When looking at the medium-term outlook for the U.K., it is tempting to focus solely on Brexit. It is undoubtedly a key component of the U.K. outlook, but there are a number of other factors investors should consider when constructing their medium-term view. Not least are how the economy behaves as we move through the monetary tightening cycle, whether politicians will be able to avoid the temptation of fiscal easing against a backdrop of continued income and wealth inequality, and how policymakers would respond in the event that the base case of low productivity growth and stable inflation is challenged. There is a lot more to the U.K. outlook than Brexit, important though it is.
Before we look to the future, it is important to recognise initial conditions and anticipate how they may evolve. As with many other developed economies, the U.K. has enjoyed a prolonged period of steady growth, characterized by falling unemployment but disappointingly sluggish wage and productivity growth. The total number of people employed is a record-high 32.4 million, the unemployment rate is a 50-year-low 4.2% and government finances are moving back into balance.
However, average earnings for workers are rising at just 2.5% per annum, and with Consumer Prices Index (CPI) inflation at 2.4% and the household saving rate back at just 4.3%, household finance remains under pressure. It is this pressure that has been the primary cause of the recent slowdown in GDP. As we look to the future, the key questions we need to address are: What scope is there in other parts of the economy to support the recovery, and if we see a global slowdown, how well equipped is the U.K. to weather that particular storm?
Inevitably any medium-term forecast will have to take into account the risks to the economy that could arise from the U.K.’s separation from the European Union (EU). However, before we take a look at the impact of Brexit itself, it is useful to think about the driver of the various components of the domestic economy. Consumer spending represents two-thirds of U.K. GDP and will continue to exert considerable influence on the outlook for the economy. That in turn will be guided by both monetary and fiscal policy.
In particular, we expect the Bank of England to continue to slowly increase interest rates over the first few years of the secular horizon. Given the uncertainty around the neutral real interest rate in the U.K., we think it prudent to weigh the prospective interest rate cycle in the context of previous hiking cycles. Considering most household mortgages relate to short-term interest rates, monetary policy can affect spending patterns faster than in other developed economies. Historically, interest rate hiking cycles have ranged at between 1% and 1.5% of cumulative rate hikes, typically completed over a 12-month period (Source: Bank of England). This hiking cycle will no doubt be longer than previous ones, but we think the cumulative degree of monetary tightening will be consistent with prior cycles. Clearly there is a large range of potential outcomes, but importantly, we believe that interest rates are likely to stay low over the secular horizon. This should limit the collective pressure on household balance sheets, such that household consumption can grow close to the growth in real incomes. As discussed in our 2018 Secular Outlook, “Rude Awakenings,” while we acknowledge the scope for a positive surprise in productivity and real wage growth, sadly this does not form our central expectation.
With the annual fiscal deficit back to 2% of GDP, there remains scope for fiscal policy to both add to GDP as well as detract. Unlike in the U.S., where we see the risks of late-cycle fiscal expansion ultimately accelerating the downturn, we expect fiscal policy to be more neutral in the early stages of the secular outlook but certainly with scope to become a bigger influence as we move towards the next general election, scheduled for 2022.
Where Brexit risks will undoubtedly take center stage is in the outlook for investment. Observed business investment has been sluggish in recent years despite surveys indicating relatively upbeat investment intentions on behalf of businesses. This gap we believe relates to uncertainty over the Brexit negotiations, where businesses would prefer to hire additional staff rather than commit to greater spending on plant and machinery. We believe that the path of the Brexit negotiations will continue to influence corporate behavior.
Given the nature of the Brexit negotiations, and the importance of the next six to nine months, it is hard to separate out the cyclical aspects from the secular outlook. In particular, as the negotiations accelerate over the second half of 2018, the risk of political uncertainty rises as the prime minister tries to negotiate the difficult path of placating her own ruling Conservative Party and striking a future trading arrangement with the EU. There is certainly a wide range of potential outcomes: a smooth transitional deal, a delay to the negotiations, a stalling of the negotiations if the U.K. government falls, or no deal. Our central expectation is still for the U.K. and EU to coalesce around a cooperative outcome, which sees the U.K. transition out of the EU over the secular horizon. In that event we see some scope for a recovery in business investment, although clearly there are material risks around this expectation.
Risks to our forecast
So while our base case is for a relatively stable economic backdrop characterized by a gradual interest rate cycle and cooperative Brexit, there remains considerable risk to that central forecast. With the economy at or close to full capacity, a slow and gradual set of interest rate hikes engineering a smooth deceleration of growth may well be the aim of the Bank of England, but we have to acknowledge that such outcomes are often very difficult to achieve.
Regarding Brexit risks, a more protracted set of negotiations would drag out uncertainty over the final trading arrangements. In the event that Parliament cannot agree on any outcome, a wide range of possibilities open up, including an early general election, or a second referendum. We assign a low probability to either scenario, but we have to acknowledge the risk.
On the more positive side, an unexpected improvement in productivity growth supporting higher real wage growth would certainly aid household balance sheet repair, although conversely this would also likely give the Bank of England more confidence in raising interest rates. In that case it is possible that alongside interest rate hikes, we could see the Bank of England start the discussion of balance sheet shrinkage, with the associated risks that would pose to longer-term interest rates.
U.K. asset markets continue to price in a very gradual path of interest rate rises, and to some degree have become desensitized to daily political volatility. In particular, longer-term interest rates remain very low by both domestic and international standards, and as such we remain cautious on valuations of long-dated U.K. yields. Where we can, we prefer to emphasize duration outside of the U.K., and within the U.K. we prefer to emphasize a curve-steepening bias to reflect the low level of additional yield compensation for extending maturity in both the nominal and real interest rate curves. Sterling will continue to be the most sensitive asset market to broad political risk and remains the most efficient tool for reflecting evolving views on the Brexit negotiations.
Meanwhile, within the non-government sector, corporate bond yields offer similar excess spreads to other global credit markets. With that in mind, we will focus on sector selection and issuers with a global presence rather than those heavily focused on the domestic sector. Where we do see value in domestically focused issuers is financials, where U.K. banks have built up substantial capital, and in securitized assets, such as high quality residential mortgage-backed securities, which offer a measure of protection in the event of great volatility ahead.