It has been more than two years since the UK referendum and the uncertainty around Brexit is still very elevated, creating some concerns on the economic outlook over the next 12 months. It is hard to believe that only four years ago, the UK economy recorded the fastest growth since 2007 with an annual rate of 2.6% in real terms, the highest rate among the developed nations (figure 1, left frame). Today, economists and international institutions forecast an annual growth rate of roughly 1.5% for the year 2018, the second lowest after Japan (1.2%). As a result, the Bank of England had to keep interest rates low for longer than expected (figure 1, right frame), and added GBP 60 billion of Gilts and GBP 10 billion of Corporate bonds to its balance sheet and GBP 127 billion of TFS drawings (cheap loans) through the Term Funding Scheme (TFS) introduced in August 2016 in order to sustain the economic activity.
However, the elevated uncertainty associated with the sharp decline in our leading indicators suggests that the UK economy might be growing at a lower rate than what the consensus expects. In this article, we first review the UK economic outlook, and then we describe the potential impact on asset prices.
Source: IMF, Eikon Reuters
1. Macro indicators, uncertainty and consumer spending to weigh on UK growth outlook
There are several reasons why we think that the UK may experience a more severe slowdown than what the market expects. First of all, our short-term leading indicator, which combines a set of surveys and price data, forecast that the industrial production should continue to fall within the next 6 months. Sentiment and consumer confidence have been sliding and are now sitting at the lowest levels since 2013 on the back of trade war escalation and uncertainty over tariffs, Brexit and EU negotiations. We look at industrial production (IP) as a proxy for GDP growth rates, hence a significant decline in IP would lead to lower-than-expected real growth (figure 2, right frame).
Second, an interesting study from Melolinna et al. (2018) looks at the impact of firm-level uncertainty on business investment. We know from empirical studies that macroeconomic fundamentals, the cost of capital and uncertainty are all important drivers of business investment, which represents a strong component of economic growth. In their paper, the authors measure the firm-level uncertainty as the remaining volatility in individual stock prices that cannot be explained by general market variation (using CAPM model), using data on 178 firms from 2000 to 2015. Running a firm-level panel regression, which relates the firm-level investment to economic fundamentals, cost of capital (WACC) and uncertainty, they found a statistical negative relationship between firms’ investment and WACC and uncertainty. More importantly, the effects of uncertainty are more significant than the effect of WACC; a 1% increase in uncertainty leads to a 0.39% decrease in firms’ investment, while a 1% increase in WACC leads to a -0.15% decrease in investment. This means that even if the cost of capital remains low for UK firms, an increase in firm-level uncertainty tends to reduce investment in the medium term. Figure 2 (right frame) shows that the uncertainty (HFM, inverted) tends to lead business investment over time, therefore if uncertainty persists ahead of Brexit negotiations, firms should invest less.
Source: Eikon Reuters, Rothko Research, Melolinna et al. (2018)
Even though the post-Brexit real estate slowdown was not as bad as expected, the annual growth in house prices has decreased sharply over the past 3 years, from 5.6% to 2%, according to Nationwide's index. Even though economists are more divided on the question of whether the weakening housing market will slow down GDP significantly, the UK property market outlook remains fragile for the medium term, especially if the BoE is considering starting a ‘tightening cycle’. We can notice that the yearly change in Mortgage Approvals tends to act as a good leading indicator (6M) of the annual change in house prices (figure 3, left frame), therefore if the contraction in lending persists in this current environment, the UK housing market performance may be capped within the next 6 to 12 months.
On the top of that, consumption growth has remained weak since the referendum, averaging 0.3% per quarter compared to 0.6% in the previous five years and nearly 0.9% in the pre-crisis decade (according to BoE’s Ramsden June speech). In addition, UK households have on aggregate reduced their saving ratio (as a percentage of disposable income), from 9.4% in December 2015 to 4.3% in March 2018 (figure 3, right frame), which leaves little room for spending in periods of high uncertainty.
Source: Eikon Reuters
2. Impacts on asset prices
It is interesting to notice that the main asset that suffered from speculation over Brexit uncertainty has been the British pound. The REER index fell from 110 in May 2016 to a low of 92 in October 2016, resulting in a 16% Sterling depreciation in only 6 months (figure 4, left frame). Moreover, if we consider that speculation on the pound started months prior the referendum, we can increase the Sterling depreciation up to 20%. As a result, the UK inflation rate soared from roughly 0 in Q3 2015 to over 3% in Q3 2017, before slowing down in recent months on the back of a GBP recovery in 2017. Our model still forecasts UK headline inflation to remain high in the next 6 months to come due to the lagged effect of the rise in energy prices and the persistent low unemployment rate (figure 4, right frame). We don’t expect a new spike above the 3% level; however, headline inflation should remain above 2% within the next 12 months.
Source: Eikon Reuters, Rothko Research
Interestingly, the 10Y yield on Gilts has remained weak despite the sharp increase in inflation, widening the spread between the nominal growth rate (3.8% in 2017 according to the OECD) and the 10Y nominal yield. Figure 5 shows that since 2017, the 10Y yield has remained steady, oscillating between 1% and 1.5%. In addition, for the first time in many years, it has diverged significantly from the US 10Y yield, which has been on a rise over the past 18 months. UK equities have also continued to increase despite Brexit uncertainty, gradually reaching new all-time highs. To the exception of the early 2018 global equity sell-off, we can notice that the FTSE has been strongly co-moving with GBP/USD (see more in this article), therefore international investors may have found interesting value in UK stocks due to the fall in the national currency (71% of revenues generated by FTSE 100 companies come from outside of the UK according to Schroders).
Source: Eikon Reuters
We don’t expect UK equities to experience a significant rise in the next 12 months to come, as the FTSE could react negatively to a sudden increase in UK LT yields in the medium term. In addition, the excess liquidity, computed as the difference between real M1 growth and industrial production (figure 6, left frame), has been reduced sharply over the past two years and therefore limits the upside gain on risky assets.
We think that the Sterling will be on the play in the medium term, as the market is once again starting to be increasingly short GBP. According to the CFTC (figure 6, right frame), net short went down from +11K on June 12th to –47K contracts as of July 31st on the back of a sharp reduction in longs (-35K, green shades). In addition, the 3M 25-Delta Risk Reversal on GBP/USD, which provides a market sentiment from the options market, is currently trading at -1.5, its lowest level since January 2017 (according to Bloomberg). There is still potential downside risk for the British pound in the next couple of months, especially if the US dollar starts strengthening in a sudden risk-off environment; however, it may be worth buying the oversold Sterling in case we start to see a positive turn in our leading macro indicators. We would also carefully watch the 10Y UK-US interest rate differential in the medium term, a convergence between the two LT yields could be beneficiary to the British pound as well.
Source: Eikon Reuters, BoE, CFTC
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.