As we speculate over whether Q1 gross domestic product (GDP) is going to edge into positive territory or provide the UK with its third technical recession since the collapse of Lehman Brothers in September 2008, one area of the economy that has been a constant source of disappointment is the UK’s external trade performance. Sterling fell by 20% on a trade-weighted basis over the second half of 2008 (Source: Bloomberg), thus setting the stage for the prospective rebalancing of the UK economy away from domestic consumption towards stronger exports and less reliance upon financial services. The expectation was that export volumes would be able to outpace import volumes, and the trade deficit would move back towards balance. While the domestic economy would be held back by the necessary debt reduction, the UK export sector could fill at least part of the gap. So why has our external sector proved such a disappointment? Is there any reason to believe the picture will improve, and what are the implications for us as investors?
The first point to note in our analysis of the UK trade deficit is that, as a percentage of GDP, the deficit has shown no improvement from the level seen over much of the last decade, including the five years prior to the collapse of Northern Rock in 2007 and Lehman in 2008. The total UK trade deficit has remained resolute at around 2.5% of GDP, having briefly shown some signs of life in the immediate aftermath of the event of September 2008 before normal business resumed. Or has it? The most striking aspect of the UK trade performance is not that the total trade deficit is unchanged, but rather that the split of the deficit in goods and the surplus in services has continued to widen (see Figure 1), as if nothing has happened! So is there any hope that we can rebalance towards stronger export growth or is this simply a pipe dream?
As many readers are aware, part of the problem faced by the traded goods sector is that our exports remain highly focussed on the “old” economies of Europe and North America (three-quarters of exports are to these regions). The other problem is that while exports of goods represent 20% of annual UK output, our imports are equivalent to just over 25% of annual output (see Figure 2). To prevent this deficit widening further, for any 10% rise in the cash spent on imports, our exports need to improve by 12.5%. But with nearly 50% of our total exports going to Europe, an economic area constantly flirting with its own recession, it is no surprise to see that UK trade performance has been challenged.
A glimmer of hope
Granted, the U.S. economy “offers a glimmer of hope” for the UK that it can achieve sustainable growth, as laid out by my colleague Saumil Parikh in his recent article ,“PIMCO Cyclical Outlook: Glimmers of Hope,” and as such, we do have some modest hope that UK net exports may be past the worst. However, before we become too optimistic, let me share a few statistics on the challenge we face.
The first point to note is that measured in volume terms, using the latest available data from the Office of National Statistics for January 2013, UK exports are just 1% higher than in September 2008 while import volumes are unchanged. Despite the 20% fall in the value of sterling, the net benefit has been offset to date by our main export destinations’ weakness in domestic demand, and thus for imports. Given PIMCO’s expectations for a New Normal recovery, where growth is secularly challenged in Europe and North America, we should not be too surprised by the lacklustre performance of the UK export sector. So why was there such optimism among many commentators? And is there the prospect of better news ahead?
Much of the optimism relating to the performance of the UK export sector has been based on prior episodes of large falls in the value of sterling and subsequently strong rebounds in the export sector, both in absolute terms and relative to imports. Taking the example of sterling’s exit from the European Exchange Rate Mechanism (ERM) in September 1992, sterling ended that year 16% lower to the Deutschemark and 20% weaker to the U.S. dollar. With global growth less secularly challenged and UK exports some 16% – 20% more competitive, how did UK exports fare? Using an equivalent period to the one we just considered for the current episode, by January 1997 export volumes were some 48% higher while import volumes were just 34% higher. The deficit in the trade of goods was down to 1.3%, while the total trade in goods and services registered a surplus of 1.1%. Witness the power of a weaker exchange rate in a more robust global economy. (Source: Office of National Statistics)
Looking beyond traditional markets
So what now? We are seeing some small signs of export reorientation away from Europe and North America and towards the stronger growth regions of Asia and Latin America. Exports to these regions are now up to 25% of total exports and it does look like there is a steady upswing. To date, this trend has also come with a commensurate rise in imports from those regions - so it’s pretty clear that hopes for a rapid reduction in the trade deficit look still some way off. As the U.S. continues to re-heal, and trade becomes more geographically diversified, we should see exports start to grow once more, albeit off a modest base. In short, the chances of a rapid improvement in net exports remain disappointingly low.
What does this mean for us as investors, and how should we use this analysis to help us position portfolios? First, note that despite the recent second bout of weakness in sterling, this is unlikely to result in a rapid improvement in UK net exports. The easing in sterling is undoubtedly welcome and will improve prospects for exports, but it is unlikely to be a ”game changer.” Given that UK domestic demand remains constrained by fiscal austerity, a banking sector still looking to deleverage and a consumer facing at best flat real income growth, it is likely that real GDP will struggle to get above 1% for the life of the current Parliament (which ends in mid-2015). That in turn suggests that we will see further attempts by the Bank of England (BOE) to ease monetary policy, and that any rise in the Consumer Price Index (CPI) as a result of the fall in sterling will be tolerated by the monetary authorities. We will likely see further bouts of quantitative easing (QE), most likely via more gilt purchases, and it is entirely plausible that the BOE’s Funding for Lending Scheme (FLS) remains a policy tool past its current scheduled closing in January 2014. Sterling will remain under pressure, although given the array of developed countries that would be happy to see their currency weaken further, moves are more likely to come relative to the stronger economies of Latin America and potentially Asia. Brazil and Mexico remain among our favoured currency picks.
Meanwhile, as inflation tolerance rightly remains part of the behaviour pattern of the BOE, investors should continue to seek longer term inflation protection, either via the inflation-linked market or by holding non-sterling assets on a currency-unhedged basis. We expect short and intermediate nominal gilt yields will remain supported by the accommodative stance of the BOE and, given the steepness of the yield curve, should provide returns in line with inflation on a total return basis. However, longer-dated gilts will remain under pressure given the unenviable necessity of the BOE to tolerate sticky inflation.
In short, investors should continue to recognise that a monetary regime based on financially repressive “risk-free” interest rates remains in place; strategies designed to recognise this and help protect the real value of portfolios are likely to remain those that serve investors most successfully for the cyclical, and indeed secular, horizon.