UK Perspectives

Will the UK Election Derail the Recovery?

Ahead of the general elections in May, the picture for the UK is one of economic health, but likely not one that would prompt the Bank of England to move its policy rate anytime soon.

With less than 40 days to go until the UK general election, opinion polls suggest that the two main parties (Tories and Labour) remain neck-and-neck in the race for votes. As important, the rise in popularity of other parties, such as the UK Independence Party, suggests that neither of these two main parties will secure enough votes to govern alone, unless there is a very big swing back to the Conservatives or Labour. Pollsters are regularly quoted as calling the likely outcome as “too-close-to-call”; but all agree that a minority government, or at best a coalition government, will be the likely outcome. Many are talking of a second general election within 12, or even six, months of the May poll. So is this uncertain political backdrop likely to cause high and persistent volatility in financial markets, and in due course could this derail the economic recovery?

The first point to note is that, notwithstanding some recent softer official data, the UK recovery looks to be in good shape. GDP for the fourth quarter of 2014 came in at 0.6%, having been running at 0.7% and 0.8% per quarter for the prior nine months. While this was lower than expected, much of the higher frequency data has not shown any material slowdown in the recovery. Also, it is interesting to note that in each of the last five years the weakest quarter for GDP has been the fourth quarter (according to the UK Office for National Statistics). Consumer and business confidence remains high, as do employment growth and employment intentions, suggesting that businesses are comfortable continuing to hire. Part of this may be due to resilient domestic conditions and rising real wages, but as we noted in our March 2015 Economic Outlook, “Can ECB Policy Heal Europe’s Ills?”, prospects for Europe are better than they have been for several years. Europe remains our largest trading partner, by some margin.

Is the Bank of England being patient?
Meanwhile, the Monetary Policy Committee (MPC) at the Bank of England (BOE) has indicated that it is in no rush to tighten monetary policy given the weak headline consumer price index (CPI) and very benign underlying inflationary pressure. A benign inflationary backdrop would certainly aid the recovery. The best way to assess the medium-term prospects for inflation is to strip out the volatile food and energy components and look at what is known as the core CPI, currently running at 1.2%. No doubt, there will be some upwards pressure on core inflation over the coming quarters as UK growth remains resilient, the labour market moves closer to full employment and nominal wages start to rise. However, we have also seen sterling appreciate by 5% on a trade-weighted basis in the last 12 months, which should counter some of the domestically generated inflationary pressure. Our best guess is that these two factors broadly balance each other out (see Figure 1 and 2).


Rather helpfully, we have good historical examples of the behaviour of core inflation during both periods of strong domestic demand and a strong currency as well as a period of significant currency weakness and a weak domestic economy. For instance, the five years prior to the financial crisis of 2007 and 2008 provide a good example of a robust domestic economy and a persistently strong currency. During that period, sterling was consistently stronger than it is today, as was domestic demand; and yet core inflation was consistently below 2%. Thereafter, sterling fell precipitously by 25% on a trade-weighted basis and, despite the weakness of the domestic economy, higher import prices pushed core inflation up by 1.50% to 2%, peaking just above 3.5% in April 2011.

Clearly, this is a highly simplified version of the outlook for inflation; but the point is that in a world of subdued underlying inflationary pressures and sterling appreciating relative to its major trading partners, the MPC can afford to wait before concluding that the economy needs tighter monetary policy (which we still see as more likely than easier policy).

How long can they wait?
With headline CPI likely to remain below the 1% lower tolerance band until at least the fourth quarter of 2015 and no pressure on the core inflation rate, there is no need for the MPC to think seriously about hiking the bank rate in 2015.

This all paints a very benign and potentially very pleasant backdrop for the economy over the next six to 12 months. However, the economic outlook for the UK is not without risk, most notably if there is an extended period of political paralysis. Along with many other experts, our expectations are that we will end up with a minority government after the May election, something which the UK has rarely seen. The last time a general election resulted in a minority government was in February 1974, with a second election called in October 1974 (in which the minority Labour government gained a small overall majority).

