The news flow out of the UK continues to provide a steady stream of pleasant surprises. Growth is holding up well, unemployment is coming down,
inflation is in line with the 2% Bank of England (BoE) target and there is even some optimism that we may finally have the fiscal situation under
control. Of course, as George Osborne, the British Chancellor of the Exchequer, was keen to remind us, there remains much work ahead, but the outlook
is certainly brighter than it has been for several years. What is perhaps most encouraging is that we can now move the debate on from being pleased at
the cyclical upswing to genuinely posing the question as to whether the recovery is sustainable. If it is, then that has clear implications for
investment strategies, for the path of official interest rates and for the pound. However, before we jump to the all-important investment conclusions,
let us first try to address the question of growth sustainability.
So far, the UK’s economic recovery has been based on two interrelated factors: the stabilisation of the eurozone and the recovery in the UK housing market.
Why interrelated? Because part of the reason that UK mortgage rates have come down is that bank financing costs have come down equally dramatically as risk
premia on banks fell with improved clarity on the outlook for the eurozone, and therefore its (and our) banking system. This, together with the
government’s “Help to Buy” scheme, has been the driving force behind the housing renaissance. Granted, so far the renaissance has come through more in
rising house prices (running around +10% per annum) than volume (down 30% from the decade leading up to the collapse of Lehman Brothers), but this is a
decent start. What is more important is whether the hoped-for improvement in consumer sentiment and stabilisation in Europe can finally ignite a virtuous
circle of higher business investment, growing productivity and rising real wages. While it is in the very early days, the signs are also encouraging.
Is business investment finally improving?
For some time now, surveys have been indicating that we should expect a pickup in business investment – but official data have stubbornly refused to
indicate any improvement. However, the breakdown of the gross domestic product (GDP) numbers for Q4 2013 has provided the first signs of a turnaround, with
business investment up 8% from a year earlier. Looking at Figure 1, surveys of investment intentions had historically proved to be a reasonable indicator
of future business spending, although this current business cycle has been proving very different. The reasons for pessimism on business investment have
been well-versed: challenges in attaining bank financing on attractive terms, uncertainty over the path of UK growth on the back of fiscal austerity and
uncertainty over prospects for our largest trading partner, the eurozone. In each case, these challenges may be becoming less acute.
So far, using “Funding for Lending Scheme” data, there is little sign of banks increasing loans to the corporate sector; however, it has also been
well-documented that many companies sit on record amounts of cash. For now, it looks like the improvement in business investment is being financed
primarily by retained earnings, rather than additional lending. That is not necessarily a bad thing. But for a broader-based economic recovery, we will
need to see higher levels in commercial bank lending to the corporate sector. Again, there are also some signs of optimism: Rates for commercial lending
appear to be coming down (based on BoE data), and looking ahead, banks may be in a better position to lend after a multi-year recapitalisation process.
Based on BoE data, UK banks have increased their core capital by £140 billion since 2008, which corresponds to a healthy 9% of annual UK GDP. Granted,
there will likely be further capital raising ahead, but it does look like we are comfortably nearer the end of the capital raising cycle, rather than the
So, if the supply of financing for business investment is improving, what about the demand? For years, there has been something of a standoff between banks
and businesses as to whether the blockage is in the demand for financing or in the supply. Having made the argument for an improvement in the supply, there
are also grounds for optimism on the demand side. Clearly, the surveys, such as the one shown in Figure 1, indicate a willingness to invest. However, as
witnessed by our own cyclical forecasts at PIMCO, growth in the developed world will hold up tolerably well. Given where we have come from, and with the
majority of UK trade taking place with developed economies, this provides further grounds for optimism on business investment going forward.
What about the prospect of real income growth?
If the outlook for investment looks more promising, does it naturally follow that we will see higher real incomes at last? While not guaranteed, again the
outlook is more promising than it has been for a number of years. Although individual months and quarters have shown some volatility, the big picture is
that there has been precious little productivity growth over the last five years (see Figure 2). In turn, that makes it very hard for companies to raise
wages if they lack additional output with which to finance those wages. Likewise, it is hard to see innovation and productivity growth without business
investment. However, as we look ahead to a period of rising business investment, it looks plausible that we will see productivity recover, and ultimately
As can be seen from the last twenty years (see Figure 2), while there is year-to-year volatility, there does indeed appear to be a long-term relationship
between productivity growth and real wages (defined as whole economy earnings less consumer price index). It is always reassuring when intuitive
relationships seem to stand up to the analysis, but it does indeed seem to be the case that if employees become more productive, they will in turn be
rewarded for that.
Before we sound the all clear on the outlook for the UK, it is important to note that headwinds remain: The fiscal deficit remains at 4.9% of GDP (5.5%, if
you exclude transfers from the BoE), banks still have further recapitalisation ahead, consumers are already saving less each year than the long-term
average and sterling remains relatively elevated. However, the basic point is that the economic outlook is better now than it has been for any time since
the collapse of Lehman Brothers in 2008.
So what does that mean for the markets?
As the BoE has always been at pains to explain, they will only raise interest rates when the economy can withstand it. Given the UK’s encouraging economic
outlook, it is looking increasingly plausible that we are moving to that point, probably sometime next year. Indeed if recent rhetoric from the BoE is to
be believed, they anticipate hiking rates over the first half of 2015 (ahead of the May 2015 election). That is quite a turnaround from where they were six
months ago as we detailed in our 13 February 2014 European Market Update, “An About Turn at the Bank of England”; but for now, the mantra seems to
have moved from letting the economy run as long as possible to pre-emptive tightening. Given that markets price in the first hike around the start of Q2
2015, that suggests to us that the term premium, or excess yield to compensate you for the shift in central bank rhetoric, is very low.
Looking further out on the yield curve, at the time of writing, ten-year gilt yields at 2.75% (as of 21 March 2014) – flat to US Treasury yields – also
look on the rich side. The BoE appears to be ahead of the US Federal Reserve on the timing of rate hikes, and yet intermediate yields are the same.
Whichever way you look at it, there seems better value away from the UK bond market.
So what does that imply for sterling? Ironically, the one part of the UK market that picked up on the about turn in BoE rhetoric was the currency market,
which at an exchange rate of about $1.65 (as of 21 March 2014) has in our view already priced in much of the change in timing of UK rate hikes. That in
turn will be good news for the BoE in the event that they do indeed hike rates, as it suggests that a further spike up in the pound is not that likely.
With inflation already likely to come in at or below the 2% target, that should be welcome news. It does, however, suggest little value in longer-term
inflation-linked gilts, where the breakeven inflation rate at 3.5% looks high relative to the retail price index, which is unlikely to get sustainably
The bottom line
For the first time in five years, the outlook for interest rates is more balanced towards savers and borrowers. We would all agree that even if rates do go
higher, they are very (very) unlikely to get close to the 4%–5% level of the pre-Lehman period. However, a successful move away from what are effectively
zero percent rates would be a key point in the economic recovery, and one that all of us should be glad about.