more employees this year compared to last. These sectors tend to be volatile, not particularly well paying, and have predominantly young staff. If there is a downturn, they will likely be the first sectors to shed employment. This can have tricky consequences for individuals, particularly 'generation rent', the young who are usually the first to be let go during economic downturns. They tend to live in big cities like London, where asset bubbles and other factors have increased rent levels by large amounts but where high levels of employment have led to lower levels of wage growth and higher levels of debt. They might be the first to feel the pinch of prolonged uncertainty (if not already).

The UK's economic recovery, while strong, remains fragile. Employment is high, but wage growth is low. Personal debt is high, but employment is becoming more secure. Consumption remains high, but expensive purchases are being delayed. While the UK collectively holds its breath over the next month, the referendum has, it seems, already started to exert an effect. How this feeds into the eventual outcome remains (or is left) to be seen.

Photo by Leon Neal - WPA Pool/Getty Images

Michael Martins