The unnecessary and unexpected general election has led to a political risk premium now being factored into the outlook for the UK economy and financial assets. Investors and savers frequently ask what are our views on the political outlook.
This is part two of Economic and Political Update. Part one is here.
Policy still easy in Japan and Europe, Fed tightening gradually
There are many contributors to a better external environment, one of which has been monetary policy across western economies, including the UK. In recent years, the printing of money by the European Central Bank (ECB) and Bank of Japan (BOJ) has seen their sheets rise sizeably. This is helping growth in both Japan and across the euro zone - the latter is also benefitting from the scope for catch-up in many countries, such as France, because of previous sluggish growth. So provided the BOJ and ECB are not in a rush to tighten policy - and we don't think they are - then recoveries in Japan and Europe can gather momentum.
The US Federal Reserve, meanwhile, has continued to tighten its policy, raising interest rates. But because they have proceeded in a very predictable and gradual way, US financial markets have not been spooked, instead taking higher interest rates in their stride. Also, an improvement in business confidence in the US in the wake of Trump's victory has also helped, suggesting higher interest rates there are justified - and will continue, alongside a shrinking of the Fed's balance sheet this autumn. Indeed, as Fed Chairman Yellen's testimony this week to the House Financial Services Panel said, "With further gradual adjustments in the stance of monetary policy, the economy will continue to expand at a moderate pace over the next couple of years." Meanwhile, because the dollar has not strengthened in response to higher US rates, economies elsewhere, including those across the emerging world, have also benefited.
Mixed UK signals
The Bank of England has been sending mixed signals, in part reflecting, as well as contributing to, the uncertain economic climate. This is never a good thing. The Financial Policy Committee has tightened lending conditions recently. The Monetary Policy Committee, meanwhile, has left policy rates unchanged, but is now engaged in a more open debate about when the first hike in interest rates for a decade will occur. The best way to view this is that we are in the early stages of policy normalisation. In which case, the implication is that that rates will rise, but will do so very gradually. The latest jobs data shows that while UK unemployment fell to a 42 year low of 4.5%, overall earnings growth remains sluggish, rising just 1.8% and putting no immediate pressure on the Bank to tighten policy.
Be wary of spill-overs
Quantitative easing, plus low interest rates, has been like a drug. Withdrawal symptoms are always possible. It is now nine years since the global banking crisis and over that time low rates have: led markets to not price properly for risk; have led banks to regard property and government bonds as safe assets (even though both now look expensive); reduced the price of leverage and thus triggered an increase in debt; led to a misallocation of resources as zombie firms have been kept alive and capital has been diverted to financial markets and not real investments. Also, the combination of cheap money, leverage and one-way expectations has been a key driver behind rising property prices, and so if interest rates rise, one would expect the property market to look less solid. And there is the currency effect, with the spill-over of monetary policy from one country to another.
Given all this, markets will be wary of the path for UK rates and for monetary policy elsewhere. Likewise, the fear of how vulnerable both the economy and markets are to higher rates will make the Bank of England cautious about raising rates - especially given the uncertainty linked to Brexit talks - but much depends upon how they see the inflation and economic outlook.
During the first half of the year UK inflation has risen significantly. With wage growth sluggish, the result has been a squeeze on real incomes, weighing on spending, whose pace of growth has slowed. It has not collapsed, however, as there has also been a sharp rise in credit growth and a fall in the savings ratio. All this has created uncertainty about what lies ahead. The good news is that inflation looks set to peak by the autumn, before it starts to fall, and during next year it should be easing significantly. Consumer spending may be subdued in the second half of the year, and we may have to wait until spring time for real incomes to start to improve again. Between now and then an important issue will be what happens to business confidence and investment. All this is consistent with our view of a more subdued but still steady pace of growth during the second half of the year.