Relative to almost any point in the last five years, the UK economy is faced with a far more agreeable backdrop than twelve months ago as we move into 2014. UK growth is up, inflation is down and the fiscal deficit is starting to look more manageable. However, we are still faced with questions over the durability of the recovery, the likely path of interest rates and what this means for UK asset markets. We will not spoil the punch line, but with the recovery in its very early stages and the level of output still below its 2008 peak, we hope, and expect, that this recovery will be allowed to continue. To tighten monetary policy too early creates many, many more risks than risking policy that is too loose for a little too long. We believe policymakers are well aware of this and have no desire to preside over a failed UK recovery.
So far, the recovery appears to have been based on two interrelated factors: the stabilisation of the eurozone and the lowering of UK mortgage rates. We say interrelated as the stabilisation in the eurozone has not only eliminated the drag of a weak demand from our main trading partner, but has also helped to bring down funding costs for the banking system. Along with the UK government’s Funding for Lending Scheme (FLS), the decline in funding costs for banks has been behind the fall in UK mortgage rates. This leaves us with a fairly classic early stage recovery of lower mortgage rates, higher household consumption and a lower personal savings rate. Clearly, the challenge now is to translate this early stage recovery into a more durable recovery involving business investments, higher productivity and stronger real wages. To date, the signs are mixed, with little hard evidence of a handoff to the corporate sector. Without a handoff, it is very hard to see a durable recovery.
What is the likelihood of a handoff?
At this stage, the headwinds look significant as domestic demand is hampered by weak (i.e., negative) real income growth, continued fiscal austerity and tepid demand in the eurozone. Similarly, the banking system appears far more enthusiastic to lend to home buyers (where lending is typically secured) rather than to businesses, where the risk associated with lending tends to be higher. On the other hand, the good news is that the focus of FLS will now be solely on lending to businesses, and there remains some scope for consumer spending to outstrip demand as the savings ratio can fall further in the short term (see Figures 1 and 2).
That would also give more time for the UK’s fiscal position to improve and for the banking system to conclude its recapitalisation. We may not be able to hold on to the 3%, and higher, rates of real growth in GDP seen in recent quarters, but similarly we should be able to avoid reverting to levels of growth that would leave us constantly flirting with recession.
What about inflation?
Arguably, as good as the news on growth has been, the news on inflation has been even better. The Consumer Price Index (CPI) has fallen to 2.2%, barely above the Bank of England’s (BoE) 2% target as commodity prices have borne down on the headline numbers and core inflation has remained stable around the 2% level. With utility bills now likely to rise by 3% to 5% this year, rather than the 8% to 10% rises seen in the past, the pressure from “administered prices” also seems to be abating. Put alongside the 5% rise in the trade-weighted sterling index and European inflation proving extremely benign, the outlook for UK CPI seems balanced around or just above the 2% target for the first time in several years. That in turn gives the BoE breathing space to “let the recovery run”, rather than having to constantly defend ultra-loose monetary policy despite a persistent overshoot on its inflation target.
Risks around our central expectations for growth and inflation
For growth, the risks are somewhat balanced. We expect growth to slow to 2%–2.5% over the next twelve months, partially hampered by low real wage growth, and the “sugar high” from lower mortgage rates to fade. It is, however, possible that business investment will improve earlier than expected and sustain growth rates closer to the 3% level.
On the downside, the main risks appear twofold: either higher official interest rates (unlikely, as we will explain later) or further eurozone turbulence. As my colleague Andrew Bosomworth recently explained in his December 2013 European Perspectives, “Muddling Through: The ‘Realpolitik’ of the Eurozone Crisis”, we believe the eurozone is in for a period of relative calm and is in fact happy not to be the centre of attention. Indeed, if there are risks from the eurozone, they are more skewed to inflation that continues to come in weaker than expected, putting downward pressure on the UK traded goods sector. Therefore, we believe that the risks to UK inflation appear to be more balanced around the 2% target.
While the messaging from the BoE’s Monetary Policy Committee (MPC) has evolved over recent months, we believe, with inflation well-behaved and real wages benign, the MPC will be happy to leave interest rates on hold at least through the end of 2015. To some degree, this is due to the much more benign inflationary backdrop as well as a reflection of the recovery remaining consumer-dependent; thus, the MPC may be wary of potentially snuffing out the recovery if rate hikes were to happen over 2015.
As numerous MPC members have explained, the MPC will only raise rates when the economy can take it. Clearly, one of the key risks to the UK is an overheating housing market, of which the Bank of England is already aware (hence the recent announcement to end the eligibility of mortgage lending under the FLS from January 2014). Given the much wider array of policy tools available at the BoE, we would expect the Financial Policy Committee to be the main body tasked with cooling the housing market, if needed, via more technical measures such as raising the regulatory cost of higher-risk mortgage lending. Since housing is the key “bright spot” for the economy, we believe it is very unlikely that the rest of the economy will be sufficiently robust to warrant higher official interest rates anytime soon.
So what are the implications for UK markets?
All else equal, stronger growth should mean that bond yields are likely to go higher over 2014. We believe, however, that much of the rise in bond yields is already behind us as five- and 10-year gilts currently (as of 9 December 2013) yield 1.65% and 2.9%, respectively. With the primary lending rate likely to be on hold at 0.5% for the next two years, it will constrain how high intermediate yields can go.
To explain this particular conundrum, let us look at the five-year yield at 1.65% and ask ourselves what a rise to 2% would suggest.
Recall that a five-year yield at 2% implies that the official interest rate average is close to 2% over the next five years. With the first two years at 0.5%, a 2% five-year gilt yield would imply the BoE hikes official rates to 3% for the period 2016 to 2019 (to achieve an average rate of 2% for the period 2014 to 2019). Given the current sensitivity to higher mortgage rates, it seems hard to believe that consumers could withstand a rise of 2.5% in mortgage rates early in the next Parliament. Indeed, much of the improvement in the economy to date is due to the fact that mortgage rates have come down by 1%-1.5%. So imagine what a rise of 2.5% would cause! Hence, our view is that much of the selloff in intermediate bonds has already happened.
On the other hand, 30-year gilts at 3.6% is slightly trickier – over the long term, these are not attractive levels. However, with funding levels improving across the defined benefit pensions market, we are seeing renewed appetite to buy long-dated UK bonds. With clearer value in shorter bonds, our preference lies in short and intermediate gilts.
Finally, when looking at the UK inflation-linked market, long-dated real yields at 0% have constrained the scope for any rally. With the inflation outlook now much more balanced, the appeal of UK linkers is much reduced. Breakeven inflation rates of 3% for the next 10 years and 3.5% for 30 years look high given that the Retail Price Index is expected to hold below 3% (it is 2.6% as of 9 December 2013). For those who can, we would underweight long-dated UK real yields at zero and favour long-dated U.S. Treasury Inflation-Protected Securities at 1.6%.