Saving Private (U.K.) Consumption

Includes: EWU
by: Adam Whitehead


The UK industrial economy is in contraction.

The UK consumer is the only driver of economic activity.

The UK consumer borrows to survive rather than to speculate.

UK consumer sovereignty rules independent Bank of England monetary policy decisions.

A UK economy post Brexit is a safe haven.

(Source: Bloomberg)

The last report suggested that the Bank of England's decision to stay on hold, mitigated the short term global growth risk to the UK economy; at a cost of introducing inflation risk to the medium term outlook. The scale of the growth risk was signaled by the trend breaking fall in December industrial output. The latest living standards survey by the Resolution Foundation also confirmed an economic inflection point. This report concluded that, whilst wages and consumer spending are back to where they were pre-recession, the potential for further progress is poor. This scenario was underlined in the latest wage and employment data from the Office for National Statistics (NASDAQ:ONS). This report showed that whilst Q4/2015 unemployment held at a decade low, earnings growth weakened to 1.9% per annum. The inflation risk is not there, yet neither is the risk of rising unemployment.

(Source: Economics as Classical Mechanics)

The bean counters at the Bank of England will no doubt be pouring over their models and assumptions; to explain why the Phillips Curve is not working, or has shifted, or changed shape ….. or something. Then at some point, some Monetary Policy Committee (MPC) member will feel obliged to announce that the Phillips Curve no longer seems to be working again. In truth it has not been working for some time, but the MPC has just winged it and assumed that normal service would be restored later.

A similarly conflicting picture was given by the Q4/2015 GDP data. The consumer is basically doing all the economic heavy lifting right now as businesses pull back their horns. The prospect for job creation and capital investment are therefore poor looking further into 2016. Under such conditions the consumer has to borrow, in order to subsidize his/her employer's parsimony, assuming that he/she is lucky enough to have a job. For those not lucky enough to have a job, it will be game over once George Osborne's welfare cuts catch up with their spending plans. By taking out the unemployed and those on welfare, Osborne makes the UK economy even more highly leveraged to what appears to be an over-leveraged consumer.

(Source: The Daily Shot)

The reliance on the consumer, signaled in the GDP report, was then confirmed by the latest consumer credit figures. Consumer credit is back to pre-crisis levels, but this is neither a reason to cheer nor a reason to shout bubble. The UK consumer is basically borrowing to sustain his/her survival and current standard of living. If George Osborne is about to pull the plug on the public sector and tighten up on welfare payments, the UK consumer will then have to leverage up his/her sustainability beyond pre-financial bubble levels. In many ways this situation is worse than an asset bubble, because it truly represents peoples' livelihoods and not a vicarious view of alleged prosperity through asset prices. This is the reality of the situation that the Bank of England's models have failed to capture.

The Bank of England is therefore perplexed and worried enough, for Kristin Forbes to recently opine that its models are broken. There is however no imminent need to tighten monetary policy though. The Monetary Policy Committee and the Governor are in effect flying blind and reacting to markets rather than anticipating them. This was exemplified by the commentary from MPC veteran Martin Weale. According to Weale, inflation is now expected to take longer than previously expected to return to target levels. The drag from the falling oil price has prompted his revision.

Weale's take on the Pound also shows how the MPC's models have been whipped around by its volatile data inputs. Since 2013, the Pound has allegedly been so strong that inflation has been subdued. How to read its recent slide however is now presenting Weale with a different problem.

Just to put the icing on the cake, Weale then said that he does not agree with market's assumptions about how long it will take for UK interest rates to rise. The Economist Intelligence Unit has now rolled back interest rate hikes until at least 2020, in view of the unfolding situation. Weale is not sure of what is going on, but he is sure that the market is wrong. He is not the only central banker who disagrees with Mr Market these days. This seems to be a growing affliction. This is a double edged sword for Sterling and Gilts.

(Source: Bloomberg)

In the short term the low interest rate environment is good for Gilts, however it undermines also them by weakening Sterling. Forward rates are now implying a 25 basis point interest rate cut this year; which is a clear signal of the double edged sword's edges.

(Source: Markit)

Britons have worked out the Bank of England and its governor; and now think that they understand just how to play them. The British consumer has understood that he/she is driving the economy; and therefore that the Bank of England works for them. The consumer also understands that on the contrary to what Mark Carney tells them, deflation is good for them. Lower prices on the high street, lower the amount of consumer credit they require to make purchases. It should be noted that they are not consuming more with lower prices. There is inelastic consumer demand at this point; perhaps because it is being financed through borrowing rather than with pure cash.

A recent Markit survey found that Britons were less downbeat about their personal finances; but only because they feel that the Bank of England will keep interest rates lower for longer. This is terrible news for the Bank of England, because it indicates that lower consumer inflation expectations are now entrenched. The British consumer is now playing the Bank of England; and thus far the Bank of England is being played. Deflation is playing them both.

Deputy Governor Broadbent seems to be ill-at-ease with the situation; as he struggles to rationalize the impact of declining oil prices and the MPC's reaction to its fall. His instinct tells him that the fall in oil prices "is a net good" for the UK economy. This creates his discomfort in being reactive to the markets' dictated policy action to stay on hold. It also confirms that he sees the introduction of inflation risk by staying on hold; that may need to be addressed with significantly higher interest rates in the future. His uncertainty leads him to the assumption that inflation will return to target within two or three years; giving the MPC plenty of time to deal with the nascent inflation risk. This vagueness also supports the bid for the Gilt market in the meantime; which gives the MPC one less thing to worry about. Broadbent's concern is also felt by Deputy Governor John Cunliffe , in his view that the forward pricing of no rate increases until 2019 is an incorrect anomaly.