We agree that such an outcome will be an unusual situation for the UK, but is it one that investors should be very concerned by? Ironically, a weak minority government would have been a much bigger issue at the time of the last election in 2010, when the economy was in the early stages of the recovery and the fiscal position was much more precarious at 10% of GDP (according to the Office for Budget Responsibility). Now the economy is on a stable trajectory and the public deficit is set to be between 4% and 5% of GDP this year. As such, a period of policy stasis is much less concerning than five years earlier and indeed a situation that many developed economies deal with on a regular basis. Undoubtedly we will see some volatility in markets ahead of and after the election, but we do not believe that these gyrations will be enough to blow the economy off course.

Against such a backdrop, how do we position our portfolios?
UK government bond yields have rallied sharply, with 10-year yields falling back to 1.5% after briefly touching 1.95% early in March 2015 (according to Bloomberg, as of 6 March 2015), just ahead of the European Central Bank’s (ECB) implementation of quantitative easing (QE). As we already discussed, UK economic data remains solid, but not threatening from an inflation perspective, but as core European yields fall to-and-through zero, we believe that a good part of the recent rally in UK bonds relates to the knock-on effects of the ECB’s QE programme. Part of the story is clearly the rise in sterling relative to the euro and the downwards pressure that will exert on UK inflation, and part is likely to be a rotation out of European bonds into a market that is geographically and economically close. As we are just a few weeks into the ECB programme, and we have been told that it will run until September 2016, it is likely that these technical factors will be with us for some time to come.

Meanwhile, shorter-dated bonds have now pushed out expectations for a tightening in UK monetary policy to the middle of 2016. As the BOE’s chief economist, Andy Haldane, reminded us recently, it is far from certain that the next move will be a tightening of policy, but given the UK’s economic conditions that remains our central expectation. The market is pricing in both a relatively late start to the monetary cycle but also a benign one, with the bank rate predicted to rise from 0.5% around the summer of 2016 and peak at 1.5% by the end of 2018. If there is a risk to the UK bond market, it would appear that this is where it is, if indeed the economy continues to perform well and wages rise as we all hope and expect.

At the other end of the UK bond market, yields are also re-approaching their lows, with long-dated nominal yields at 2.30%, and long-dated index-linked yields at -0.98%. To some degree, the best explanation as to why yields are where they are is also the best reason as to why they will not reverse course aggressively. At these yield levels, long-term UK investors (such as defined benefit pension schemes) find themselves with significant funding gaps as a result of the very low level of long-term bond yields. Using the estimates of the Pension Protection Fund and bond yields as they stood at the end of January 2015, the aggregated deficit of UK-regulated pension schemes was £367.5 billion. To put this into context, the UK Debt Management Office has recently announced that they plan to issue a total of £37.4 billion of long-dated nominal gilts and £31.4 billion of index-linked gilts this year. Put simply, low bond yields create a big headache for pension schemes, suggesting that they would be willing buyers on any material rise in yields (in turn capping that rise in yields).

As we look forward, the underlying picture for the UK is one of economic health, but unfortunately not one that is sufficient to push interest rates back to any kind of “normal” level anytime soon.

The Author

Mike Amey

Head of Sterling Portfolio Management

View Profile

Latest Insights


A word about risk : All investments contain risk and may lose value.

This material contains the current opinions of the manager and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Investments LLC, U.S. distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the U.K. The Amsterdam and Italy branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie-Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO Asia Pte Ltd (501 Orchard Road #09-03, Wheelock Place, Singapore 238880, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia) offers products and services to both wholesale and retail clients as defined in the Corporations Act 2001 (limited to general financial product advice in the case of retail clients). This communication is provided for general information only without taking into account the objectives, financial situation or needs of any particular investors. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No. 382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein.| PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1o andar, Rio de Janeiro – RJ Brasil 22210-906. | No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. © 2015, PIMCO.