The Reports of U.K. Economic Demise Appear to Have Been Greatly Exaggerated

Around the curve

The Reports of U.K. Economic Demise Appear to Have Been Greatly Exaggerated

Following the Brexit vote nearly a year ago, the U.K. economy was thought to be on its deathbed. Despite widespread forecasts of recession, the U.K. has continued to defy those dire predictions. However, concerns certainly abound.


Some variation of the above title was attributed to Mark Twain after he learned of a widespread rumor that he had died. While originally another example of Twain’s dry wit, the quote has more serious relevance today for the U.K. economy. Following the Brexit vote nearly a year ago, the U.K. economy was thought to be on its deathbed. Despite widespread forecasts of recession, the U.K. has continued to defy those dire predictions. However, concerns certainly abound. Consumer confidence is weak. First quarter gross domestic product (GDP) growth slowed and while inflation breached the 2% target, it will likely move higher before receding next year. As we “celebrate” the first-year anniversary of the British people’s historic decision to leave the European Union (EU), with the Brexit clock ticking and the snap election approaching, we continue to assess the prognosis for the U.K. economy.

What Do We Know about the U.K.’s Vital Signs?

1. The U.K.’s purported economic demise. The U.K. economy did slow in the first quarter of the year from last year’s strong pace. Yet, while recent indicators do point to slower growth, those indicators hardly scream “recession.” Consumer spending has slowed and real wages are threatened by the acceleration of inflation above the Bank of England’s (BOE) target. The central bank has raised its inflation forecast to 2.7% in 2017 and slightly lowered its growth expectation to 1.9% from its earlier 2% forecast. Consumer incomes have been hit by the higher inflation (see Chart 1), and consumers have dipped into savings to fund spending. But even here the deterioration in the savings ratio owes more to falling non-labor income, according to the Office for National Statistics, which expects 2017 revisions to show less of a drop in the ratio.

More recently, April retail sales showed a solid rebound and are now growing at a 4% annual rate. The labor market remains strong, even as forecasts of its deterioration followed the Brexit vote. The unemployment rate has fallen steadily to its current low of 4.7%. What has not accompanied this drop have been higher wages, a phenomenon also observed in the U.S. and Germany. The lack of wage growth could owe more to disappointing U.K. productivity and the quality of the jobs that are being created. Despite weakened consumer confidence, however, U.K. property transactions have moved decidedly higher (see Chart 2) and loan approvals for home purchases have rebounded following the increased stamp tax levy on purchases (see Chart 3). Finally, consumer intentions on home improvement, home buying, and car purchases over the next 12 months each are showing gains (see Chart 4).

2. The Pound and the BOE to the rescue. Pound sterling fell roughly 28% against the U.S. dollar from July 2014 through year end 2016, before mounting a gradual recovery. Pound sterling is currently around $1.28, having appreciated between 3-4% this year. One would expect the cheaper currency to have an impact on trade and the manufacturing sector. The currency is not only cheap and under-owned, traders are significantly short the pound, as shown in the chart on trader positioning (see Chart 5). The U.K. Purchasing Managers Index (PMI) has seen the composite output index pushed firmly into the expansion zone (see Chart 6), and this survey correlates reasonably well with economic growth, as measured by GDP.

Indexes like the PMI represent soft data. Can economic improvement also be found in the so-called “hard” data, like industrial production, for example? Chart 7 depicts a rebound in industrial production, as U.K. manufacturing industrial production maintains a strong relationship with the PMI’s exporters’ index. Strength in exports typically generates gains in industrial production. As seen in the hard data, the pound sterling’s earlier depreciation appears to be stimulating a more positive industrial production environment.

BOE monetary policy should also lend some support to the economy. It lowered its policy rate and stepped up its quantitative easing (QE) program, adding the purchasing of corporate bonds. For the banks, the BOE cushioned the blow of lower interest rates by including a new Term Funding Scheme (TFS), providing an inexpensive source of funding. Uncertainty concerning the economic outlook will keep the BOE accommodative, despite the trajectory of inflation. The BOE is not a doctrinaire inflation-targeter and will focus on economic growth, too. Some monetary stimulus will be removed from the economy, as the BOE meets its purchase goals for bonds. Tightening of monetary policy could occur sometime in the later part of 2018.

3. Then there’s the political backdrop. At the end of March 2017, the U.K. invoked Article 50 which officially commenced Britain’s divorce proceedings from the EU. Prime Minister Theresa May also shocked the markets by announcing a snap election to be held on June 8, 2017. The original scheduled election date was May 2020. The early election announcement pushed the pound higher along its upward track. The decision to seek an earlier election is designed to strengthen May’s negotiating hand in dealing with the EU and increase her Conservative Party parliamentary support. May indicated in her January speech on leaving the EU that both houses of Parliament would vote on the eventual treaty. The euphoria that accompanied the election announcement has ebbed, as the Labour Party has surprisingly demonstrated improvement in the polls. May’s vision is for a hard Brexit, a clean break from the EU and departure from the Customs Union. On the surface, discussions, once begun, will likely be contentious, with EU ministers initially focusing on the amount the U.K. must pay to exit the EU before they will even consider new trade agreements and other negotiations.

The outcome of the snap election promises to have an impact on the British economy and the path taken by the U.K. and the EU regarding Brexit negotiations. Until recently, May and her Tories enjoyed a wide lead over the nearest rival, Jeremy Corbyn and the Labour Party. Opinium Research reported May’s lead slipping to 13 points from 15 while another poll by YouGov calculates May’s lead in the mid-single digits. News reports point to planks in the Conservative Party’s platform that promise to spark intergenerational concerns, like the abandonment of state pension increases of at least 2.5%. May’s margin of victory is unlikely to match original expectations. The failure to win a sizeable victory could affect May’s negotiating strength with the EU.

     

Conclusion

Thus far, the U.K. has defied the predictions of a fading economy. Certainly the economy has slowed below its long-term average growth rate of 2.6%. The major risk to the economy is its largest sector, the consumer. Other areas, however, should pick up some of the slack left by consumers. The steep drop in pound sterling has begun to do its job, helping the export sector and, in turn, giving a jolt to manufacturing industrial production. The BOE is unlikely to embark on a more hawkish course while the economy is plagued by uncertainty over the economy and the direction taken by the Brexit negotiations. These proceedings will begin after the U.K. elections. The intent of the snap election is to enhance the Conservative Party majority and give Theresa May a stronger hand in the Brexit negotiations. Her sizeable lead has been reduced, and we are left to wonder if May will increase her majority in the Parliament. Another wild card in the elections is how voters will react following the terrorist attacks in Manchester and London. Smaller gains in the election could weaken May’s negotiating stance, diminish the pound’s strength, and create more economic uncertainty. While the U.K. economy is far from dead, it is not out of the woods quite yet either.

 

Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach. 

 

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