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Market views - UK Economy/Fixed Interest

UK ECONOMY/FIXED INTEREST

June 2010

Market levels (18 June 2010)

The UK economy is slowly recovering after the big contraction of the last 2 years. But while growth has resumed, recovery is going to be a long haul. Low growth, low inflation, and low interest rates will be the norm for some time.

Over the past 2 years the economy has been extremely weak. Gross Domestic Product (GDP) peaked in the first quarter of 2008 and then contracted for 6 quarters, until finally registering a small gain at the end of last year. From peak to trough GDP fell 6.3%, before rebounding by around 1% to the present.

Recovery will be slow. The factors that fuelled the economic boom - easy finance, confidence, big rises in government spending, strong global background - are no longer present. We expect growth in 2010 to be around 1-1.5%.

Three factors in particular are worth noting. First, the cost of living is going up faster than wages. In the year to April average earnings were up 4.2%, while the Retail Price Index (RPI) rose 5.3%. The RPI is a better measure of inflation in this context because it is designed to measure the overall cost of living, including mortgage interest. Falling real incomes will hold back people’s readiness to spend, as will the squeeze announced in the emergency budget.
The second factor to note is the unfavourable background in international trade. The WTO free trade structure has opened Western economies to intense competition from Asia. With the disparity in living standards and hence wage costs, Western industries are rapidly losing ground. In the UK, the trade deficit widened alarmingly during the boom years to £44 billion. During the slowdown the deficit fell 60%, to £18 bn last year, but it is a bad sign that the UK still had a deficit at all, given the scale of the drop in consumer demand. The deficit has now levelled off, and it remains to be seen whether the improvement can resume, or whether the modest economic recovery will lead to a fresh deterioration. This is important because if demand leaks out into imports then domestic output is correspondingly lower. It is also important because it means that the UK is falling further into debt. The new international competition means that the road out of recession will be tougher than in the early 1990’s.

This brings us to the third factor, also in the international background and also negative. In the high spending countries (UK/US/Club Med) consumers are looking to pay off debt, and governments are looking to reduce budget deficits. At the same time, countries with big trade surpluses are looking to resume export led growth rather than encourage domestic spending. This will be hard to achieve when spending countries are cutting back, and the result is likely to be intense competition. The situation could become profoundly deflationary.
Having looked into the gloom, it is time to look at an important mitigant - the UK has its own currency. This has enabled the UK to take interest rates right down to 0.5%, and to adopt fiscal and monetary measures as it wishes. By contrast countries in the Eurozone have been tied to policies which reflect the needs of all members. From the end of 2007 to the end of 2009 the Pound fell 20% against both the US dollar and the Euro. In effect everyone took a pay cut – a much smoother and faster adjustment mechanism than individual groups of workers having to agree to cuts. While a return to the boom years is unlikely for some time, the UK is better placed to navigate through the challenging international environment.

Turning to interest rates. The MPC continues to balance the weak economy against the big budget deficit and higher than expected inflation. The CPI rose 3.4% in the year to May, still above the 1-3% target range. But with the weakness of the economy there is no real pressure on the MPC to worry about rising prices. Their priority continues to be to see economic recovery, and they will not raise interest rates until recovery is clearly in place. The MPC will also take into account the effort to cut the budget deficit. The fiscal squeeze will encourage them to keep interest rates low as the UK tries to repair its economy. With only weak growth expected in 2010, interest rates are likely to be kept at 0.5% throughout the year.

Finally, what are the prospects for gilts? They are looking more attractive to international investors following the general election and the emergency budget. The coalition government is seen as having a strong mandate to reduce the budget deficit, which will cut the amount of gilts to be issued. At the same time the threat to the UK’s AAA credit rating has receded. However, while this will make gilts more attractive to investors, on the international scene interest rates are starting to rise as growth recovers. So the likely outcome is for gilts to hold their present levels while other rates drift upwards. We expect 10 year yields, currently 3.5%, to stand at around the same level at year end.

Page last updated July, 2010 ID1718