With 5 July having marked ten years since the Bank of England (BoE) last raised UK interest rates, we assess the state of the economy and its prospects in light of recent political developments.
Although the UK economy has shown resilience since last year’s Brexit referendum, its growth rate decelerated in the first quarter of 2017. Sterling’s devaluation has caused inflation to rise above the level of wage growth, putting pressure on real income levels. Meanwhile, uncertainty surrounding Brexit and the recent general election result is also weighing on business and consumer confidence. Together these forces are holding back consumption, a major component of overall GDP (Figure 1).
Real wage growth and consumer confidence
Figure 1: Sterling’s post-referendum devaluation has pushed UK consumer price inflation higher and consumer confidence is declining as prices are now rising faster than wages (real wage growth is negative). The hung parliament result of June’s election has also had an adverse impact. In turn, this is weighing on consumption growth, a major component of overall UK economic growth.
Consumption growth has widely been expected to come under pressure as a result of sterling’s devaluation. This has led the government and BoE to temper their growth expectations and the latter to keep its monetary policy stance highly accommodative. However, some members of the Monetary Policy Committee (MPC) have recently begun to indicate that it could soon become appropriate to move away from extremely-accommodative policy if wage growth accelerates or if an increase in business investment is able to offset the adverse effect of slowing consumption. We note that the UK unemployment is already at multi-decade lows, while sterling’s devaluation has boosted the competitiveness of large UK-based exporters, encouraging investment.
Nevertheless, wage growth has been held back by structural factors within the labour market in recent years and political uncertainty has begun to weigh more heavily on business confidence since June’s general election. Meanwhile, businesses whose costs are dependent on imports are suffering as these have become more expensive in sterling terms, while export growth has underwhelmed in recent months as manufacturers have been unable to derive as much benefit from improved competitiveness as had been expected. As such, BoE Governor Mark Carney has indicated that the MPC remains in ‘wait and see’ mode regarding any change to the BoE’s policy stance. In line with this, we expect monetary policy to remain unchanged until greater clarity is gained on the economic backdrop.
Political uncertainty – Brexit
The government’s plans regarding the UK’s secession from the European Union (EU) are defined in its European Union (Withdrawal) Bill (previously the Repeal Bill). This is intended to repeal the 1972 European Communities Act, through which the UK originally joined the EU. The Prime Minister interpreted the result of last year’s referendum as voters choosing to leave the European Economic Area, while rejecting membership of the Customs Union and free movement of people across the UK-EU border. She is therefore seeking to move forward with a bill that is based on these terms.
However, the EU’s Brexit negotiators have insisted that a secession under such terms would end with the UK not having access to the European single market; this would be considered a ‘hard’ Brexit. However, the opposition parties and a large number of dissenting Conservative MPs favour a ‘soft’ Brexit, which would include the UK retaining access to the single market; they argue that this would better protect the interests of UK-based businesses and keep UK workers’ jobs safer. These groups are therefore expected to band together to try and force the government to compromise on a number of the Bill’s elements and we note that an All-Party Parliamentary Group on EU Relations has been formed with a view to avoiding a hard Brexit. As such, it is highly uncertain what the final version of the Bill will encompass.
One key aspect up for debate is whether the government will seek to include or exclude the UK from the jurisdiction of the European Court of Justice (ECJ). The ECJ is the arbiter in disputes within the European single market and a backstop for various European regulatory bodies in sectors such as energy, healthcare, transportation, security and justice. The Prime Minister has interpreted the referendum result as voters wanting the UK to be excluded from the ECJ’s jurisdiction, but it looks increasingly likely that the government may now accept some continuing jurisdiction for a limited amount of time. Such a decision may help smooth the exit process; for example, by assisting in trade negotiations.
Ultimately, a ‘softer’ Brexit would likely improve UK growth expectations, with positive implications for sterling. Stronger growth prospects would likely lead the BoE to become more hawkish in its monetary policy projections. They would also be considered positive for domestically-focused UK equities, while greater political clarity would be beneficial for UK-based multinationals. However, given that sterling’s post-referendum devaluation has been a key support for the latter, we would expect the former to outperform if it became apparent a soft Brexit were likely to occur.
Given that the various political groups are so highly opposed in their expectations for what the secession should entail, we cannot rule out that political gridlock may ultimately lead to Brexit not occurring at all. Nevertheless, we consider this possibility a tail risk at present. Given the market reaction following last year’s Brexit referendum result, we would expect sentiment towards sterling and UK equities to improve significantly if it appeared that the UK was set to remain within the EU.
