The first item in Theresa May’s in-tray: A Brexit-induced recession

The Home Secretary Addresses The Police Federation Conference
Theresa May's hostility to free movement means Britain is going to leave the Single Market (Source: Getty)

Theresa May will be the next UK Prime Minister, and sterling and the FTSE 250 rose almost immediately. Markets think that May will be more pro-EU than Andrea Leadsom, the tribune of the europhobic Tory grass roots.

But don’t imagine that domestic political uncertainty was the only reason for the recent falls in the currency and stock markets. A recession is the most likely outcome of the Brexit vote. May has so far been careful not to make any promises about the EU – apart from stating that “there is clearly no mandate for a deal that involves accepting the free movement of people as it has worked hitherto”. That means she will not be able to keep Britain in the Single Market.

Why should we think a recession is likely? First: the pound. It hasn’t yet fallen as much as one might have expected – by about 9 per cent on a trade-weighted basis (although it is at a 30-year low against the dollar). But the fall in sterling is unlikely to lead to a big pick-up in exports. A lot of Britain’s high-technology and financial services exports are quite insensitive to price changes, and because the UK is tied into supply chains in Europe, a lot of imported components will become more expensive, pushing up exporters’ costs. In addition, the global and European economies are only growing slowly, which means that demand for British exports is unlikely to expand rapidly.

Read more: Can Britain avoid a recession?

Second: the stock market. The FTSE 100 is up slightly – but these are large international companies that generate much of their revenue outside the UK. The FTSE 250, which includes more domestic companies, is down 4 per cent since the Brexit vote. The biggest falls – between 15 and 35 per cent – have been to the share prices of companies serving the much-maligned sources of UK growth: household goods and construction, banks and insurers, and real estate investment and agency services. Commercial real estate funds have stopped investors withdrawing their capital. If house prices fall and hiring freezes, household consumption will fall – and this has been the biggest source of growth over the last three years.

Third: investment. There is some anecdotal evidence that an investment and hiring slowdown is underway. A survey of German firms found that a quarter were planning to cut jobs in their UK operations, and a third said they were planning to reduce investment. There are rumours that multinational companies are thinking of moving some of their operations out of the UK. Uncertainty about the future EU/UK relationship is at the heart of this.

Therein lies the reason why the UK is in for a prolonged period of low growth after the downturn. The negotiation with the EU will be lengthy – at least two years, and probably longer. There can be no credible pre-announced “plan” offered by May that will give investors certainty, because the rest of the EU must agree with it. This means that increasing numbers of companies will choose to invest in an EU member state rather than the UK. This will have a scarring effect on the supply capacity of the UK economy. Once location decisions have led to investments being made, there’s little reason to come back to Britain.

Read more: Seven reasons Brexiteers are wrong to think EU exit talks would be easy

And it is hard to find an easy compromise between the UK and the EU. May has signalled that she will end free movement. Labour MPs are also saying privately that they would not be able to vote for a deal that allowed unfettered immigration from the EU. For their part, the rest of the EU has been unanimous that the UK cannot be part of the Single Market without it. And it is in the rest of the EU’s interest to allow economic pressures to mount by refusing to cave in, in order to both make an example of the UK so that anti-EU forces elsewhere in Europe are not emboldened and to ensure that the Single Market does not unravel.

Recessions are usually followed by a bounceback, as pent-up consumption and investment resumes. But the cause of the UK’s downturn is, at heart, that investors are betting that Britain will leave the Single Market. And given that the force of Britain’s hostility towards free movement will soon meet the immovable object of the EU’s commitment to its founding principles, investors are probably making the right call.

Click here to read the full report on the Centre for European Reform's website.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.

Related articles