Tuesday, July 7, 2009

The UK: Down and out?

UK's green shoots have arguably been a bit greener than elsewhere. For example Halifax house prices rose by 2.6% in May with also the Nationwide survey indicating rising house prcies, the services PMI rose back above 50 in June and stayed there this month and also unemployment is rising less fast than expected. All this is clearly encouraging for the short term. However, I remain seriously worried about the more longer-term outlook and consider the risks for an inflationary outcome amid a significantly weaker currency and rising sovereign default concerns as being the most pronounced by far of any of the larger non-EM economies (just as a reminder: I expect US and EUR nominal growth to be very low for a multi-year period amid low real growth and low inflation).
I think the key reason for the positive UK data surprises are the larger macro-economic stimulus than for example in Europe. First, the BoE was faster in cutting rates than the ECB and also engaged in a more aggressive asset purchasing program sooner. Additionally, the fiscal stimulus in the UK is significant. Finally, the drop in GBP on a trade-weighted-basis has provided an additional boost. GBP dropped by almost 30% between August 2007 and January 2009 (see chart). On the other side, the trade-weighted Euro gained some 3% during the same time period.
Source: Bloomberg
Such a huge drop of 30% provides an additional boost, be it in the form of import substitution (as imported goods and services become much more expensive) and gains in export market shares. Additionally, UK assets have become 30% cheaper for non-residents just due to the exchange rate. For example UK houses have become cheaper by approx. 50% for non-residents (approx. 30% drop in GBP + approx. 20% drop in house prices), an enourmous drop.
So, I think that the recent UK developments are down to a more significant and more timely stimulus (as the exchange rate started to fall already in 2007) than elsewhere but not down to a better underlying economic situation. Rather to the contrary, the structural problems the UK economy is facing are even more substantial than elsewhere. For one, the structural imbalances (overvalued housing market, over-indebted under-saving consumer, high current account deficit to name a few) are at least as pronounced as in the US. However, the banking sector liabilities are significantly larger and the share of the financial sector is larger than in the US (with the added threat of tighter regulation of the financial sector pushing financial institutions out of the UK). Furthermore, the sustained current account deficit of the past years led to foreign investors pouring capital into the UK. While this seemed attractive when the UK was perceived as a high-growth, high-return economy, the prospects for ZIRP by the BoE and extended real growth weakness are changing the investment rationale. In contrast to the situation in the US, so far the UK current account deficit has failed to really improve and deteriorated even further in Q4 with only a small improvement in Q1 at higher than expected levels. Additionally, while inflation has come down significantly in the US, the Eurozone and the UK, the fall in UK CPI was much less pronounced (see chart for developments of YOY CPI).
Source: Bloomberg

Finally, the fall in UK inflation was also much less than expected. The chart below adds the difference between actual inflation (mom value) minus the forecasted value (Bloomberg consensus). While during 2007, US inflation tended to overshoot vs. expectations, since mid 2008 this has been the reverse. In the Eurozone (I have used German inflation as it is been released relatively early), inflation tended to be more or less in line with expectations. In the UK, however, since early 2008, the consensus has consistently underestimated inflation (be it on the way up during early 2008 as well as on the way down over the past months).
Source: Bloomberg

Overall, I do not see how the UK can get back on a sustainable growth path already and think that the positive economic surprises are purely down to a more pronounced macro-economic stimulus and will prove temporary. Rather, the structural problems are very pronounced and will take a long time to be reduced with trend growth falling significantly in turn. In combination with the huge fiscal and current account deficits, the risk remains that foreign investors will take money out of the UK again. Whereas there is no alternative to the USD (yet), international investors do not really need to hold GBP.
I think that the recovery in GBP of the past months' has run its course and we are in for another longer-lasting move lower. EURGBP is likely to retest its highs above 0.95 in this process. While I think it is too early to short Gilts as Gilt yields should be able to drop further over the next weeks/months as they are pulled lower by their US and Eurozone counterparts, I recommend a more cautious positioning with only a very limited exposure.

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