As we are all too painfully aware, the recovery in the UK is proving slower and more protracted than any recovery in the last 100 years, including the 1929 recession (See "Monetary policy and the damaged economy;' David Miles, external member of the Monetary Policy Committee, 24 May 2012). Even based on the somewhat optimistic Bank of England forecasts, the economy will likely not return to the level of output seen in 2008 until 2014. After borrowing growth in the form of excessive leverage, managing delevering in an orderly and socially tolerable fashion is a challenging task indeed. Inflation has consistently overshot expectations, remaining above target while output growth is probably flat, at best. That said, not all aspects of the post 2008 economic performance have been uniformly disappointing. The labour market has proven much more flexible than most dared hope, with weak real earnings growth more of an issue than unemployment. Indeed, the unemployment rate has held at a much lower level than it has done in previous recessions. This is reason for cheer.
As the chart below illustrates, despite growth being weaker than in any recession of the last 40 years, the 3.4% rise in the unemployment rate to 8.1% is very comparable with the 3.6% rise during the early 1990s and compares very favourably with the awful 6.6% rise in the early 1980s. Relatively speaking, this is good news.
However, the aggregate employment picture masks some striking deviations across age groups, and if we are to minimize the long-term impact of the recession, this is an area where much more needs to be done. If we separate the labour market into the younger 16- to 24-year cohort and those over 25 years old, a very striking picture emerges. Employment in the over 25 cohort has held up very well, with current employment at 25.7 million, a new high. The real strength has been amongst those 50 and over, which may be the result of the savings deficiency forcing workers to remain in the labour market longer. However, the flip side of this has been the crowding out of the youth, where current employment has fallen by 620,000 since the peak in 2008.
Tackling this weakness in youth employment must be one of the key tasks for the economy as we move through the next few years. At present, the weakness in growth risks creating a cohort who never get an employment opportunity, introducing the risk of slipping back into the hysteresis that beset the UK in decades past. Already it seems clear that the growth/inflation trade-off has deteriorated as both are consistently worse than expected. The Bank of England (BoE) believes that growth is currently positive, and that it will strengthen as we move through this year and next. However, with the European recession looming large, it is incumbent on the policy-making authorities to maintain monetary policy that continues to support what growth it can while the government looks to ways to support longer-term growth initiatives, such as structural investment, especially where this can be aligned to raising employment levels amongst the youth. Professor Miles highlighted this risk in his most recent speech, and it is a view I would support. Spencer Dale, BoE chief economist, has also raised the prospect of addressing the supply side of the economy rather than continually expecting cyclical demand management to support the long-term growth of the economy. The supply side and cyclical demand management need not be mutually exclusive in my opinion.
There is already a whiff of stagflation about the UK economy, and we need to take steps to support youth employment before we end up with longer-term unemployed. If we start now, in time we should be able to improve both the outlook for growth and the outlook for inflation. A relatively high level of employment but a low level of growth necessitates a worse productivity outcome and goes some way to explain why non-financial corporates' profits as a share of GDP are at a 10-year low (according to the Bank of England Quarterly Inflation report of May 2012). It also helps to explain why inflation has proven stickier than the BoE expected. Looking at the performance of unit labour costs you would be hard pressed to spot that this is the slowest recovery for a century. Rather you could be forgiven for thinking that we had returned to the pre-Lehman era of 2 %-3% annual increases in unit labour costs. During that era, domestically generated inflation was offset by global goods price deflation. Now that we have stopped importing goods price deflation, we need to see domestically generated inflation come down to sustainably hit the 2% inflation target. To date that has not happened, which is one of the key reasons why the inflation data has proven stickier than most expected. Reinvigorating productivity growth is arguably the challenge for the years ahead.
What does this mean for us as investors? For now it means that the secular inflation risk in the UK is higher than most other developed countries. UK investors should seek opportunities to buy inflation protection, and secularly the British pound should exhibit downward pressure to compensate for the productivity challenges that we face. UK investors should continue to seek out exposures to countries and companies without stressed balance sheets or secular growth challenges. While negative real yields on most UK index-linked gilts don't appear to present an attractive investment opportunity, in our view real yields are unlikely to return to positive territory for several years (outside of the very long end). As long as CPI stays sufficiently close to the 2% target, the BoE will stand at the ready for further bouts of quantitative easing (QE). Who knows - perhaps in time, QE may embrace not just gilts, but also government guaranteed infrastructure bonds. In that way the youth of today may avoid becoming the long-term unemployed of tomorrow, and that would be to all our benefit.