As the European debt crisis continues to unfold, many in the U.K. have been quick to point out, with huge relief, the benefits of maintaining monetary independence. As a highly leveraged finance-based economy, we are in no doubt that gilt yields would be comfortably higher were the U.K. to be part of the single currency. As of 4th November, 10-year Italian government bonds were yielding 4.7% more than their German counterpart and the Italian economy is less leveraged than the U.K. economy. As it is, 10-year U.K. gilt yields sit 0.5% above German bunds and 0.3% above U.S. Treasuries (Bloomberg, 4 November 2011). Given its monetary independence, gilts do not demand a yield premium for the credit risk. Does that mean the U.K. citizens should watch the challenges facing European policy makers with interest, without concern, or should they be worried? Unfortunately, it is very much the latter. Let me try to explain why and what investment implications the European debt crisis is likely to have on U.K. investors.
The first way in which the U.K. economy is inextricably linked to the eurozone is through trade. The eurozone area is by far the U.K.’s largest trade partner with 50% of its exported goods destined for countries within the euro area, according to latest figures from the Office of National Statistics. At the aggregate level, a weak eurozone means weak export prospects at a time when the country is trying to rebalance its economy towards greater exports. If there is a small silver lining it is that two thirds of the U.K.’s exports are destined for the economically more robust states of Northern Europe. However, the trade links are only the beginning of the story. At a minimum, we expect U.K. growth to be depressed even in the event of a “successful” resolution of the crisis. As has been noted by a number of my colleagues, the longer the crisis continues, the more lasting the economic damage and the harder it becomes to move away from the current fall in confidence. Indeed, any outcome that does not involve multiple defaults is starting to look like a good result.
Given PIMCO’s expectation for a multi-year period of fiscal austerity across the region, Europe is flirting with recession over the 18-month cyclical horizon. This prospect, coupled with the U.K.’s program of tight fiscal policy, points to a challenging economic outlook for the U.K. Clearly, there are still policy levers at the Bank of England that can offset part of this but it looks very hard to see how the U.K. can achieve its target 1% fiscal deficit by 2015. That doesn’t mean to say it stands to lose its fiscal credibility but it will likely take longer than the lifetime of the current parliament to bring the government finances decisively under control.
Taking a look at the current fiscal projections at the time of writing, the U.K.’s GDP growth is projected to be 2.5% next year, and 2.8% to 2.9% in the years thereafter, according to the Office for Budget Responsibility. Similarly, in nominal terms GDP is expected to be 5.2% next year and then 5.6% to 5.7% thereafter. For the record, the average increase in nominal GDP for the decade ending 2007 was 5.4%. It’s hard to see how this can be repeated given the current economic backdrop. So what does that mean for the fiscal projections? Assuming that GDP averages 1% below expectations per annum and assuming that each percentage point of growth disappointment adds 0.6% of GDP to the fiscal deficit, then the annual deficit will still be 4% of GDP by 2015 (Figure 1). That does not mean the U.K. will necessarily lose its credibility but it does give you an idea of the challenges posed by a weak growth environment.
In summary, even in the event that there is a successful resolution of the European debt crisis, the U.K. will come under pressure to achieve anything like enough growth to fully de-lever the economy by 2015. If that’s the central scenario, what are the risks around that? On the more optimistic side, there is a possibility of rapid fiscal integration alongside aggressive monetary stimulus, in turn unlocking the Northern European consumer. Unfortunately, the bigger risk at present appears to be European policy response to the crisis with European policymakers continuing to “react” rather than “lead” market developments. That begs the question: Can the U.K. economy withstand a further sharp deterioration in the European debt crisis?
U.K. banks are not immune from the contagion
It is true that the U.K. economy has made great strides in stabilizing its banking system but it is not yet in a position where it can withstand a systemic European crisis involving multiple defaults. At a minimum, the U.K. banking system is still significantly reliant on the wholesale markets. According to the Bank of England, U.K .banks have around 10% more loans outstanding than they have deposits. This may be half of its 2007 peak but it is still enough to put severe pressure on the banks in the event the wholesale banking markets freeze up. As it did before, the Bank of England would be forced to intervene but again, the degree of leverage embedded in the banking system would be very visible. Needless to say the markets know this, evident from the high correlation between Spanish and Italian credit default swaps (CDS), and Lloyds and Barclays CDS levels (Figure 2). As the European debt crisis escalates so does the correlation between European sovereign CDS and UK bank CDS irrespective of their holdings in European debt.
That in turn brings the U.K. consumer back into play. If the banking system is forced to de-lever more rapidly, the finance available to the private sector will also shrink rapidly. While the personal savings ratio has risen to a healthy 7.4%, the stock of household debt still sits at an uncomfortable 100% of GDP, or £1,450 billion (down £11.7 billion from the peak). Of that, 85% is secured on housing and with house price-to-earnings levels still 6% above the 30-year average, suggesting the household sector still has some deleveraging to do (Office for National Statistics, Bank of England). As with the government sector, the household sector should be able to work this down over time but it remains highly vulnerable to negative shocks.
So where is the good news in all of this? Well, the best news is that the Bank of England is very clearly aware of these vulnerabilities and this is why it has resumed quantitative easing. Highly respected member of the Monetary Policy Committee, Adam Posen, has recently been quoted saying that the U.K. is still in control of its own destiny. Up to a point that is correct, but there remains a point after which its future becomes highly correlated with that of Europe. It’s important that we are all aware of that.
Investment implications
What does this mean for us as investors? Long-dated gilt yields are already low at 3.3% but inflation expectations of 3.1% means that real yields are already very low (Bloomberg, 4 November 2011). We are currently in a world economists refer to as “multiple equilibria”, where we could end up with a favorable outcome whereby growth will remain weak but positive, or we could end up back in an environment similar to that of 2008- 2009. Given the degree of uncertainty, it is important to remain open to all eventualities and ask yourself what scenario would cause your portfolios the greatest hardship. For a lot of U.K. pension funds, the debt deflation scenario is the outcome with the most severe consequences. In that case, 30-year gilts yielding 3.3% could still offer a hedge against the credit assets that pension funds typically hold. Of course there would be a severe challenge for funding levels across the pension fund industry but that doesn’t mean doing nothing is the right course of action. For others concerned about longer-term inflation risks, in the event Europe is successfully stabilized, taking the opportunity to hedge out inflation may be appropriate.
Whether the U.K. is in the euro or not, we are all in this together. Ultimately, we are all “Europeans” and if things continue to deteriorate it will certainly become everyone’s problem.