Brexit Trigger Spells Trouble for U.K.’s Sweet Economic Run

The U.K. economy’s sweet spot is about to be challenged.

Prime Minister Theresa May kickstarted the formal withdrawal from the European Union on Wednesday, leaving businesses and investors facing the realities of Brexit and changes to everything from regulation to the movement of workers and goods. There’s also a lack of clarity over whether a good deal -- or any deal -- can be reached.

Bank of England Deputy Governor Ben Broadbent said last week the economy was in a post-referendum, pre-Brexit “sweet spot” for exports. That situation, where the pound has fallen but trading rules are as yet unchanged, may not last, according to Broadbent.

While forecasts of the referendum’s economic impact have so far proved too pessimistic, most were about “when the trade barriers come into place,” said Swati Dhingra, an economics lecturer at the London School of Economics who specializes in trade policy. “That hasn’t happened -- we haven’t exited yet.”

Brexit uncertainty is already proving a factor in some companies’ investment plans, while faster inflation as a result of sterling’s depreciation may weigh on consumer spending. But while economists forecast a slowdown this year, the consensus is for a very modest drop to 1.7 percent from 1.8 percent. The economy still has momentum, and there’s a chance that the pickup in inflation is at least partly matched by wage growth, softening the hit on consumers.

May invoked Article 50 of the EU’s Lisbon Treaty in a letter to EU President Donald Tusk on Wednesday, striking a conciliatory tone. In response, European leaders pledged to work “constructively” with the government in London, expressing hope that the U.K. would remain a close partner.

Leaders from the bloc won’t meet formally on the issue until April 29 and discussions on the future trading relationship won’t commence until progress has been reached on issues such as the cost of exit and rights of EU workers in the U.K.

An early clash was visible Wednesday, with May calling for discussion of future partnership alongside the terms of exit and Tusk preferring to focus solely on an “orderly withdrawal.” With two years to complete negotiations, the economy faces the real possibility of no agreement and a sudden move to World Trade Organization rules.

No deal being reached “could potentially be quite damaging,” said Azad Zangana, an economist at Schroders. WTO rules would impose higher tariffs on goods and wouldn’t cover services, the biggest part of the U.K. economy. BOE policy maker Ian McCafferty said leaving the bloc without new trade arrangements in place would mean “quite a lot of disruption.”

The “macro uncertainty” of whether Brexit will happen will now be replaced by “micro” uncertainties for businesses such as whether investments will clash with changing regulation, said Nick Bloom, an economics professor at Stanford University.

Whatever the outcome, most agree there will be some sort of damage to the economy that, while not crippling, will be long-lasting. That pessimism is based on an expectation that potential tariffs, less migration and lower investment hit productivity and output. Companies were already complaining about skills shortages before the referendum.

Lloyd’s of London said Thursday that it plans to open a European hub in Brussels at the beginning of 2019, with Chairman John Nelson citing “obvious implications for the market and our business with Europe” due to Brexit as an explanation for the move.

So far, the “sweet spot” has seen the economy prove unexpectedly strong. Data Friday will probably confirm it grew the fastest in a year in the fourth quarter, when net trade provided its biggest boost in almost six years.

But the true test will be whether, at the end of negotiations, the nation can maintain levels of trade, attract investment and bolster productivity, according to BOE Chief Economist Andy Haldane.

“These are open questions,” he said at the London School of Economics this month. “It takes two to tango. Whatever we want as a country, it depends just as much on what the other side of the table wants too.”

By Jill Ward and Lucy Meakin