Viewpoints

U.K. Outlook: It’s Not Just Brexit

We see key factors beyond Brexit affecting the medium-term economic outlook for the U.K.

When looking at the medium-term outlook for the U.K., it is tempting to focus solely on Brexit. It is undoubtedly a key component of the U.K. outlook, but there are a number of other factors investors should consider when constructing their medium-term view. Not least are how the economy behaves as we move through the monetary tightening cycle, whether politicians will be able to avoid the temptation of fiscal easing against a backdrop of continued income and wealth inequality, and how policymakers would respond in the event that the base case of low productivity growth and stable inflation is challenged. There is a lot more to the U.K. outlook than Brexit, important though it is.

Initial conditions

Before we look to the future, it is important to recognise initial conditions and anticipate how they may evolve. As with many other developed economies, the U.K. has enjoyed a prolonged period of steady growth, characterized by falling unemployment but disappointingly sluggish wage and productivity growth. The total number of people employed is a record-high 32.4 million, the unemployment rate is a 50-year-low 4.2% and government finances are moving back into balance.

However, average earnings for workers are rising at just 2.5% per annum, and with Consumer Prices Index (CPI) inflation at 2.4% and the household saving rate back at just 4.3%, household finance remains under pressure. It is this pressure that has been the primary cause of the recent slowdown in GDP. As we look to the future, the key questions we need to address are: What scope is there in other parts of the economy to support the recovery, and if we see a global slowdown, how well equipped is the U.K. to weather that particular storm?

Figure 1- U.K. GDP is Declining

Domestic drivers

Inevitably any medium-term forecast will have to take into account the risks to the economy that could arise from the U.K.’s separation from the European Union (EU). However, before we take a look at the impact of Brexit itself, it is useful to think about the driver of the various components of the domestic economy. Consumer spending represents two-thirds of U.K. GDP and will continue to exert considerable influence on the outlook for the economy. That in turn will be guided by both monetary and fiscal policy.

In particular, we expect the Bank of England to continue to slowly increase interest rates over the first few years of the secular horizon. Given the uncertainty around the neutral real interest rate in the U.K., we think it prudent to weigh the prospective interest rate cycle in the context of previous hiking cycles. Considering most household mortgages relate to short-term interest rates, monetary policy can affect spending patterns faster than in other developed economies. Historically, interest rate hiking cycles have ranged at between 1% and 1.5% of cumulative rate hikes, typically completed over a 12-month period (Source: Bank of England). This hiking cycle will no doubt be longer than previous ones, but we think the cumulative degree of monetary tightening will be consistent with prior cycles. Clearly there is a large range of potential outcomes, but importantly, we believe that interest rates are likely to stay low over the secular horizon. This should limit the collective pressure on household balance sheets, such that household consumption can grow close to the growth in real incomes. As discussed in our 2018 Secular Outlook, “Rude Awakenings,” while we acknowledge the scope for a positive surprise in productivity and real wage growth, sadly this does not form our central expectation.

With the annual fiscal deficit back to 2% of GDP, there remains scope for fiscal policy to both add to GDP as well as detract. Unlike in the U.S., where we see the risks of late-cycle fiscal expansion ultimately accelerating the downturn, we expect fiscal policy to be more neutral in the early stages of the secular outlook but certainly with scope to become a bigger influence as we move towards the next general election, scheduled for 2022.

Business investment

Where Brexit risks will undoubtedly take center stage is in the outlook for investment. Observed business investment has been sluggish in recent years despite surveys indicating relatively upbeat investment intentions on behalf of businesses. This gap we believe relates to uncertainty over the Brexit negotiations, where businesses would prefer to hire additional staff rather than commit to greater spending on plant and machinery. We believe that the path of the Brexit negotiations will continue to influence corporate behavior.

Figure 2 - Business investment remains sluggish

Given the nature of the Brexit negotiations, and the importance of the next six to nine months, it is hard to separate out the cyclical aspects from the secular outlook. In particular, as the negotiations accelerate over the second half of 2018, the risk of political uncertainty rises as the prime minister tries to negotiate the difficult path of placating her own ruling Conservative Party and striking a future trading arrangement with the EU. There is certainly a wide range of potential outcomes: a smooth transitional deal, a delay to the negotiations, a stalling of the negotiations if the U.K. government falls, or no deal. Our central expectation is still for the U.K. and EU to coalesce around a cooperative outcome, which sees the U.K. transition out of the EU over the secular horizon. In that event we see some scope for a recovery in business investment, although clearly there are material risks around this expectation.

Risks to our forecast

So while our base case is for a relatively stable economic backdrop characterized by a gradual interest rate cycle and cooperative Brexit, there remains considerable risk to that central forecast. With the economy at or close to full capacity, a slow and gradual set of interest rate hikes engineering a smooth deceleration of growth may well be the aim of the Bank of England, but we have to acknowledge that such outcomes are often very difficult to achieve.

Regarding Brexit risks, a more protracted set of negotiations would drag out uncertainty over the final trading arrangements. In the event that Parliament cannot agree on any outcome, a wide range of possibilities open up, including an early general election, or a second referendum. We assign a low probability to either scenario, but we have to acknowledge the risk.

On the more positive side, an unexpected improvement in productivity growth supporting higher real wage growth would certainly aid household balance sheet repair, although conversely this would also likely give the Bank of England more confidence in raising interest rates. In that case it is possible that alongside interest rate hikes, we could see the Bank of England start the discussion of balance sheet shrinkage, with the associated risks that would pose to longer-term interest rates.

Positioning portfolios

U.K. asset markets continue to price in a very gradual path of interest rate rises, and to some degree have become desensitized to daily political volatility. In particular, longer-term interest rates remain very low by both domestic and international standards, and as such we remain cautious on valuations of long-dated U.K. yields. Where we can, we prefer to emphasize duration outside of the U.K., and within the U.K. we prefer to emphasize a curve-steepening bias to reflect the low level of additional yield compensation for extending maturity in both the nominal and real interest rate curves. Sterling will continue to be the most sensitive asset market to broad political risk and remains the most efficient tool for reflecting evolving views on the Brexit negotiations.

Meanwhile, within the non-government sector, corporate bond yields offer similar excess spreads to other global credit markets. With that in mind, we will focus on sector selection and issuers with a global presence rather than those heavily focused on the domestic sector. Where we do see value in domestically focused issuers is financials, where U.K. banks have built up substantial capital, and in securitized assets, such as high quality residential mortgage-backed securities, which offer a measure of protection in the event of great volatility ahead.

The Author

Mike Amey

Head of Sterling Portfolio Management and ESG Strategies

View Profile

Latest Insights

Related

Disclosures

Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd- Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam and Italy Branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH(Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO Switzerland GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (8 Marina View, #30-01, Asia Square Tower 1, Singapore 018960, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia) offers products and services to both wholesale and retail clients as defined in the Corporations Act 2001 (limited to general financial product advice in the case of retail clients). This communication is provided for general information only without taking into account the objectives, financial situation or needs of any particular investors. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1° andar, Rio de Janeiro – RJ Brasil 22210-906.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. 

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2018, PIMCO.