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.