- We have revised downward our forecast and now expect U.K. GDP to contract by 8.1% in 2020. We are also more pessimistic about the time it will take the economy to recover.
- We no longer assume the post-Brexit transition period will be extended, but expect the U.K. and EU will strike a core free trade deal starting 2021. The switch to this regime would dampen the rebound in 2021 and slow growth in the following years.
- We now forecast the economy will still be around 3% smaller by 2023 than we had expected prior to the pandemic and under the assumption of an extension of the transition period.
|U.K. Economic Forecasts|
|10-year government bond||1.46||0.94||0.39||0.74||1.15||1.53|
|Exchange rate (euro per GBP)||1.13||1.14||1.12||1.08||1.12||1.13|
|CPI--Consumer price index. Source: ONS, BoE, S&P Global Ratings.|
As the U.K.'s COVID-19 lockdown restrictions continue to be eased, the economy is emerging from the sharpest recession it has ever recorded. In a matter of weeks, almost all the gains made since the low point of the financial crisis in 2008 were erased. The path to recovery is paved with many risks and headwinds. The most notable of these are further spikes in COVID-19 outbreaks, and the risk of the U.K. and EU failing to come to an agreement about their future trading relationship by the end of this year.
The U.K. economy and society are now starting to benefit from the ongoing relaxation of restrictions implemented from late March to contain the spread of COVID-19. So-called nonessential shops can now trade again and traffic is picking up (see charts 1 and 2). Large parts of the hospitality sector, which was hit hardest, are likely to reopen in early July.
This means that the worst of the slump in the economy is now likely to be over. The 20% month-on-month drop in GDP reported by the Office of National Statistics (ONS) for April should soon be followed by outsized positive numbers, although not quite commensurate to the magnitude of the downturn. Even after the most restrictive lockdown measures are lifted, it will take time for demand to return. Businesses and consumers must adjust to the new normal and some degree of social distancing may persist, even if it is not imposed. Some measures are likely to remain in place until the second half of next year--with effects equivalent to about an 8% reduction in normal consumption, in our view. This is when we consider it likely that a vaccine or an effective treatment will be found, manufactured at scale, and distributed.
Rebound And (Limited) Catch-Up
Even under the assumption that some restrictions will continue, we expect GDP growth to rebound in 2021 by 6.5%. This is much stronger than a typical cyclical upswing and notably faster than the upturn that followed the global financial crisis. This is because the health shock is relatively short-lived and external to the economy itself. We expect some catch-up effects will continue to boost growth in 2022, before fading in 2023.
The unlocking of some pent-up household spending will drive the rebound. The household sector as a whole has been accumulating a large amount of savings. Over the March to May period, households paid off debt to the tune of £16 billion (see chart 3)--corresponding to between 7% and 10% of monthly household expenditure. We estimate the savings rate could have climbed as high as 20% in the second quarter of this year, from just 6.2% in the final quarter of 2019, representing a lot of money that is currently going unspent.
However, not all of the money saved now is likely to be spent later when households catch up with some consumption forgone during the lockdown. Households will need to resume payments, such as mortgages or personal contract purchases (on cars, for example), that are currently suspended as part of forbearance measures by lenders. Some households will also have to catch up with missed rent and utility payments. Traumatized by the shock of the pandemic lockdown, many households may also continue saving more as a precautionary measure.
Furthermore, households will have varying degrees of ability to catch up with forgone consumption. Lockdown measures have most affected those in lower-paid service jobs. On average, these households spend less on discretionary consumption and had few savings in pre-pandemic times. They will continue to struggle during the recovery.
The return to pre-pandemic levels of economic activity will also be hampered by inevitable damage to the structure of the economy. Some businesses will have failed, or may fail during the recovery phase when demand and revenue will still be weak. During such times, businesses typically need additional working capital to finance inventories and growth. At the same time, banks might be unwilling to extend loans to businesses they consider too fragile and therefore a commercial risk. Across Europe, we estimate that default rates in the speculative-grade category alone could rise to 8.5% by March 2021, from 2.7% in April (see "Related Research" below). This provides some indication of failure rates for the U.K. It does not include unrated small and midsize enterprises (SME), which are more vulnerable. The £28 billion uptake of the government underwritten bounce-back loans targeting these businesses illustrates SME's need of funding for survival.
