Mike Amey of PIMCO explains why there is a lot more to the UK outlook than Brexit, important though it is.
When looking at the medium-term outlook for the UK, it is tempting to focus solely on Brexit. It is undoubtedly a key component of the UK outlook, but there are a number of other factors investors should consider when constructing their medium-term view.
Not least are how the economy behaves as we move through the monetary tightening cycle, whether politicians will be able to avoid the temptation of fiscal easing against a backdrop of continued income and wealth inequality, and how policymakers would respond in the event that the base case of low productivity growth and stable inflation is challenged.
There is a lot more to the UK outlook than Brexit, important though it is.
Before we look to the future, it is important to recognise initial conditions and anticipate how they may evolve. As with many other developed economies, the UK has enjoyed a prolonged period of steady growth, characterised by falling unemployment but disappointingly sluggish wage and productivity growth. The total number of people employed is a record-high 32.4 million, the unemployment rate is a 50-year-low 4.2% and government finances are moving back into balance.
However, average earnings for workers are rising at just 2.5% per annum, and with Consumer Prices Index (CPI) inflation at 2.4% and the household saving rate back at just 4.3%, household finance remains under pressure. It is this pressure that has been the primary cause of the recent slowdown in GDP. As we look to the future, the key questions we need to address are: What scope is there in other parts of the economy to support the recovery, and if we see a global slowdown, how well equipped is the UK to weather that particular storm?
Inevitably any medium-term forecast will have to take into account the risks to the economy that could arise from the UK's separation from the European Union (EU). However, before we take a look at the impact of Brexit itself, it is useful to think about the driver of the various components of the domestic economy. Consumer spending represents two-thirds of UK GDP and will continue to exert considerable influence on the outlook for the economy. That in turn will be guided by both monetary and fiscal policy.
We expect the Bank of England to continue to slowly increase interest rates over the first few years of the secular horizon. Given the uncertainty around the neutral real interest rate in the UK, we think it prudent to weigh the prospective interest rate cycle in the context of previous hiking cycles.
Considering most household mortgages relate to short-term interest rates, monetary policy can affect spending patterns faster than in other developed economies. Historically, interest rate hiking cycles have ranged at between 1% and 1.5% of cumulative rate hikes, typically completed over a 12-month period (Source: Bank of England).
This hiking cycle will no doubt be longer than previous ones, but we think the cumulative degree of monetary tightening will be consistent with prior cycles.
Clearly there is a large range of potential outcomes, but importantly, we believe that interest rates are likely to stay low over the secular horizon. This should limit the collective pressure on household balance sheets, such that household consumption can grow close to the growth in real incomes.
With the annual fiscal deficit back to 2% of GDP, there remains scope for fiscal policy to both add to GDP as well as detract. Unlike in the US, where we see the risks of late-cycle fiscal expansion ultimately accelerating the downturn, we expect fiscal policy to be more neutral in the early stages of the secular outlook but certainly with scope to become a bigger influence as we move towards the next general election, scheduled for 2022.
Where Brexit risks will undoubtedly take centre stage is in the outlook for investment. Observed business investment has been sluggish in recent years despite surveys indicating relatively upbeat investment intentions on behalf of businesses.
This gap we believe relates to uncertainty over the Brexit negotiations, where businesses would prefer to hire additional staff rather than commit to greater spending on plant and machinery. We believe that the path of the Brexit negotiations will continue to influence corporate behaviour.
Given the nature of the Brexit negotiations and the importance of the next six to nine months, it is hard to separate out the cyclical aspects from the secular outlook. In particular, as the negotiations accelerate over the second half of 2018, the risk of political uncertainty rises as the prime minister tries to negotiate the difficult path of placating her own ruling Conservative Party and striking a future trading arrangement with the EU. There is certainly a wide range of potential outcomes: a smooth transitional deal, a delay to the negotiations, a stalling of the negotiations if the UK government falls, or no deal. Our central expectation is still for the UK and EU to coalesce around a cooperative outcome, which sees the UK transition out of the EU over the secular horizon. In that event, we see some scope for a recovery in business investment, although clearly there are material risks around this expectation.
In sum, our base case is for a relatively stable economic backdrop and cooperative Brexit, with the Bank of England raising interest rates slowly over the next few years. However, there are several risks to our outlook, which we discuss in greater detail in the full article.
For more on our outlook including the risks and opportunities for investors, read "UK Outlook: It's Not Just Brexit".
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