Tuesday, August 18, 2009

Revisiting the UK: not much good news

I already previously highlighted my worries with respect to the medium-term outlook for the UK (The UK: down and out dated July 7). While in the meantime the recovery has continued, my doubts about the UK outlook have not become less pronounced, rather to the contrary. I remain seriously worried about the more longer-term outlook and consider the risks for an inflationary outcome as being the most pronounced by far of any of the larger non-EM economies (I continue to expect US and EUR nominal growth to be very low for a multi-year period amid low real growth and low inflation).

Just to repeat: I think 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.
For me, the key reason for the positive UK data surprises of the past months are down to 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.

However, there is a real problem brewing and today's CPI release highlighted this again.
Yes, inflation in the UK has come down as well during the past quarters, however, this fall was much less pronounced than in the US and the Eurozone (yoy numbers):
Source: Bloomberg

Moreover, 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). This was evident again today where actual yoy CPI came in at 1.8% (unchanged from the previous month) vs. expectations of 1.5%:
Source: Research Ahead, Bloomberg

Finally, core CPI in the US and the Eurozone has been falling (albeit slowly) on a trend basis since late 2008. However, UK core CPI has been increasing over the course of this year! Usually, UK core CPI is significantly below its US counterpart. But this is not the case anymore and the current difference of +0.3% (UK core CPI of 1.8% vs. US core CPI of 1.5%) is the highest so far this decade.
Source: Bloomberg

This inflation dynamic in the UK is very worrisome and if it continues might force the BoE into an early withdrawal of its massive stimulus despite the ongoing subdued economic state. For the Gilt market this would be a dramatic development as it depends on the substantial buying support of the BoE (via its quantitative easing program). The chart below shows the development of the 10y UK Gilt yield and the 10y Gilt-Bund spread.
Source: Bloomberg

Since the beginning of the year, Gilts have been underperforming. However, the QE announcement in early March led to a substantial tightening in spreads (i.e. UK Gilt outperformance). Thereafter however, Gilts started to underperform again. The early August QE increase announcement seems to have led to a much less pronounced and much shorter-lived UK Gilt outperformance than back in March. So to me this suggests that without the help of QE, UK Gilts would be much cheaper vs. Bunds (in line with the bond-market negative inflation developments). Additionally, I think it will need an increasing amount of QE in order to defy the pressure for Gilt yields to move higher amid the negative inflation dynamics. But this would just mean that the BoE's credibilty would be tarnished further, leading to higher risk premia and weighing on the currency. Overall, this looks highly unsustainable to me and I believe that sooner or later the BoE has to give in and tolerate higher Gilt yields.

Conclusion: I remain seriously worried about an inflationary outcome in the UK (in contrast to the US and the Eurozone) and suggest to underweight the UK from an asset allocation perspective. UK Gilts risk underperforming significantly vs. the US and Eurozone counterparts over the medium term and yields are likely to rise over the next quarters.

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