UK Update

Despite the political crisis that has engulfed the UK since the 2017 general election, the UK has not suffered an economic crisis. That being said, political uncertainty linked to Brexit, alongside the global slowdown, has weighed upon the economy. Now, with a general election set for December 12th, uncertainty about future policy may weigh in coming weeks upon both the economy and markets.

Since the 2008 global financial crisis the UK economy has experienced a weak recovery by historical standards. This is a similar experience to other western economies, although growth paths have not been identical. While there are dominant global influences, domestic factors clearly matter.

Global slowdown

The global environment has been particularly challenging over the last 18 months. The title of the International Monetary Fund’s (IMF) recent half-yearly Global Economic Outlook report, that summarises their thinking on the global economy, captured the present situation well: “Global manufacturing downturn, rising trade barriers”.

Since spring last year the world economy has slowed, and it has been weak this year as trade tensions have risen, adding to concerns about both the future economic outlook and policy cooperation. While the unresolved trade dispute is still the big downside risk, easing of monetary and fiscal policy across many economies points to a global recession being avoided and boosts the prospect of growth rising next year.

While there are different measures of global growth they tell the same story. The IMF’s main measure of growth suggests the world economy grew at a solid pace of 3.8% in 2017, slowed to 3.6% in 2018 and to a very weak 3.0% this year, the slowest pace of growth since 2009. Next year, a rebound to 3.4% is expected.

Some forecasters prefer to quote the IMF’s numbers that are based on current (market) exchange rates. For reference, these figures are 3.2% growth in 2017, 3.1% in 2018, only 2.5% this year, rising to 2.7% next year. Despite the UK political crisis, the UK this year looks set to grow at a stronger pace than three G7 countries: Germany, Italy and Japan.

Changing economy

Alongside modest growth, since the 2016 Referendum there have been three noteworthy developments:

- one, the UK economy has demonstrated its flexibility, creating over one million jobs, although the latest jobs data for August were poor, indicative of a slowdown;

- two, despite sizeable inward foreign direct investment, the UK has seen low investment versus other G7 countries, but this could rebound if uncertainty lifts;

- and three, sterling has been a shock absorber, falling to a very competitive level. But in recent weeks sterling has rallied on expectations of a Brexit deal.

The near-term outlook will likely be influenced heavily by politics. The EU has agreed a flexible-extension, until January 31st, and thus after the election the hope is that the Brexit path should be clear. Our expectation has remained that the UK leaves the EU in an orderly way, with a deal, before moving onto the next stage where it will be in the interests of both the UK and EU to agree a future free trade agreement.

A general election is now scheduled for December 12th. We are not going to comment on the policies of the major parties here, suffice to say that the fate of Brexit is heavily intertwined with the election result. Moreover, there are strongly divergent views on domestic policy among the parties, too. Of course, UK politics is far from predictable, and thus a political risk premium may be attached in the near term to investing in UK assets.

The data

The economy has behaved much as we expected this year. Growth has been modest and erratic. Growth of 0.6% (versus the previous quarter) in Q1 has been followed by a contraction of 0.2% in Q2. This was the first such quarterly decline since the last three months of 2012. The last recession was in 2008-09 when the economy contracted for five successive quarters from spring 2008 to summer 2009.

In the ten quarters since the Referendum, growth has averaged 0.46% per quarter. This compares with an average of 0.71% in the ten quarters before.

Third quarter GDP figures will be released soon. The market expects modest positive growth in Q3. However, recent data suggests the economy weakened during the quarter, reflecting the global downturn and domestic political uncertainty.

For instance, UK manufacturing has shared in the global trade turmoil and structural problems impacting autos, continuing to contract in recent months. Manufacturing output is down 1.7% year on year.

The latest purchasing managers’ index (PMI) survey from Markit/CIPS dipped below 50, showing service sector weakness, too. Below 50 suggests contraction. Admittedly the average monthly service PMI measure over the last year has been only 50.6. Meanwhile, the measure for the construction PMI is at only 43.3 currently, reflecting weakness in the sector.

The positive, as we thought it would be, has been consumption as wage growth has recovered and is outstripping inflation, thus boosting purchasing power. Wages over the three months to August grew at an annual rate of 3.8%. Meanwhile, the annual rate of inflation, having decelerated to 1.7% in both August and September, versus a recent cyclical high of 2.8% in September 2017, is now at more subdued levels. Thus, there is now a significant boost to real earnings.

Of course, the fall in employment in August warrants close attention. Employment can be regarded as more of a coincident than a lagging indicator given the flexibility of the labour market. The August figure was so poor it is possible that it may be partially reversed in coming months. If not then it may reflect current business uncertainty and be indicative of recent weakening in the economy. If so, it would be dovish for rates and take the shine off sterling. It adds to current economic uncertainty.

Monetary growth is weak, at 3.2%, but above its lows of only 0.5% seen in January. Yet it has only averaged an annual rate of 2.4% per month over the last five years.

The policy outlook suggests there is room for a policy boost in the UK. The budget deficit has deteriorated in recent months. Despite this, as we have touched on before, we believe there is scope for fiscal relaxation, particularly on infrastructure spending, and within the context of a stable debt to GDP ratio. The November 6th Budget has been postponed, given the election.

Meanwhile, the Bank of England looks set to keep policy on hold. The next policy meetings are on 7th November and 19th December. Although the quarterly Inflation Report is released in November, the markets will expect the December meeting to provide firm insights on the direction of policy. With inflation low and the economy vulnerable to shocks, recent comments from the rate-setting members of the Monetary Policy Committee reflect an open discussion.

The latest October comparison of forecasts for the UK economy, compiled by the Treasury, point to growth of 1.2% this year and 1.0% next year. This 2020 forecast may prove too low if the election removes uncertainty, and sees a recovery in investment, alongside solid consumer spending and a fiscal boost. The consensus expectation is for inflation to hover around its 2% target.

There is considerable uncertainty at home and overseas. The global economy looks like it may stabilise, helped by policy easing. This will help the UK outlook, too. More importantly, perhaps, the domestic political paralysis needs to clear to help reduce economic and financial market uncertainty.

Please remember that when investing your capital is at risk.

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