How might the UK economy react to different Brexit scenarios?

The 31 October deadline for the UK to leave the European Union is fast approaching. However, parliament recently passed the Benn Act, which forces the prime minister to seek a three-month extension if he cannot get a Brexit deal agreed by 19 October.

This in theory means that leaving with no deal is no longer an option. But Prime Minister Boris Johnson had previously said in a speech on 5 September that he would rather be “dead in a ditch” than ask the EU for an extension to the Brexit deadline.

The chart below shows the implied probability of a no-deal Brexit occurring in 2019 from the Betfair Exchange - a peer-to-peer betting platform. The probability climbed from around 30% to just over 40% after Boris Johnson became prime minister, and announced the prorogation of parliament.

However, as parliament passed the Benn Act, the probability collapsed to under 20%, with the latest reading at 16%. 

Sterling rebounds as risk of no-deal Brexit recedes

Source: Refinitiv Datastream, Betfair Exchange, Schroders Economics Group. 29 September 2019.

The chart above also shows the performance of sterling against the US dollar and the euro, as both exchange rates are indexed and inverted on the right hand side axis. Other factors are of course contributing, such as the threat of another Italian election in the summer, or the escalation of the US-China trade war. But on the whole, sterling still has substantial potential to fall further in the event of a no-deal, and some potential to rise if a deal can be agreed.

Our baseline assumption remains that the Brexit deadline will be delayed into 2020, and that a deal will eventually be found to allow the UK to leave with a transition period. However, a number of alternative scenarios are possible.

Scenario 1: What if the UK leaves with no deal?

If the UK leaves the EU without a deal, then it would do so without a transition period, and all current EU trade deals would cease. Customs borders would be erected, which could cause significant blockages and delays to the delivery of goods.

In this scenario, we expect sterling to fall to around 1.10 against the US dollar and 1.02 against the euro (these currency assumptions are based on Schroders’ polling of other financial institutions). Inflation would rise significantly, reducing the purchasing power of households.

Due to the near-record low household savings rate, the safety buffers have been depleted, which would force consumers to cut back spending. As household spending is the biggest driver of GDP growth, the economy would suffer a technical recession, which may last up to a year (a technical recession is two consecutive quarters of negative growth). 

Business investment would also fall amidst the uncertainty, though government spending would most likely increase to limit the downturn. Interest rates would probably be lowered to near zero, and quantitative easing may also be restarted.

It is worth mentioning that in a no-deal scenario, the EU could also slip into a technical recession. The negative impact combined with the current low growth environment could be enough to cause a short and small contraction in activity.

Scenario 2: What if the UK leaves with a deal?

If the UK were to leave with a deal (this year or next), then we would expect sterling to rise to around 1.35 against the US dollar and 1.19 versus the euro. Inflation would temporarily dip, helping households by boosting real income growth. Business investment would rebound after contracting in recent quarters, while government spending would probably increase in any case due to government policy of late.

The recent build-up of inventories would have to be worked through, but within a year the economy should see a marked pick-up in growth compared to its current lacklustre performance. Interest rates would probably rise as growth accelerated, though increases would be limited.

Uncertainty would remain as the future relationship with the EU would still need to be negotiated, but the immediate risk of disruption would be removed.

Scenario 3: What if the UK revoked Article 50 and remained in the EU?

Finally, if the UK were to revoke Article 50 and remain in the EU, we would expect sterling to rise to 1.50 against the US dollar, and 1.29 against the euro. This would be the most positive scenario for economic growth.

In the near term, it would resemble the ‘leave with a deal’ scenario. Over the medium and long term, we would assume ongoing free movement of labour, which secures greater growth in the working-age population. While investment could take years to recover, research and co-operation would benefit productivity growth.

Political uncertainty to remain high

With the government lacking a working majority, a general election now looks inevitable although its timing is uncertain. Opposition leaders have said that they will support a call for an early general election once a delay to Brexit is guaranteed.

The biggest economic and political risk facing the UK is Brexit. Everything else pales into insignificance, making forecasting the economic outlook especially hazardous. We have attempted to outline above the most likely potential paths for Brexit, but there is a very good chance that events find a way to surprise us.