The UK's green shoots have arguably been a bit greener than elsewhere. For example Halifax house prices rose by 2.6% in May while the services PMI rose back above 50 in June and stayed there this month. All this is clearly encouraging for the short term. However, I remain seriously worried about the more longer-term outlook and think the key reason for the recent positive UK data surprises is the larger macro-economic stimulus than elsewhere (with especially the 30% in GBP on a trade-weighted bias between August 2007 and January 2009 providing a temporary boost).
The structural problems facing the UK economy, however, are even more substantial than elsewhere. For one, the structural imbalances (overvalued housing market, over-indebted under-saving consumer, high current account deficit to name a few) are at least as pronounced as in the US, but the banking sector liabilities are significantly larger and the share of the financial sector is larger than in the US (with the added threat of tighter regulation of the financial sector pushing financial institutions out of the UK).
Furthermore, the sustained current account deficit of the past years led to foreign investors pouring capital into the UK. While this seemed attractive when the UK was perceived as a high-growth, high-return economy, the prospects for ZIRP by the BoE and extended real growth weakness are changing the investment rationale. In contrast to the situation in the US, so far the UK current account deficit has failed to really improve and deteriorated even further in Q4 with only a small improvement in Q1 at higher than expected levels. I think there is no way around a significantly falling UK trend growth rate and a there remains substantial risk of a much weaker GBP over the medium term.
In Switzerland, the situation is almost the opposite. I am less worried about the medium term prospects of Switzerland despite the current severe recession with the SNB expecting growth this year around -3%. Yes, similar to Germany and Japan, Switzerland is one of those countries with limited domestic imbalances but a significant dependence on exports. In fact, Switzerland is even more dependent on foreign demand than Japan or Germany as exports account for almost 50% of GDP (with the current account deficit in 2008 close to 10%) and according to the latest data for May, exports are down 21% from a year ago. Clearly, there is much more downside ahead for exports given that 60% of Switzerland's exports go to the EU with Europe's fall in demand only finding its way into Switzerland with a delay. Furthermore, with UBS, the largest bank continues to struggle. Finally, the cracks in the banking secrecy for non-residents are becoming larger and might threaten the status of Switzerland as an offshore financial centre.
However, there are several medium-term positives. First, while house prices rose steadily during the current decade, there was no real boom and the housing market does not appear significantly overvalued. Consumers as well do not appear stretched (in contrast to the overindebted, undersaving and overconsuming US and UK consumers). With respect to the state of the banking sector, UBS appears to be rather the exception than the rule and for example the state-near cantonal banks (in contrary to the German Landesbanks) have not been hurt significantly. More importantly, I think that besides the current cyclical weakness, the structural story for Switzerland as a refuge for rich individuals and international corporations has become even better. Yes, the bank secrecy is becoming a bit weaker for non-residents. But this is not the case for residents.
Furthermore, the Swiss tax system remains extremely competitive internationally and given that taxes are rising (as in the UK) or likely to rise (as in the US) for the high-income earners, stable and low taxes in Switzerland are becoming even more competitive. The combination of higher taxes and higher tax-evasion hurdles for non-residents renders moving to Switzerland more attractive. For corporations a similar logic applies (with some hedge funds moving to Switzerland amid a threat of tougher EU-wide regulation) and just yesterday McDonald's (NYSE:MCD) announced to be moving its European headquarters to Geneva from London amid more preferential intellectual property tax laws.
This erodes the tax base of the affected countries but increases the tax base of Switzerland, helping to keep fiscal deficits in check without having to resort to tax increases, a positive feedback loop for Switzerland. Furthermore, the movement of wealthy and highly educated people as well as corporate headquarters is increasing demand for the already scare land and houses, supporting their prices. Overall, therefore, I think that despite the significant cyclical weakness of the export-dependent Swiss economy, the medium term outlook is superior compared to the rest of Western Europe. In particular, scarce land/houses should do well over the medium term amid an increase in demand for high-priced office space and high-end housing. Domestically focused high-end corporates should see rising demand for their services. Additionally, the SNB will continue to struggle to fight the inherent strength of the CHF.
Selling GBP vs. CHF looks attractive on a longer term horizon. However, export-dependent companies will continue to face a mix of weaker demand and an increasingly uncompetitive exchange rate.