Three sources of economic uncertainty looming large
After the post-election relief rally big challenges remain for the new government and for investors, says Stephanie Flanders, chief market strategist for Europe, J.P. Morgan Asset Management
Markets reacted to the surprising UK election result with relief. Both the currency and the UK stock market rallied at the news. Gilt prices also rose – meaning a corresponding fall in long-term interest rates. This makes sense. Fiscal policy under a Conservative government is likely to be tighter, on balance, than under a coalition or Labour-led government. Other things equal, that would suggest lower interest rates over the medium term, because reduced spending by the public sector ought to give the Bank of England slightly more need to keep rates at record lows.
But we have learned the past few years that “other things” are not equal. Budget policy is only one factor influencing the Bank of England. In setting policy, the central bank also looks at the broader strength of the UK economy and – just as crucial – growth in the rest of the world. Though the Conservatives hammered home their message of economic recovery throughout the election, in reality there are still enormous uncertainties hanging over the UK recovery, which have not gone away with this surprising clear-cut election result.
Three sources of uncertainty
Three sources of uncertainty should loom especially large for investors.
The first crucial factor is obvious but still too often ignored: the health of the global recovery. George Osborne has learned the hard way since 2010 that few things are more important to the UK economy and the long-term value of UK assets than the state of global – and especially European – demand. That is especially true for Britain, where more than 70 per cent of UK-listed companies’ earnings come from overseas.
Like the winter snows, economic momentum both here and in America melted as spring arrived. Gone is the assumption that both economies are rolling inevitably towards an exit from the malaise of years past. Maybe we’ll bounce back soon, or maybe not. On that short-term outlook, you can label us optimists because we think the recent deceleration in the UK should be temporary.
The larger point is that US consumption growth and the rate of domestic demand growth in the Eurozone in 2015 and 2016 are likely to have a bigger impact on the prospects for UK companies than the number of Scottish National party MPs in Westminster — or even the number of Conservative ones.
The second crucial factor hanging over the recovery is productivity growth. UK productivity – output per head – is now around 15% lower than it would have been if it had continued to grow at its long term trend rate of just over 2 per cent a year since the onset of the recession. For years the Bank of England has predicted a rebound, only to be disappointed. In its latest quarterly forecast it cut the medium term forecast for the 28th time in a row. We don’t know what is driving this supply side problem, but the very lack of an explanation suggests some caution is in order; we cannot automatically assume it will be reversed.
Without productivity growth, real wages can’t recover the ground lost since 2008 without hurting corporate earnings, the Bank of England will have much less room for manouevre in setting interest rates and George Osborne will have that much more need for austerity to balance the books. There was far too little debate on the problem in the campaign but boosting productivity growth should now be front and centre of the Chancellor’s first truly Conservative Budget in July.
A third concern is Britain’s external accounts. Not only is the current account deficit, at 5.5 per cent of GDP, the largest in the post-war era, but also we are more reliant on volatile portfolio flows to fund it rather than “stickier” sources such as foreign direct investment, which takes longer to go into reverse.
So far policy makers – including senior figures at the Bank of England – have been less concerned about this vast gap between Britain’s global spending and its global earnings than the numbers would have led you to expect. That’s because the gap has been driven, not by deterioration in the trade balance but by a 4 percent of GDP-swing in the investment account.
After decades of making more money on our investments abroad than foreigners made on their UK assets, the chart shows how this part of the balance of payments has swung violently in the other direction, leading to a net outflow of investment earnings out of the UK. Officials believe this is likely to be largely temporary. But the longer the problem persists the more worried we should be.
Whatever the reason, no country can afford to borrow 5-6 percent of its GDP from the rest of the world forever. And anyone unconcerned with relying on those short-term flows to fill the gap should remind themselves of the fickleness of financial markets – which was once again demonstrated by the brutal recent sell-off in core Eurozone government bonds. Investors who bought those bonds at their peak have in some cases lost double digits in only a few days.
In or out of the EU?
Finally, there is Britain’s future role in the European Union, which is now going to be decided in a referendum held in 2016 or 2017. Financial markets consider this the big negative to emerge from this surprising result. But in reality, the choice between the two parties on the referendum really came down to timing, not outcome.
In the past five years, the likely future shape of Europe has changed dramatically and so have UK popular attitudes towards it. Both these developments will make it much more difficult for us to remain in the EU on the same terms as before. Sooner or later, we will have to choose what we want to have instead.
So, the question of Britain’s continued membership in the EU was going to remain on the agenda, regardless of who won power and how long they kept it. There could be a short-term hit to investment in the run-up to the referendum. But other global forces may well matter more. It is not obvious that a referendum held in 2016 or 2017 is more likely to end in a UK exit from the EU than one held in 2020 — or even 2025. Nor can we say now which would cause more lasting uncertainty for business — or investment.
Our role in Europe, the growth rate of productivity and the state of global demand: on any reasonable timeframe, these are the things that matter most to Britain’s economy and its markets.
With growth and policy still broadly supportive, we believe it makes sense for investors to have a modest bias towards risk assets in their portfolio. But recent volatility is a reminder of the importance of diversification. Investors with a medium-term outlook have reason to be broadly positive about the UK. It is, after all, likely to be one of the fastest growing countries in Europe in 2015 and possibly 2016 as well. But if you were focused on those long-term uncertainties before the election you should realise that they remain just as uncertain today.