The Institute of Fiscal Studies (IFS) does not seem to concur with Broadbent. By its own estimates, despite the stimulus from falling oil prices, the UK economy is not growing fast enough to create the tax yield that Chancellor Osborne needs in order to hit his 2020 fiscal surplus target. A tax increase or a cut in fiscal spending is recognized as being required in order to hit the spot in 2020. The economic headwinds from either move risk slowing the economy even further, so that Osborne ends up chasing his tail but never quite catching it. Under such a scenario, it is hard to see much enthusiasm for tightening from the Bank of England. It is also hard to see any real enthusiasm to hold Gilts or Sterling either, until the economic and debt situation becomes more certain.

(Source: Seeking Alpha)

Once European Union (NYSEARCA:EU) leaders understood that the compromise deal negotiated with Britain had given the light to every EU nation to renegotiate its membership terms, the deal was effectively stalled. The Brexit is therefore back on and other EU member states have been encouraged to try their hand at breaking away also. The referendum will be held on June 23rd.

The last report explained how Boris Johnson was extracting political capital from Cameron's dalliance with the EU; and also that he would soon have to get off the fence in relation to the Brexit. Further capital was under extraction, as it became known that Johnson has been consorting with Justice Secretary and recently outed Brexit rebel Michael Gove. Having been caught in the act of sedition, Johnson had no alternative other than to declare his support for the Brexit and hence his direct challenge to Cameron's leadership of the party. In the event of a Brexit vote, Cameron will come under extreme pressure to step down; at which point Johnson will mount a more serious challenge.

With the focus on June 23rd and life in the event of the Brexit, the Bank of England was forced to communicate its own contingency planning. This is unfortunate, because the Bank actually has no plan; since all its plans devolve from models which it freely admits are not working. The Bank is therefore going to be reactive and will shoot from the hip. To assuage concerns about this new mode of policy making and execution, Governor Carney took to the stand in front of a Treasury select committee with his colleagues Nemat Shafik, Gertjan Vlieghe and Martin Weale.

The evolving consensus assumes that the Brexit will lead to further UK economic stagnation. To address this fear, Governor Carney responded that he has room on both the conventional and unconventional policy fronts. Conventionally, he can cut interest rates. Unconventionally, he can apply more QE and even move the goalposts on the target date for achieving his 2% inflation mandate even further into the future. He did however explicitly rule out crossing the conventional-unconventional line with negative interest rates.

Vlieghe supported Carney with the view that he is prepared to vote to cut interest rates if economic conditions deteriorate further.

Nemat Shafik is much smarter than her colleagues. She acknowledged that the lagged effect on real economic behavior, to moves in the value of the Pound, are difficult to predict. Whilst Sterling is falling, based on Brexit fears and anticipation of the Bank's easier policy stance, it is providing an economic stimulus. Speculators currently driving the Pound lower are now doing Bank of England's economic stimulus for it therefore. With such evolving dynamics, Shafik is thus loath to give any concrete policy guidance.

Picking up on Shafik's points, Martin Weale opined that his expectation is that the next move in interest rates will be up. Presumably Weale is worried about the inflationary impacts of the speculative overshooting of the Pound to the downside.

The Bank of England has therefore signaled that it has strapped itself in for a white knuckle ride in the capital markets. The Bank may not have to worry ultimately, since a Brexit looks set to be the catalyst that breaks the European Union (EU) and hence the Eurozone apart by default. Recent polls show that the Dutch now want a simple in/out referendum on EU membership. In the event of the Brexit, the Czech Republic is talking about the "Czexit" also. The Pound may therefore find support as a known unknown safe haven, in comparison to other former Eurozone nations and currencies. At least the Pound currently exists, whilst there is nothing to replace the Euro in countries that leave the Eurozone.

Some of the recent G20 Shanghai delegates noted the significance of the Brexit. Treasury Secretary Lew urged Britain to remain in the EU, for both economic and geostrategic reasons. According to George Osborne, the melodramatic consensus amongst the G20 attendees was that the Brexit would be a growth "shock" to the global economy.

It could also be said that the Brexit would trigger a political shock to established global macro order of things; that would endanger the livelihoods of those currently with skin in the game. Perhaps the G20 delegates were being a little too subjective with their melodrama therefore.

The UK consumer is unfazed by all the headlines and nudging from the government and the Bank of England. He/she has realized that the politicians and the Bank of England are there to serve and not to lead any more. The fact that there is a Brexit referendum at all, only serves to reinforce this opinion. Falling prices are a friend and not a foe. They own the banks anyway after the last bailout; so the banks have to fund their consumption. What else is there to worry about? It is going to take a real shock to the financial system to convince the UK consumer to believe what he/she is told by policy makers and central bankers any more.

On a global basis there is significant relative value in a nation with its own currency and an existing political system that can deal with the current volatility. There is also value in national mind-set that has a tendency not to panic when its leaders mess up. There is also fundamental value in a nation which understands that its central bankers and government are there to serve, rather than to lead up the garden path. Many Eurozone nations are currently rediscovering their own national political systems. Unfortunately, they do not have their own national currency to deal with the situation though. A UK economy post Brexit is therefore more of a safe haven than a UK economy that remains in the EU.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.