When businesses fail, trading relationships will end, supply chains will be broken, and production capacity will shrink. While the economy is reorganizing itself, these factors reduce its ability to grow. As a result, the rebound from the recession and subsequent catch-up growth will not be sufficiently strong for the economy to regain its pre-pandemic levels, at least not over our forecast horizon to 2023. In the longer term, the picture is less clear. New, more viable and productive businesses may emerge and replace the ones that failed during the COVID-19 crisis, boosting capacity and long-term growth potential.
What's The Post-Brexit Deal?
Our earlier economic forecasts for the U.K. were based on the assumption that the U.K would request an extension to the post-Brexit transition period, so that U.K.-EU trade would continue beyond 2021 as if the U.K. was still a member of the EU single market. We have now revised this assumption. We now believe that both sides will negotiate a core free trade agreement (FTA) similar to the one Canada has with the EU, and start trading under this new regime from 2021. Under such an agreement, trade in goods would be largely tariff-free, but trade in services, with a few exceptions, would not be covered.
Trade in goods, although largely tariff-free, would still be more costly because of other costs, such as more border checks and longer waiting times at customs, rules of origin verification, and generally increased administrative overheads. Similarly, trade in services would also suffer from a greater burden of red tape in the form of licenses, recognition of qualifications, and compliance with individual member-state regulations on top of EU regulation. For example, a U.K. company transporting goods from the U.K. to Greece on a lorry might need a license from each country it crosses.
The shift to a new post-Brexit regime will come at an inopportune time when the recovery from the pandemic is still fragile. While we do not expect this will stall the recovery, we think it will slow it significantly, reducing growth by about 1 percentage point in 2021 alone. By 2023, we forecast the economy will still be 1.7% smaller than if the transition period had been extended.
The main effect will be loss of EU demand for U.K. exports. In addition, although some businesses will need to spend extra to adapt to new requirements, on aggregate, investment spending will suffer due to a weaker outlook. Higher inflation, resulting from a weaker exchange rate and higher import prices, will also weigh on household spending.
Various factors should mitigate the impact. The private economy as a whole is now better prepared than two years ago, when the prospect of losing access to the single market first emerged. This is not to say that it is fully prepared, notably in areas such as building the customs infrastructure. However, extensive monetary and fiscal policy support is already in place. Measures deployed by the Bank of England (BoE) and the government extend to 2021 and, in some areas, even longer. This should prevent any significant impact on markets and, in particular, on funding for otherwise viable businesses.
Finally, since the EU referendum in 2016, net migration from the EU has fallen steadily to just 50,000 at the end of 2019, from 200,000 in 2016. Travel restrictions across Europe during the pandemic will have exacerbated this decline. As a result, the U.K. economy has already even more reduced access to the EU workers it used to rely on. We do not expect a further reduction in EU net immigration beyond this low point, following the establishment of a new trade regime. As a result, there should not be any additional downward pressure on the economy.
Keeping Jobs Alive Now Will Be Key To Recovery Later
The U.K. government's job retention scheme will be key in enabling the relatively swift recovery that we expect to start from early in the third quarter this year. By protecting jobs, it avoids a lengthy and costly rematching process of employees and employers, enabling people to simply return to their workplace. It also protects incomes, so that households will have more to spend immediately when the situation improves. Under this scheme, the government currently pays 80% of employees' regular wage (capped at £2,500 pounds per month). In May, it encompassed 8.5 million workers, more than 30% of the private sector workforce. Absent this scheme, we estimate the unemployment rate could have risen to 20% in May, with a significantly more detrimental impact on the economy over the medium term.
The scheme costs the Treasury an estimated £10 billion each month, or 0.5% of GDP. However, it still makes fiscal sense provided that it is phased out carefully and with the right incentives for employers. Higher fiscal revenues during a speedier recovery make it worthwhile compared with the alternative scenario characterized by high employment, a slow recovery, and lower fiscal revenues (see "European Short-Time Work Schemes Pave The Way For A Smoother Recovery," published on May 20, 2020, on RatingsDirect.
