UK Economic Update – The UK Economy in a Rising Rate Environment – 15 August 2014
The last 18 months have proved to be a pivotal period for UK-focused investors, one where the economy has gone from teetering on the verge of recession in the first half (H1) of 2013 to the fastest growing in the group of seven nations so far into 2014.
With the change in fortunes for the economy, the attention of investors has now turned resolutely toward the question of interest rates and when they will begin to rise. On this note, current consensus estimates see a 15-25 basis point increase coming in Q1 2015, with rates reaching 2.25% three years from now.
While we agree that rates are likely to rise sometime during H1 2015, either shortly before or shortly after the general election, the timing of the first interest rate increase is not a question that we are concerned with in this report.
In this article, we assume that interest rates will begin to rise in H1 of next year and set out to look past the first rate increase, and assess what we believe will likely happen to the economy after this time; paying particular attention to the implications for investors.
A short summary of our conclusion is that the UK economy remains ill prepared for an environment of markedly higher interest rates. From this and an observation of past tightening cycles, we project that interest rates will likely top-out between 1.00% and 1.25% in Q1 2016, following a steady flow of gradual increases.
Looking further out, we believe it is highly likely that interest rates will again begin to reduce some time during the latter half of 2016, in response to a slowdown in growth that leaves the economy close to recessionary territory.
Below we outline the reasoning for our conclusion, while at the bottom of this report we assess the implications to investors and update our asset allocation view for the quarters ahead.
A breakdown and overview of the recovery so far
While economic growth has certainly accelerated throughout 2014, the UK recovery has, so far, been largely driven by the housing market and consumer spending.
As government initiatives throughout 2013 proved successful in encouraging bank lending to mortgage borrowers, transaction volumes increased, leading to a broad-based uplift in both house prices and consumer confidence.
With confidence recovering rapidly, consumers have become both more willing to borrow additional funds for personal expenditures and to also spend down savings. This has been a key secondary driver behind the recovery. More recently, we note, business investment has also began to rise and is now at a level where it can make a meaningful contribution to the recovery.
Going forward, official forecasts see further increases in both business investment and consumer spending as likely to support lower, but still elevated, levels of growth throughout 2015, 2016 and 2017.
However, on the downside, most of the above drivers are not sustainable at their current levels in a rising rate environment.
In addition, government spending, which has made a substantial contribution to growth over past quarters, is also set to reduce markedly during the years ahead. Below we look at each of the above areas in greater detail.
OBR Chart – Breakdown of quarterly GDP
The housing market in a rising rate environment
We have made clear our views on the UK housing market previously in our report titled UK Property Part 1 and UK Property Part 2.
However, a short and condensed version of our view is that we expect housing activity to slow throughout much of this year. While this has begun to happen, evidenced by the reduction in mortgage approvals and a slowdown in house price growth, we ultimately believe that this slowdown still has further to go.
The key drivers behind this have been the higher level of scrutiny over borrower finances and bank lending criteria which emerged from the Mortgage Market Review, recent changes to rules governing Loan to Income (LTI) multiples for mortgages, and expectations for a tighter monetary policy environment over the quarters ahead.
For further information relating to our view of the housing market, please see our earlier reports via the links below.
JP Morgan Asset Management Chart – UK Housing
OBR Chart – House Price Inflation Forecast
Public spending to reduce
The government budget deficit is currently running at 5.5% of GDP, which is one of the largest for industrialised nations and significantly above the 3% upper boundary set out in the Maastricht Treaty.
This means that government net debt to GDP (77.7%) will continue to grow until a surplus can be achieved, which is unlikely before 2018/19 at best. In short, the position of public finances leaves little to no room for higher government spending.
Given population demographics and projections for future public liabilities, it is imperative that the government is able to meaningfully reduce spending so that it can then begin to tackle an increasing debt pile.
This means that consumers and the private (SME + Corporate) sector must pick up the slack left behind by reductions in public spending, in order to maintain the same pace of economic output.
Chart illustrating projected reduction in government spending as a percentage of past expenditure
Chart illustrating projected consumption of goods and services as a share of GDP
Consumer spending, the current recovery and future growth
OBR and ONS statistics support our earlier assertion that consumer spending has been an important secondary driver of the recovery, and will be a critical factor in growth momentum going forward.
During 2013, consumer spending accounted for 0.4% of quarterly economic growth, which represents a substantial increase from the 0.3% contribution of 2012.
However, much of this increase appears to have taken place at a cost to savings and credit balances, not any form of income or otherwise economic growth (Chart 2).
Consequently, we believe that current levels of consumer spending are unsustainable and, without a meaningful acceleration in wage growth, will ultimately begin to slow as time elapses.
Looking further out, and given that much of the anticipated growth during the coming years is reliant upon increases to consumer spending, we are less than confident that official or consensus GDP projections can be achieved.
Chart (1) below illustrates the reversal in spending behaviour which took place in 2013 running into 2014, and the contribution to GDP growth that private/consumer expenditure is expected to make throughout the years ahead.
Chart (2) illustrates the erratic behaviour of consumer deposits with financial institutions. On a net basis (middle line), deposit growth has reverted to deposit draw-down as consumer confidence and spending increased with the recovery in the housing market.
(1) (Dark Blue Bar Section)
(2) (Middle Line)
Household debt remains close to historic highs
Household debt to GDP, and as a share of annual income, has actually declined in the years since the run up to the financial crisis.
