Another Interesting Week in the UK Policy Debate

The last week has been another significant one in the UK policy debate, with the Government finally being given the go-ahead from Parliament to trigger Article 50 and the Bank of England unveiling its latest thinking in its quarterly Inflation Report.

It has also been a noteworthy one in terms of how the mood since last June's referendum result has started to shift towards a more positive tone. For instance, in recent days Bank of America has received coverage for its upbeat view of sterling while PwC have released a report forecasting the UK to be the fastest growing G7 country in coming decades. TheCityUK, meanwhile, an important financial group, is now proclaiming Brexit will be good for the City.

I think there are a number of key messages for investors.

Forecast upgrades

First, the economy is enjoying solid growth. The Bank of England has revised up significantly its economic forecast. In last August's Inflation Report it expected the UK economy to grow by 0.8% this year - and that was already taking into account the policy stimulus it had unveiled after the referendum result. By November this forecast had edged up to 1.4%. Now it expects 2%.

This forecast feels right. It is significantly higher than the consensus, which is around 1.2%, although creeping up, and is in line with our view of 2.2%, which we made at the end of 2016. Also, the Bank of England has revised its forecast for growth in 2018 up, from 1.5% to 1.6%. The upward revision to the Bank's growth forecast reflected a number of factors - more relaxed fiscal spending at home and a stronger world economy - which also partly reflects a more relaxed fiscal stance across the globe. This is good news for equities, although much good news is already discounted.

But the cycle remains

Second, and despite this, at some stage the economy will slow. It might even be evident next year. When he was Chancellor, Gordon Brown proclaimed he had abolished economic boom and bust. That was nonsense, of course, even at the time when he said it. But it is relevant now, in the context of the economic outlook and Brexit.

The bulk of the data has been solid since the referendum result. While my personal view is Brexit is in the long-term economic best interest of the country, in terms of the immediate outlook it is important to note that Brexit will not abolish the economic cycle. At some stage the UK will slow down, just as China and the US will slow. In fact, after seven years of continuous economic growth, the UK may be viewed as being at the latter stages of the economic cycle. Likewise for the US.

 

Source: Bloomberg

The challenges ahead

Third, even though the immediate outlook is good, there are a number of potential challenges for the UK. These include the fact that the economy is heavily imbalanced, with a large current account deficit, a still sizeable budget deficit, regional imbalances and now a rising amount of household debt. Of course, the economy can continue to enjoy imbalanced growth for some time, and it probably will. Beyond that, the Brexit policy outlined recently by the Prime Minister and the domestic industrial and economic policy will be key.

   

Source: Bloomberg

 

Since the referendum, consumer spending has proved stronger than forecasters expected, and one of the key issues is the extent to which this will be sustained during 2017. With rates low and the jobs market solid, the referendum outcome also seems to have boosted the confidence of some people. In addition, rising wages are underpinning spending. One of the challenges this year is the extent to which household incomes are squeezed - and that depends upon many factors, including how wages rise relative to inflation.

What next for inflation?

Fourth is that there is considerable uncertainty about the inflation outlook.

One of the current key issues for investors - as well as for policy makers - is how high inflation will rise and to what extent the pick-up in inflation now being witnessed will be sustained. In the first half of last year, headline inflation was only 0.4% and 'core inflation' (which excludes food and energy) was 1.3%. By December, both had edged up to 1.6%, and headline inflation now looks set to breach the Bank of England's 2% target in coming months.

A weaker pound and higher commodity prices have pushed input costs up, but competitive pressures, technology and the extent to which currently healthy profit margins can be squeezed may limit the rise in inflation longer term.

Meanwhile, the labour market has been solid with low unemployment, but wage growth has been relatively subdued. For instance, in the years before the financial crisis wage growth averaged 4.2% from 2002-07. In 2015 wages rose 2.5%, while last year wages rose 2.4% in the third quarter and 2.8% in the fourth quarter. If this recent acceleration in wages continues, then it may sustain consumer spending for longer, and in turn add to pressure on the Bank of England. If inflation and wages both rise - perhaps in tandem - then the Bank will feel less worried about the extent to which the economy can cope with a policy tightening.

Monetary policy on auto-pilot for now

Fifth, and for now, the Bank of England looks set to keep monetary policy on auto-pilot. That is, policy will be unchanged and the Bank will continue to assess overall economic conditions. So policy rates will be unchanged and the Bank will continue with both quantitative easing (QE) and its buying of corporate bonds. As we have previously written, we agreed with the Bank's decision to inject liquidity and cut rates after the referendum and understood their decision to engage in QE, but we did not agree with the idea of buying corporate bonds.

At some stage we feel a major rethink is needed on monetary policy - a topic to which we will return. That doesn't mean we think interest rates need to rise immediately, but rather that there needs to be a rethink on the effectiveness of policy, a credible exit strategy and even more of a focus on financial, monetary and credit conditions. For investors and the markets, though, the message is that the Bank appears keen to avoid policy shocks. The question, then, for the markets is whether shocks can continue to be avoided elsewhere: in the economic data and in the Brexit political debate.

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