UK Economy Unlikely to Grow Over Next Six Months says BofAML

- UK economy to stagnate for half a year
- Increas in Covid-19 restrictions, Brexit to blame
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"We struggle to see how the economy can grow in 4Q," says a research note from Bank of America Merrill Lynch, citing "escalating lockdown measures, fading stimulus and Brexit risks".

The prediction for the UK economy comes at a time of rising covid-19 infections that on Tuesday prompted the UK government to tighten restrictions on socialisation and movement which is being widely predicted to slow the recovery that characterised the summer months.

BofAML says that a looming period of economic stagnation will in fact last into the first quarter of 2021, suggesting half a year of zero-growth lies ahead, a view that if correct will have significant implications for Bank of England policy and Sterling exchange rates.

"Downside risks have risen too in our view. A slower recovery will mean higher unemployment - we now expect a peak at 8.4% - and more consumer caution, with potential feedback to growth. A slower recovery also means more long-term scarring," says Robert Wood, UK Economist at BofAML in London.

The UK Government on Tuesday shifted its guidance in response to rising covid-19 cases and told workers to work from home where possible. In addition, a curfew of 10PM was placed on the hospitality industry.

In Scotland the devolved administration went further and banned households from mixing.

All this is expected to weigh on economic activity. Indeed, a survey of the UK economy in September shows the recovery had already started slowing, with respondents to IHS Markit's Flash PMI survey expressing concerns that the speed of recovery in customer demand had already peaked, with subdued economic conditions at home and abroad acting as a brake on new project starts.

"Covid cases spiked shortly after restaurant bookings soared in late August, suggesting the limits to sustainable economic activity (this also means some government stimulus measures may end up with a negative multiplier). The implication is that economic activity is likely to be more restricted in 4Q than 3Q. About one-sixth of the UK population face some local lockdown measures," says Wood.

Wood and his team have raised their mark-to-market 2020 growth forecast to -10.3% from -10.6% previously owing to stronger than expected growth in July. But they cut their 2021 growth forecast from 6.4% to 5.4%. No growth is forecast in the fourth quarter 2020 and the first quarter of 2021.

Market expectations for a 'no deal' outcome to Brexit trade negotiations have risen sharply in September amidst an ongoing deadlock on issues relating to future fishing rights and post-Brexit state aid policy. At one point in September the market speculated that the EU would walk away from talks after EU Commission Vice President Maroš Šefčovič warned the UK had until the end of September to drop its controversial Internal Markets Bill, or it would face unspecified consequences.

BofAML nevertheless join the consensus in expecting a trade deal to ultimately be sealed by the EU and UK, but even here the final outcome is expected to weigh on the economic outlook.

"Risks of a no deal Brexit have ballooned since the start of the month but a skinny Brexit deal (our base case) would be economically damaging too in our view," says Wood.

This view on the potential economic benefits of a 'skinny' trade deal is shared elsewhere in the analyst community. "A skinny FTA would limit, but not stop, the erection of significant non- tariff barriers between the EU and UK next year," says Shreyas Gopal, a FX strategist with Deutsche Bank in London.

With a stagnant six months of economic activity ahead BofAML says the Bank of England will ultimately be required to cut interest rates further.

"With 10y yields close to Bank Rate we do not believe more QE alone can loosen financial conditions more. Cutting Bank Rate as well as expanding QE might. Cutting to zero, so not crossing the negative rate rubicon, won't add much stimulus but may be the path of least resistance. Something is better than nothing after all. The MPC seems to be moving to this view only slowly, however. So we expect more QE in November - the easiest measure to agree - and Bank Rate cut to zero in February," says Wood.

Bank of England Governor Andrew Bailey on Tuesday rowed back against market expectations for a cut in the interest rate to 0% or below, saying that such an outcome was merely being explored.

The pushback came as markets ramped up expectations for such a cut following the Bank's September policy meeting where its as revealed the Bank would engage with banking regulators in the fourth quarter to asses the sector's ability and readiness to operate in a negative interest rate world.

Investors are however not convinced by Bailey's words as money market pricing shows expectations for an interest rate cut to zero or below to be delivered by mid-2021.