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Mark Gilbert is a Bloomberg Gadfly columnist covering asset management. He previously was a Bloomberg View columnist, and prior to that the London bureau chief for Bloomberg News. He is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”

Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

First, the good news: Friday's move by Moody's Investors Service to cut the U.K.'s credit rating tells you nothing about the U.K.'s ability to pay its debts. Now the bad: the downgrade reflects a Brexit-induced deterioration in Britain's economic outlook that looks set to worsen.

It's pertinent that Moody's acted just hours after Prime Minister Theresa May's Brexit speech in Florence. While her tone was warmer than in previous addresses, she maintained the government's fantasy that a "creative solution" is available that won’t diminish trade between Britain and the European Union. Moreover, in the Q&A session that followed, she revisited the reverie that no deal is better than a bad deal.

Here's what the rating agency said in its statement on the downgrade:

Moody's is no longer confident that the U.K. government will be able to secure a replacement free trade agreement with the EU which substantially mitigates the negative economic impact of Brexit. While the government seeks a "deep and comprehensive free trade agreement" with the EU, even such a best-case scenario would not award the same access to the EU Single Market that the U.K. currently enjoys. It would likely impose additional costs, raise the regulatory and administrative burden on U.K. businesses and put at risk the close-knit supply chains that link the U.K. and the EU.

Moody's argues that growth won't return to its historic trend rate in the coming years. Its forecast for gross domestic product growth in 2018 is even gloomier than the consensus among economists surveyed by Bloomberg.

Close to Stagflation
The consensus forecasts show U.K. growth slowing at the same time as inflation accelerates
Source: Bloomberg's ECFC function
Note: Figures from Q3 2017 are forecasts

What Moody's calls "political and social pressures" will force the government to increase spending to levels "significantly higher than under the government's current budgetary plans." As a result, the U.K. budget deficit will be stuck at between 3 percent and 3.5 percent of GDP in coming years, Moody's forecasts, with the government failing to meet its target to get the shortfall below 1 percent in the next five years.

The risks of a downturn are higher than in recent years. Economists surveyed by Bloomberg this month put the likelihood of a U.K. recession in the coming year at 25 percent; while that's down from the spike to almost 50 percent in the wake of the Brexit referendum, it's significantly higher than the levels prior to that vote.

Recession Risks Rising
Likelihood of a U.K. recession within one year
Source: Bloomberg

Moody's was the first of the three main rating companies to strip the U.K. of its coveted AAA rating, back in February 2013 when it was becoming clear that the government's finances were deteriorating. It resisted cutting again after the Brexit vote, restricting itself to a negative outlook until Friday's move.

Standard & Poor's, though, looks likely to downgrade the U.K. even further. Immediately following the Brexit vote, S&P cut the U.K. from AAA by two notches, and kept the outlook at negative. Chief Rating Officer Moritz Kraemer said in a Monday interview with Bloomberg Television that a lack of clear policy making as the U.K. leaves the EU is “an important factor for creditworthiness," and that May's speech last week contained "not that much new substance."

Divorce negotiations between the U.K. and the EU resume this week, with EU negotiators likely to insist that Britain puts some numerical flesh on May's skeletal promise Friday to "honor commitments made." 

And while neither the pound nor the gilt market paid any attention to the rating downgrade, further cuts are likely unless the Brexit talks start to make progress. While that has no bearing on the U.K.'s ability to repay its debts, the message it would send about the post-Brexit economy is the opposite of the "sunlit uplands" the pro-Brexit campaign promised Britons. 

--Bloomberg's Elaine He contributed charts.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the authors of this story:
Mark Gilbert in London at magilbert@bloomberg.net
Marcus Ashworth in London at mashworth4@bloomberg.net

To contact the editor responsible for this story:
Jennifer Ryan at jryan13@bloomberg.net