Shifting political status quo?
With so many pieces of legislation to be considered, it is important that the government does not let its Brexit responsibilities get in the way of domestic policy. This is particularly the case since June’s general election showed that voters are unhappy with the domestic political status quo. The Labour Party’s strong showing among young voters has highlighted that large sections of the electorate have become disillusioned with policies that are perceived to be facilitating large wealth disparities. As such, pressure for the Conservatives to reverse some of the austerity measures they have implemented in recent years has increased, at a time when they have committed to maintain fiscal discipline and eliminate the deficit by the middle of the next decade.
The public-sector pay cap is also likely to be the subject of significant debate, with Labour arguing that the decision to keep public-sector wage growth at 1%, at a time when inflation is far higher, is damaging the quality of public services and causing public sector workers’ quality of living to deteriorate. More broadly, the government will be under pressure to increase departmental budgets that have been cut significantly since it came into power in 2010, while also reversing some of the cuts they have made to welfare benefits.
If austerity measures are reduced, it will be hard for the Conservatives to push ahead with plans to reduce corporate tax rates. To the contrary, Labour have said they would increase corporate tax to pay for greater spending if they came into power (Figure 2). Any decision to increase the planned level of corporate tax rates may prove a significant barrier to the government attracting large global businesses to the UK, particularly at a time when Donald Trump is endeavouring to cut corporate tax rates in the US. Ultimately, a failure to attract global businesses could damage the domestic economy, reduce job availability and reduce wage growth, as higher taxes would weigh on business profitability and incomes.
Corporate tax rate projections
Figure 2: Although the Conservatives have planned to continue reducing corporate tax rates to encourage large multinationals to base operations in the UK, the Labour Party would increase them to fund higher spending. Labour would increase the main rate to 26% in time, while re-introducing the ‘small profits’ rate to assist companies with profits under £300,000. Uncertainty over the path of UK corporate tax rates is adversely impacting business confidence and could potentially reduce investment in the UK.
Source: Brooks Macdonald
Greater government spending could have various other effects. Higher demand would likely increase domestic inflationary pressures, with ramifications for the BoE’s policy stance. If the government were to choose to increase borrowing to fund additional expenditure, confidence in its financial position could be eroded. Such a path would likely push UK gilt yields higher, particularly in longer-dated issues. It is possible that this could force the BoE to resume its quantitative easing programme, essentially monetising the government’s debt, as is currently the case in Japan and certain European countries. This would further undermine sterling, adding to domestic inflationary pressures. We note that even without an increase in government spending in the near term, the Office for Budget Responsibility has projected UK government debt to increase significantly over the long term as a result of unavoidable demographic cost pressures (Figure 3); however, we note that many countries in the world face similar situations.
Projected government budget balance and net debt position
Figure 3: Although the Conservative Party plans to eliminate the fiscal deficit by the middle of the next decade, the Office for Budget Responsibility’s longer-term forecasts show borrowing rising significantly as a result of demographic pressures at current spending rates. In the long run, this could mean more debt monetisation through quantitative easing and, potentially, higher inflation; alternatively, UK citizens will have to endure a lower average standard of living.
Source: Office for Budget Responsibility
In the short term the UK economy faces a number of challenges, with consumption growth set to remain under pressure in the coming months. It is still unknown how intense the effect of declining real wages will be, or whether the other components of demand, such as investment, will increase to offset the effect on overall growth, particularly as the benefits of sterling’s devaluation will have to be weighed against the negative effect of political uncertainty. Nevertheless, it appears increasingly likely that the UK is heading for a softer Brexit, with the government’s hard line expected to face significant opposition from within and outside the Conservative Party, and this could benefit business and investor sentiment in the medium term.
The recent general election result is likely to increase pressure on the government to tackle perceptions of growing wealth inequality and we ultimately expect this to manifest itself in greater fiscal spending. This could have an inflationary effect on the domestic economic backdrop, undermining sterling, and could further propagate the ‘reflation’ trade that has been underway in global asset markets since the middle of 2016.
Ultimately, we believe the current uncertain economic and political backdrops merit caution over both domestically-focused and internationally-exposed UK assets. However, this is not to say that attractive investments cannot be found within the UK. In many cases valuations are already reflecting very pessimistic outlooks and certain quality assets can be purchased at compelling prices. However, we are cognisant that political developments are able to change investment cases in very short timeframes and therefore a nimble, active approach to investing in UK equities should be taken.
This article was first published by Brookes MacDonald in 20th July 2017.