Despite the job retention scheme, we still expect a significant number of workers currently furloughed will ultimately be made redundant and forecast the unemployment rate will rise to just under 8% in the second half of the year (see chart 5).
In view of the highly uncertain economic outlook, some businesses will soon need to make decisions about redundancies, despite the scheme running through October. This is particularly the case for larger businesses that expect demand to remain weak for longer, while at the same time facing high operating costs and being subject to a 45-day consultation period that prevents them from laying off larger numbers of staff immediately. Other businesses that are currently trading with the help of government support will make such decisions later, if demand is not strong enough for them to maintain their cost base, including employment.
Policy Support To Prevent Larger Structural Damage
When it became clear in March that the epidemic in China had grown into a pandemic, the BoE and the Treasury were swift to deploy measures to stabilize markets and provide emergency liquidity support. The BoE cut the policy rate to 0.1% from 0.75%, increased the quantitative easing target balance by £300 billion to £745 billion, and introduced the Coronavirus Corporate Funding Facility (CCFF), among others. Under this facility, BoE buys commercial paper directly from corporations that prior to March 1 were rated investment grade, with the Treasury underwriting the risk. These measures were broadly successful in stabilizing conditions and, in some cases, even improving them. Following the enhanced support for SMEs, for example, the effective floating rate charged to these businesses on outstanding loans was 60 basis points lower in May than in February, just prior to the pandemic. For new loans, the charge dropped by close to 240 basis points.
Such liquidity support, similar to the job retention scheme, aims to limit longer-term harm to the structure of the economy. The large nominal uptake of the fully government-underwritten so-called bounce-back loans, totaling £28 billion, illustrates the damage that has been averted for the most vulnerable smaller businesses, at least for now. Capacity is far from exhausted: only one-quarter of the £76 billion approved by the CCFF has been drawn down, and more approvals are in the pipeline. However, at this stage it is too early to assess how effective direct liquidity support will be over the medium term, once businesses need to repay in an environment of still weak demand.
While the measures currently implemented should limit the economic damage and aid a swifter recovery, incentives to encourage greater investment and household consumption would help further. A cut in consumption tax, currently being discussed in the U.K., could relieve pressure on lower-income households, which have been hit hardest, and that way also boost the wider economy.
A Great Deal of Uncertainty Lies Ahead
In view of the extraordinary nature of the current situation, our forecasts are clouded by a great deal of uncertainty and are subject to significant downside risk. It is currently still difficult to say how the pandemic will evolve. While developments in China, South Korea, and New Zealand, among others, are encouraging, an emergence of further waves of infections, such as in the U.S., cannot be excluded altogether now that we see restrictions being lifted further. The coronavirus will likely remain with us until a vaccine or effective treatment is found.
There is also some uncertainty over how, exactly, policymakers in the future will weigh health measures against the needs of the economy, especially if the evolution of the pandemic changes. Nevertheless, it seems almost certain that the government will not resort to as radical a measure as a full lockdown. In any case, we would revise our forecast down significantly if such a second wave were to emerge.
Moreover, while we now assume that the U.K. and EU will strike a trade deal by the end of the year, there is always a chance that negotiations will fail and both sides will trade under World Trade Organisation (WTO) rules from 2021. We consider this an elevated risk (see "Credit Conditions Europe: Curve Flattens, Recovery Unlocks," published June 30, 2020). This would further dampen the recovery and also slow growth in the medium term while the economy adjusts to the new business model. A second, bigger wave of infections in autumn, then followed by a switch to WTO trade rules in January would be a perfect storm.
S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions, but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
- Credit Conditions Europe: Curve Flattens, Recovery Unlocks, June 30, 2020
- The European Speculative-Grade Corporate Default Rate Could Reach 8.5% By March 2021, June 8, 2020
- European Short-Time Work Schemes Pave The Way For A Smoother Recovery, May 20, 2020
This report does not constitute a rating action.
|Senior Economist:||Boris S Glass, London (44) 20-7176-8420;|
|Research Contributor:||Christine Ip, London;|
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