The U.K. Economy Begins To Contract

Jul. 25, 2016 8:11 AM ETFXB, GBB-OLD8 Comments
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Douglas Adams


  • PMI survey of UK economic activity for July posted the sharpest decline in output, new orders and export prices since the spring of 2009.
  • With the sharp drop in the value of the pound in world currency markets, dollar-denominated commodities caused input prices to soar as manufacturers abruptly shifted to backlog work.
  • The yield on both the 10-year and 2-year gilt notes plummeted during the period ending with Friday's market close, leaving a spread of 0.664 percentage points.
  • Overall economic activity is likely to contract over the next two quarters given preliminary measures, with the UK economy expected to fall into recession by the new year.

In one of the first independent measures of post-referendum economic activity, the Markit/CIPS Survey of Purchasing Managers Index (PMI) posted a sharp decline in July, posting a reading of 47.7, the lowest reading since April 2009 (>50 growing, <50 contracting). Current output and new orders -- a critical component of future growth, employment and investment sentiment -- fell for the first time since the end of 2012. Output has fallen by 4.7 points since June, while new orders have fallen even further at 6.8 points over the same period. On the service side, forward business expectations logged a 10.4 point loss -- the biggest decline ever.

With little surprise, the data showed a sharp increase of new order export business, which rose for the second consecutive month to levels not seen in the past two years. The spike in export activity was due almost solely to the sharp decline of the pound in world currency markets in the post-referendum period as the comparative advantage fell quickly to British export goods in world markets.

So much for the good news: Simultaneously, the price of raw materials the manufacturing process uses to produce those export goods rose sharply as dollar-denominated commodities prices soared relative to the decline of the pound. The 1-2 punch of falling export and soaring import prices caused manufacturers to turn abruptly to existing inventory and backorder work, the latter also showing heightened activity for the period. Facing declining demand for goods and services in the greater economy, rising costs and shrinking revenue, job losses in the near term are likely in the offing.

With the close of the pound against the dollar at $1.3106 at Friday's market close (22 July), the British currency has recovered a bit of the losses it has endured since the 23rd of June vote, which saw the pound fall to a low of $1.2926 (8 July) -- a low that hadn't been seen on currency trading boards since Margaret Thatcher occupied 10 Downing Street.

The yield on the 10-year gilt tells a similar story: On the eve of the vote it was 1.375%; by Friday's market close (22 July) it posted a yield of 0.799%. Unlike the pound, however, the yield on the gilt is as much an indicator of weak forward economic activity as it is a safe harbor play largely by European investors in the wake of the cloud of uncertainty unleashed by the referendum. Similarly, the yield on the 2-year gilt on the eve of the vote was 0.526%. By Friday's market close that yield had fallen to 0.135% for a 0.664 percentage point spread between the 10-year and 2-year gilt. Little wonder many economists were predicting economic contraction for the 3rd and likely 4th quarters -- and a recession by the turn of the New Year.

All of this makes Britain's current budget deficit of roughly 4% of GDP all the more expensive to service moving forward. That money comes from the sale of government debt mostly to foreigners whose currencies have appreciated, some markedly, against the pound. Lowering interest rates and possibly dusting off the BOE's asset purchasing program shelved in the latter part of 2012 to stabilize the post-referendum economy will make that deficit even more onerous to service as the pound scratches out new lows with the rollout of the BOE's stimulus package in the coming months.

Adding to a growing tale of economic woes, Standard & Poor's stripped Britain of its top AAA credit rating days after the referendum vote. Fitch also downgraded Britain while Moody's had Britain one notch down and lowered its forward outlook to negative.

With the broad gauges painting a growingly stark dichotomy between pre- and post-Referendum economic activity, all eyes are now focused on the Bank of England. Given the growing gloom that seemed to be engulfing the UK economy, July's meeting of the Monetary Policy Committee (MPC) surprised both observers and investors alike by holding its main interest rate steady at 0.5%, already a 322-year low. While keeping borrowing costs in the greater economy steady at least for now, the MPC did lower bank capital holding requirements which effectively released £150 billion in added bank lending power, reversing a decision made only in March.

Yet with demand and jobs contracting and capital investment largely on hold, the move will likely languish in that deep, dark chasm between academic theory and practical reality. An immediate 25-basis point drop in the BOE lending rate was stayed according to news reports as so little of the available data at the time of the meeting -- just days after the vote -- was reflective of the new post-referendum reality. The fact that so many observers and investors alike were surprised by the MPC's no-move stance on interest rates speaks volumes on just how ill-prepared corporate decision- and government policy-makers were with a Leave-vote win.

The July post-MPC statement signaled heavily at a forceful BOE response to the decline in economic activity in the post-referendum era, which likely means its August meeting almost guarantees at least a 25-basis point drop in the bank's main lending rate -- the first since March of 2009. Further measures to stabilize the economy are widely held in market expectations. Adding to its sizable holdings of government debt that already stands at a quarter of outstanding issues through the end of June, the market anticipates the BOE to follow the ECB lead into the tricky realm of corporate debt. The BOE is not a newcomer to the purchase of commercial paper and currently holds about £3 billion on its balance sheet. Yet with a total bond purchase program of £375 billion, the corporate component is miniscule -- less than 1% of all purchases.

With outstanding corporate debt estimated at about £436 billion, credit-rating thresholds narrow the field to about £131 billion, according to Goldman Sachs data. Of the total, about half is debt issued by non-UK domiciled, largely US, subsidiaries which once again raises the question of ends versus means. With the perceived dearth of investment opportunities in the private sector, recent US-based debt issues have almost overwhelmingly gone to fund enhanced shareholder value programs such as share buy-backs and dividend payments.

With borrowing costs at historic lows and the availability of liquidity in the global financial system at historic highs, the availability of funds is currently close to unlimited. Government policy-makers justify the use of public funds to buy commercial paper in terms of stimulating investment in plant, equipment, workplace efficiencies -- not to mention the creation of jobs paying a living wage. Striking a balance between corporate and government decision makers is always a slippery slope to navigate.

This article was written by

Douglas Adams profile picture
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.

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.

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