Posted on 24 July 2015
"It goes on forever. It’s gibberish…you’ve vaporized the audience” - (Brian de Palma to George Lucas after seeing early screening of Star Wars – A New Hope).
A brightening past
For much of the post-crisis period, the UK economy has been a popular target for the economic doomsayers, seemingly the poster child for many of the most heinous economic crimes of the current era. In no particular order – there is too much debt, the financial services sector plays too dominant a role, productivity seems to be in terminal decline, while the economy is saddled with administrations that have persistently failed to grasp the role of government spending in a weaker economic environment.
Regular readers will know well that we’ve long suspected that such pessimism is misplaced with regards to the UK economy. Reasonably recent history told us that cuts in government spending could easily coincide with strong, even stronger, growth in the private sector (see In Focus “Doomed”, 9 August 2013 [PDF, 575KB]), much as it did in 1981. The productivity debate, meanwhile, may just lean too heavily on statistics that struggle to bear the weight – we are simply better at measuring employment and hours worked than we are at judging output. This may be even more the case in an economy increasingly dominated by the services sector. Alongside this, it is worth remembering statisticians often struggle to keep up with the reality in an economic upswing, missing some creation of new small businesses. The last few years have already seen significant positive revisions to the UK’s recent output history, already sufficient to change the way we view the recovery of the UK economy from the Great Financial Crisis.
Even if we do believe the current data on output per hour worked, a large part of this productivity puzzle can be explained by a more robustly capitalised financial services sector and lower oil prices hitting North Sea oil production. These may be good problems to have with regards to the sustainability of the current economic upswing.
The approach of interest rate rises
This consistently more optimistic view of the prospects for the UK economy has seen us recommend the more domestically exposed areas of the UK stock market (mid caps and consumer discretionary) over the large cap FTSE 100 where the majority of profits come from overseas, for much of the post-crisis period.
However, earlier this year (see Compass February 2015 [PDF, 710KB]) we recommended that clients move to proportionately favour large caps over mid and small caps within the UK equity portion of their portfolios. This change of recommended emphasis remains in place in spite of the continuing outperformance of the mid and small cap equity segments in the UK. There are many influences on this relative call, but chief among them in our opinion is the approach of interest rate rises in the UK economy. This long overdue tightening in the UK’s monetary environment may pose a more significant headwind to the more highly-rated, domestically-exposed stocks than those with more internationally diversified revenues.
This week’s minutes from the latest Bank of England meeting (which took place before the latest deal with Greece) showed the potential for a more imminently fractured vote than many might have suspected previously. The committee’s mutterings about inflationary pressures may jar with incoming CPI data showing very little evidence of any kind of price rises, in either the core or headline numbers. However, the ongoing pick-up in both nominal and real wages in the UK economy, amidst diminishing labour market slack, as well as the fact that we will now start to annualise last year’s fall in oil prices, suggest that above target inflation may not be as far away as many still forecast, particularly in an economy that is traditionally inflation prone in any case. Much as with the US, it is worth remembering that the most unusual thing about the UK economy right now is the current setting of interest rates. Even with a month-on-month pullback in June retail sales, the year-on-year figure suggests, much as data on the rest of the private sector, that higher interest rates are already overdue.
Even if the first interest rate rise does not arrive until next year, as forecasts and central bankers are still broadly suggesting, the rest of the curve is already starting to more visibly prepare. We suspect that there is more to come here, which explains our continuing recommendation that clients should tread carefully and lightly within the UK government bond universe, whilst keeping duration low.
William Hobbs, Head of Investment Strategy, Europe