UK economy: Calm before the storm?

septiembre 2016

Despite some encouraging economic data and a market bounce since June’s EU referendum vote, a UK recession remains on the cards, says Stewart Robertson.

 

Either the UK is heading for a nasty downturn and probable recession by the end of 2016 or a set of previously reliable surveys are giving misleading messages about the country’s growth prospects. We lean heavily towards the former explanation, although the possibility of the latter should not be entirely ruled out given the unprecedented situation the UK is in.

It is less than three months since the shock UK vote to leave the European Union (or ‘Brexit’). The real-world ramifications of that momentous decision will only be felt in time – it remains far too early to draw detailed conclusions about the economic impact. Some commentators have suggested the marked rebound in equities since July, along with strong consumer spending over the summer, is evidence that worries about Brexit were unfounded and that UK growth will hardly skip a beat. It is premature, and dangerous, to make that assumption.

Mixed signals

A whole host of business surveys tumbled in the aftermath of the referendum. Surveys of UK purchasing managers, manufacturers, chief financial officers and consumers each indicated a jolt to confidence or output in July. More recently, UK manufacturing and services activity saw significant bounces in August according to the Markit/CIPS purchasing managers’ index, as output and orders recovered after the initial shock. Based on historical relationships, taking July and August together suggests little growth in GDP in Q3.

The data is similarly far from conclusive in other areas. While house prices climbed by 0.6 per cent in August and are up more than one per cent since June[1], the number of mortgage approvals in July shrank to their lowest level since January 2015, according Bank of England (BoE).

Evidently the central bank believes downside risks are materialising in the UK, using that judgement to justify the decision to cut UK interest rates and to restart bond purchases. In its August Inflation Report, the BoE hinted strongly that more stimulus will follow if its much gloomier projections prove correct. Although it stopped short of forecasting a recession, it projected “little growth in the second half of the year”.

Figure 1: Bleaker outlook for the UK economy

GDP - actual and Bank of England projections

Recession nears

If growth slows as we expect, the view that there is little to worry about will change. In time-honoured fashion it may only be when UK households feel the chill winds of slowdown that they modify those views. When jobs growth slows or reverses - as unemployment rises, incomes are threatened and house prices fall - the recent positive turn in sentiment will likely reverse. Again, the BoE agrees with this outlook, forecasting an “eventual rise in unemployment” among other things.

There is one caveat to the weak prognosis and it relates to the fall in sterling exchange rates since the referendum. The depreciation of the currency has boosted the competiveness of UK exporters significantly and may help account for the buoyancy of UK equities – around three-quarters of FTSE-100 earnings are generated abroad[2]. The weaker currency helps explain why the FTSE-100 finished August around seven per cent[3] higher than the day of June’s vote, while the FTSE-250 climbed by 2.75 per cent over the same time.

Figure 2: Weaker sterling aids UK exporters' prospects


On the flip side, the weaker exchange rate will boost UK inflation in time. Import prices are already notably higher, climbing by the highest monthly amount in five years in August among manufacturers according to Markit/CIPS, and this is likely to continue over the next six to 12 months.

We foresee the consumer price index exceeding target next year, but believe that the Bank of England will look through any such spike. Even if the pound falls further, as looks possible, and inflation moves higher, the central bank should prioritise support for growth. Despite an uptick in some data in recent weeks and the prospect of more stimulative policy if needed, the next year or so will be a tough time for the UK economy. And that is all before exit negotiations have even begun.

Investment implications

Domestic financial markets have been aided since July by a more buoyant mood among investors globally, signs of an easier monetary policy outlook than expected ahead of the June vote, and some clearing of the intial political uncertainty through the quick change in UK prime minister. Any negative shock from any of these factors may dent some of the recent market bounce.

The bias of the FTSE-250 towards domestic earnings will leave the index more exposed to a possible UK downturn than the more multinationally-focused FTSE-100.  Conversely, businesses that are relatively resilient to slowing consumer spending may be better placed to weather any downturn. 

As for debt, we expect bond yields to remain suppressed as growth considerations win the tussle with any inflation fears among central bankers to keep monetary policy loose. However, a surprise surge in UK inflation may well trip bond markets up. 

 

[1] Source: Nationwide, 31 August 2016

[2] Source: Daily Telegraph, 28 June 2016

[3]  Source: Bloomberg, 2 September 2016

Important Information

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RA16/0638/31122016

In Summary

  • Any suggestion that the UK economy has survived June’s shock vote to leave the European Union relatively unscathed is premature and dangerous
  • Despite an uptick in some data in recent weeks and the prospect  of more stimulative policy if needed, the UK economy is facing a nasty downturn
  • Even if the pound falls further, as looks possible, and inflation moves higher still, the central bank should prioritise support for growth
  • Domestic financial markets have been aided since July by a more buoyant mood among investors globally, signs of an easier monetary policy outlook than expected ahead of the June vote and some clearing of the intial political uncertainty through the quick change in UK prime minister. A negative shock in any of these factors may dent some of the recent market bounce