However, both measures remain close to their pre-financial crisis highs and for official growth projections to be viable both will need to increase further during the years ahead.
While OBR forecasts suggest that this will happen, and that household debt will eventually peak at 170% of annual income in 2018/19, we are less certain that this will happen.
We are concerned as to whether financial institutions will have the requisite risk appetite to support such increases in this form of lending, given the evolving regulatory regime as well as increased scrutiny of asset quality and balance sheet risk.
We are also less certain that households will demonstrate the desire to take on increased levels of credit, while overall indebtedness remains at current levels or above. In fact, we believe it is more likely that households will continue to pay down debts and reduce credit balances further as interest rates begin to rise.
Household Gross Debt to Income 2005 -2014 Actual and 2014 – 2019 Projections
Net increase in outstanding mortgage credit (middle line), which is largely flat with previous years despite high uptake on multiple government initiatives
Mortgagors expected to react to higher debt servicing costs with re-mortgages, or by continuing to pay down debt at higher rates
Wage growth falls to lowest level since 2008
Following a multi-year period of declining real incomes, and given the importance of increased consumer spending to the recovery, it is now more imperative than ever before that wages begin to rise meaningfully.
Although debt levels remain high, and are likely to be a key focus of consumers as interest rates rise, a meaningful and broad based increase in wages may make it possible for spending to be sustained at or close to the current pace.
However, in the final quarter of 2013 real wages (adjusted for inflation) were at their lowest levels since Q1 2004. In the subsequent months, actual wage growth has decelerated to its lowest level since 2008, while ONS data released in early August 2014 showed nominal wages also fell during the last year. (For those who are unaware, nominal wages are pay cheques as they come – without being adjusted for the level of inflation).
Clearly, the trend of falling pay has exhibited no signs of reversing and according to research by some bodies, is unlikely to do so for some time to come.
An OBR survey of independent forecasters, which range from charities to city institutions, sees projections for wage growth running through to 2019 ranging from 1% to 2.4% per year. With this in mind, the outlook for wages is less than certain.
Given that even the most ambitious of projections places best case scenario wage growth below the long run average for inflation, we see downside risks for both average incomes as well as economic growth over the months, quarters and potentially years ahead.
UK Average earnings growth as a percentage since 2001
CPI Inflation consistently higher than wage growth; meaning real incomes are set to continue falling
Wage growth (Dark Blue) benchmarked against RPI (Retail Price Index) and CPI (Consumer Price Index)
Business investment undergoes strong rebound in 2014 – Will it be enough to prop up the economy?
Given the level of underinvestment from businesses over recent years, there is good reason to believe that the nascent recovery here has further to go.
However, productivity within the economy remains low and could, if allowed to persist, limit the amount of further investment undertaken by businesses. In addition to this, traditional economic theory holds that investment is a negative function of interest rates. This means that as rates rise further and further, investment by most businesses should naturally slow.
Consequently, with both of the above factors taken into account, we doubt that business investment can sustain itself at the level required to prop up the economy amidst lesser activity in the housing market, declining consumer spending and reduced government spending.
Business investment as a share of GDP
Summary and Conclusion
Our outlook for the UK economy over the longer-term is supported by the fact that key pillars of the recovery to date, such as increasing housing market activity as well as the resultant surge in confidence and consumer spending, are less than dependable going into 2015 and the years beyond.
In short: with public spending set to reduce, business investment tentative, household debt levels close to record highs and both real as well as nominal wages heading in the wrong direction, we see downside risks to the recovery ahead.
In light of the louder argument for interest rates to rise, we see clear risks that monetary policy will tighten and that this could prove to be the catalyst that derails an economic recovery which is, in the grander scheme of things, still fragile.
To conclude, we assert that a 2015 rise in interest rates will have negative connotations for growth, although it is likely that the adverse impact of this will not be fully felt until the later stages of the year (Q4 2015 – Q1 2016).
In the absence of economic feedback, and given the prevailing trend among policy makers to rely upon concrete data and to stay the course until conditions warrant otherwise, we believe it is likely that interest rates will have risen to at least the 1% level by this time.
From here (Q1 2016), we expect that interest rates will then begin to reduce in response to a persistent deceleration in growth and an insufficient improvement in the outlook for wages, both of which could leave the economy, once again, teetering on the verge of a recession.
Should we prove to be correct, then such an outcome would have long-term implications for both investors as well as the economy.
Most notably, a return to ultra-low interest rates so soon into the tightening cycle may have a substantially adverse impact upon confidence, which could then lead to a self-perpetuating cycle of low or negative growth and extraordinary policy measures.
While for investors this would be supportive of both equity and fixed income markets relative to other assets such as cash, for the economy our baseline scenario could give enhanced meaning to the phrase “the new normal” and would imply a protracted period of hardship for many people.
While the implications of our findings are in some respect unsettling, they do offer a glimmer of hope for investors who have been concerned about the impact of a rising rate environment upon equity markets and bond prices. This is as our baseline scenario implies lower rates for longer over the broader term, which suggests a supportive environment for both equities and to a degree, bonds as well.
Consequently, we favour ongoing high allocations to equities and believe that opportunities may also arise in sterling fixed income markets during the latter stages of 2015.
The contents of this report and the Stockatonia website (https://www.stockatonia.co.uk/