It is a time of considerable uncertainty. The need to take account of uncertainty in investing has been a central feature of our many webinars and client events throughout this year. Economic, financial, political or policy uncertainty are very evident across many countries and markets.
Uncertainty looks likely to mount as latest data shows the world economy heading for recession. This is not yet guaranteed as a rapid de-escalation of the US-China trade dispute and further monetary and fiscal policy easing could prevent it, but such necessary corrective policy action may not be forthcoming quickly enough.
A further sign of the slowdown is seen in the collapse in international air cargo. This fell sharply in the latest data for August, with IATA’s measure of “air freight kilometres” down 3.9% year-on-year versus 2.4% in July. Global air freight volumes have been falling in annual terms for ten consecutive months now – the longest period of decline since 2008. On the positive side, air freight volumes in North America and Europe have stabilised recently, having fallen for a year.
This mirrors the sluggish tone to global trade and widespread weakness in manufacturing indices that has spilled over to service sector data. In this context, expect further monetary and fiscal policy easing globally.
Whether the US-China dispute is settled remains to be seen.
How is this impacting the UK?
We do not plan to delve into the politics here; suffice to say, there is heightened political uncertainty.
An election is widely expected, with this year or by next spring being regularly cited as likely timescales. This seems a sensible assumption, but it is possible also to construct a credible scenario where even an election is delayed for some time.
Imminently, moreover, we face the critical next decisions on Brexit. The central assumption in most economic forecasts – including the independent Office for Budget Responsibility and the Bank of England – is that of a smooth and orderly exit. This effectively means an agreement now, followed by a transition period during which a future UK-EU trade deal is negotiated.
But, as we can observe, this is by no means certain, even though in economic and financial terms it makes sense for there to be a “deal”. Raw politics will determine the next steps.
Modest but fragile UK growth
During the first half of this year the UK economy performed much as we had anticipated. The underlying trend reflected modest growth, with consumer spending strengthened by a gradual rise in wage growth that boosted real earnings.
Meanwhile, corporate activity was impacted by the Brexit timetable, the net effect of which was to see a front-loading of activity, including higher inventories, ahead of the initial March 29th Brexit deadline. The economy grew 0.5% in Q1 and contracted 0.2% in Q2.
However, as the year has progressed, the economy has been pulled down by two factors that we might genuinely have expected to be clearer by now: Brexit uncertainty and its associated political and economic fallout; and the escalating US-China trade dispute, which continues to weigh on global trade. The market expects mildly positive growth in Q3, but recent indicators suggest fragile confidence.
Three UK economic features
Since the 2016 referendum three features of the UK economy merit attention: the economy’s flexibility and ability to adapt, reflected most in the strong jobs data over that time; the underperformance of investment, despite some large foreign direct investment flows; and sterling’s softer trend. These economic variables, jobs, investment and sterling are the three most likely to respond to the likely path taken.
Jobs growth has slowed recently, reflecting the domestic and global slowdown. Many investment plans are on hold before decisions are taken, while sterling remains the market’s shock absorber. It is hard to argue on economic grounds that the pound should be cheaper. Already it is competitive. But if an increased risk premium is attached to the UK by speculators or international investors – whether because of Brexit or an election – then it might not be a surprise if the pound were to weaken further to an even more competitive level.
Low productivity persists
One feature of the economy that persists is the low rate of productivity growth. This was seen again in the latest data released this week. Productivity growth fell by an annual rate of 0.5% in Q2. With jobs growth outstripping output, these productivity figures were expected to be poor; they reached a five-year low.
Part of the challenge is how an economy breaks out of a low productive, low growth environment. There is much evidence that the UK has high productive sectors and firms but that the gains are not shared more widely. The UK is also a very innovative economy. And, according to the European Commission, the UK has three of the top five most competitive regions in the EU. This week the World Economic Forum reported that the UK slipped from eight to ninth most competitive globally; Singapore was first, the US second. So if anything the productivity figures fit the picture of an imbalanced UK economy.
This requires a long-term response. For markets the focus is more short term. The danger, perhaps, in assessing markets now is the challenge of pro-cyclical policies. These would be most acute were a no deal to happen soon. If trend growth is seen as too low, policy makers may fear having to keep monetary policy tighter than it would otherwise be, to prevent hitting inflation bottlenecks, and also more of the budget deficit would be seen as structural, limiting room for fiscal manoeuvre.
Given this, what is likely to be the policy outlook?
Policy stimulus is likely
With inflation subdued, and growth lacking momentum, policy stimulus is likely. This, however, needs to address both the demand and supply side of the economy, and as well as providing a near-term boost to both, address longer-term issues, too.
It is no easy challenge when the market perception is that the room for policy manoeuvre is limited. Policy will be data dependent and heavily influenced by Brexit decisions. The likelihood is that if we move to either an extension or to a transition period post October 31st there will be gradual stimulus; there would be a larger stimulus in the event of a no deal.
With a deal, sterling would bounce and confidence recover. This would not rule out a fiscal stimulus in the Budget although the emphasis may change slightly.
The message is that we should expect an appropriate – and potentially significant – policy response whatever the political decisions of the next few weeks. The path will vary but the bias is towards easier fiscal and monetary policy.
Then market attention will likely turn more towards an election. It seems likely that there will be very contrasting manifestos on offer, with the election outcome possibly having a material impact on the future direction of the economy in a way in which previous elections have not. That implies a significant risk premium in UK assets.
Overall the world economy is slowing and markets are focussed on whether policy can act quickly enough to prevent recession. Meanwhile, in the UK the slowing jobs data, weak investment picture and competitive value of sterling reflect an uncertain domestic climate. Further UK policy easing seems inevitable, the scale of it heavily dependent upon politics and the Brexit path that is taken.
Please remember that when investing your capital is at risk.