The world economy has slowed and markets appear divided about what lies ahead; equities anticipating stabilisation and then recovery, helped by the recent shift in global monetary policy towards easing. This outlook is also reflected in consensus thinking and was evident in the recent half-year forecasts from the International Monetary Fund.
Also, while markets are nervously watching the current deterioration in trade tensions between the US and China, an agreement is expected at some stage. Yet, the recent sell-off in equity markets triggered by an escalation of the trade dispute reflects concerns that if not resolved then this could dampen US and China growth and trigger a deterioration in their relationship.
Meanwhile, the continued low yields on bond markets reflect greater concerns about future growth, alongside reflecting a far more subdued global inflation picture. Bond markets, one might argue, also reflect the increased vulnerability of the world economy to any escalation in geopolitical tensions.
Politics drives uncertainty in the UK
Against this international backdrop, the UK outlook is further clouded, largely because of the ongoing political crisis and how it might evolve. The political risk premium – and thus policy uncertainty – overhanging sterling and UK assets is high.
Raw politics takes centre-stage when analysing the outlook for financial assets here in the UK. The recent local election results, the imminent European elections, and the still unclear path regarding Brexit (ahead of the October 31st deadline for the UK to reach a decision), point to a political environment where many different possible outcomes are projected.
For financial markets two issues appear most important: for now, the outcome for Brexit is more under the spotlight; but increasingly there is more comment, although not yet that much analysis, on whether there might be an early general election later this year, or next. This will overhang the prospects for sterling.
Brexit resolution may not diminish political unrest
When it comes to the Brexit impact, the effect has been seen more in sterling’s performance, rallying if a soft Brexit (where the UK remains closely aligned with the EU) is boosted by events, weakening if events are seen as strengthening the possibility of a no-deal outcome.
The challenge, though, is that even if the first stage of the Brexit outcome is resolved before the end of October, as the EU and UK hope, it is by no means clear that the political risk premium overhanging sterling and UK assets would diminish. This is because the focus might well then shift to not just the next step of the Brexit process, but to a possible future leadership challenge in the Conservative Party followed by a general election.
In such an environment, it is perhaps therefore a reflection of the economy’s resilience that growth has been so solid so far this year. Data released last Friday showed that GDP rose by a quarterly rate of 0.5% in the first three months of 2019, versus 0.2% in the final three months of 2018. There were, however, two very different contributory factors to the solid first quarter performance.
Inventories help boost Q1 growth
One was that stock building gave a temporary boost to the economy in the first three months. Ahead of the initial Brexit deadline of the end of March, many firms boosted inventories. This helped contribute to the fastest quarterly increase in manufacturing output since the late 1980s.
At the recent Bank of England press conference (the week before last), Governor Mark Carney highlighted that Brexit uncertainty had not only boosted inventories in the UK in the first quarter, but also on the Continent, too, thus helping UK exports. (Incidentally, at a global level, worries linked to trade tensions may also have boosted inventories in the US during the first quarter.)
Boosting inventories carries a cost for the firms involved, and thus the general expectation is that this may be reversed in the second quarter and dampen activity. If so, the effect would be seen in manufacturing and PMI data. This is clearly a risk in the US, euro area and the UK, albeit for different reasons.
Yet many parts of the economy show resilience
The other issue in the first quarter’s data was that the GDP figures reflect continued resilience in many parts of the economy. Growth was broad based, in services as well as construction. This mirrors the tax revenue and jobs data, which are usually good coincident indicators of how the UK economy is performing. These suggest steady growth.
Moreover, one of the positives evident is an improving backdrop for consumer spending – something we have anticipated for some time – as the low rate of unemployment is now being accompanied by a recovery in wage growth. Wages are now rising by more than the rate of inflation, which itself has decelerated to 1.9%, thus boosting real spending power.
Of course, the positives need to be kept in context. Productivity growth and investment spending are still low. Indeed, as the recent Bank of England Inflation Report indicated, while the economy has grown in line with the Bank’s predictions, the make-up of growth has been different, with consumption stronger and investment weaker.
Forecasts for UK economic growth have been revised higher in recent weeks. For instance, the Bank of England raised its growth forecast for 2019 from 1.2% to 1.5%. They expect 1.6% growth next year and 2.1% in 2021. The BOE projects that the Bank Rate – now 0.75% – will reach 1% in 2021.
Meanwhile, the fiscal outlook continues to improve
While market attention is focused on monetary policy, it is perhaps also worth keeping a closer eye on the fiscal outlook, given present economic uncertainty and political tensions.
Fiscal numbers in the UK continue to improve, reflecting previous policy choices as well as the modest to steady growth in the economy and the continued low level of rates and of bond yields. This trend is market friendly and also may open up more room for a relaxed fiscal stance later this year.
The budget deficit for the last fiscal year 2018/19 was £24.7 billion, and while that was slightly above the Chancellor’s projection in his March Spring Statement, more importantly it was significantly lower than the previous fiscal year’s £41.9 billion. The budget deficit is now 1.2% of GDP, versus 16.1% at its peak in 2009-10.
The turnaround on the fiscal numbers is also evident in the peaking of the government debt to GDP ratio, which in March was a high 83.1% but below the recent peak of 86.4% in September 2017, and it looks set to head lower.
Overall: still room for manoeuvre within the UK economy
All this feeds into the present political debate, as later this year there are two major fiscal events: the annual Budget, likely in November, and the Comprehensive Spending Review. An increase in spending has already been announced for the Review.
The picture on government spending is complex, comprised of annual managed expenditure, which has risen modestly, and departmental spending, where capital spending is rising but the far bigger component, resource or day-to-day spending, has been constrained, with large variations across departments. It would not be a surprise if the net outcome from the present political situation is a more relaxed fiscal stance, giving another prop to domestic demand.
Overall, the UK economy is growing at a modest to steady pace, while the monetary and fiscal stances indicate there is still room for manoeuvre in response to how the economic data unfolds. This is a comforting backdrop for the markets in the face of political uncertainty which continues to overhang UK assets.
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