UK economy faces stormy outlook

It is my fear that the UK economy is likely to recover more slowly over 2012 than market commentators have previously forecast.

That’s because the outlook for global growth has deteriorated substantially in recent months, due both to policy errors and the prospect of further fiscal tightening in the US and Europe. This is likely to weigh on the UK’s “export led recovery”. Forecasts will likely be chopped in aggregate to around 1.5 per cent, but while exports remain a key driver of the recovery, they do now make a smaller contribution and the main reasons to expect weak growth are fiscal consolidation and a weak recovery in investment.

Despite this apparent gloom, we can still expect a small acceleration in activity in the UK over 2012. There are modest grounds for optimism on growth in real disposable income owing to less weakness in real wage growth, and there may be a small fall in the savings rate, as households deleverage and credit constraints ease. The Olympics should also provide a one-off boost to activity.

As for the monetary policy backcloth, lingering concerns over growth are likely to discourage the BoE (Bank of England) from a near-term rate rise. But what of Quantitative Easing (QE)? Certainly the BoE’s medium-term outlook for weak growth does not appear inconsistent with further QE. If the UK economy did slip back and growth contracted, then this would substantially raise the chance of further QE. We expect inflation pressures to persist.

But there are much bigger issues for the economy, in particular a strange sense of xenophobic triumphalism circulating in the London markets as peripheral Euroland debt has been priced lower. The mood is one of yet ‘but for the grace of God go I’, with the UK mired in debt, and our economy clearly weak.

FINDING A SOLUTION

Each side of the political divide has a different take on the best solutions, with the coalition government believing the huge fiscal deficit must be eliminated and its opponents arguing fiscal tightening will undermine growth prospects. Clearly growth is important but so too is constraining the build-up of debt, and there is a realistic chance that both sides’ warnings are correct but that neither side’s prescriptions will work.

Although we observe and manage assets rather than indulge in political positioning, it is apparent and important that radical solutions are required if a debt disaster is to be averted in the UK.

The key options for policy lie in supply-side reform. Unfortunately, public opinion may be inimical to the scale of reform required and the general public are probably unaware of the true scale of Britain’s debts. Public debt, widely reported as 60 per cent of GDP, rises to 75 per cent on the Maastricht Treaty definition by which countries such as Greece, Ireland and Portugal are measured, and even with optimistic assumptions about growth, revenues and the deficit, the government concedes debt ratios are set to rise further.

Of more immediate concern, official debt numbers exclude the net present value of unfunded public sector pension commitments and obligations under Private Finance Initiative contracts. Together, these total an estimated £1,350bn (€1,600), lifting the total of public debt and quasi-debt to £2,460bn (167 per cent of GDP). In addition, the potential costs of financial sector interventions total £1,340bn, and taken altogether, the UK can be seen as a heavily indebted European peripheral country.

The government is undoubtedly right to assert the UK must achieve a drastic reduction in the pace at which public debt is rising. This is not a political statement, but simply reflection of what would happen if the UK continued to run primary deficits at the 2009-10 level. In recognising the imperative to reduce the deficit, the government has set out its plan whereby modest spending cuts in real terms coupled with a big increase in revenues, reduces the deficit from 11.1 per cent of GDP in 2009-10 to 1.6 per cent by 2015-16.

The problem with the plan is that it depends upon ‘heroic’ economic assumptions, most notably delivery of growth of 2.9 per cent by 2012-13. At 2010-11 values, and after allowing for an expected £25bn increase in debt interest, the government plan requires that the gap between revenue and expenditures be narrowed by £159bn. Increases in tax rates will contribute £31bn, and spending cuts a possible £44bn (so long as unemployment falls as the government expects), but the bulk of deficit reduction is expected to result from a growth-created £84bn increase in tax revenues.

If growth were to come in at half of the official target, interest costs and other spending would rise, tax revenues would fall very far short of expectations, and the plan would unravel.

There is a significant risk that the UK economy, as currently configured, is incapable of delivering growth anywhere close to levels required by deficit reduction agenda. In the decade prior to the financial crisis, the UK economy became hugely dependent upon debt. Taking public and private components together, debts increased at an annual average rate of 11.2 per cent of GDP in the period since 2003, and the two big drivers of the economy have been private (mortgage and credit) borrowing, and huge (and debt-dependent) increases in public spending.

Reflecting growth in debt-funded activities, three of the UK’s eight largest industries (real estate, financial services and construction), which account for 39 per cent of the economy, may be considered incapable of growth now that net private borrowing has evaporated. Another three (health, education, and public administration and defence) account for a further 19 per cent, and cannot expand now growth in public spending is constrained.

This means 58 per cent of the economy is ‘ex-growth’, and the figure could actually be 70 per cent, if growth in retailing is held back by falling real consumer incomes.

The conclusion is that far from being well positioned in contrast to the US or the peripheral Euroland economies, the UK may come to be seen as highly indebted and facing a low growth trap.

LOOKING BACK

We can trace the fiscal and economic problems to Gordon Brown’s reform of the financial regulatory system, and his insistence that the BoE determine monetary policy on the basis of retail inflation alone.

Taken together, these measures resulted in a reckless escalation in mortgage lending, and the ensuing property price boom spurred unsustainable growth across a range of housing-related sectors, and underpinned a fast and substantial expansion in consumer borrowing. This problem was compounded by Mr Brown’s expectation that what can now be described as a bubble was in fact real growth. Thus, real public spending increased by 53 per ent while the economy expanded by just 17 per cent, and when the bubble burst, a gap opened up between the huge scale of spending and falling tax revenues.

In the immediate aftermath of the ‘global financial crisis’, there was a focus on massive and unsustainable public borrowing which protected the British public from pain of deep economic recession, but resolution of the imbalances requires more than a simple cocktail of policy initiatives. There are those that have called for more, not less, public spending or fiscal expansion, but in the years prior to the recession, Britain borrowed £2.18 for every £1 of growth. Continued high borrowing would be nothing more than a pain-deferral exercise leading inevitably to a full blown economic crisis.

This is a very difficult backcloth for UK-focused risk asset investment opportunities. We should feel more optimistic if there were reforms designed to free small and medium enterprises from the onerous burden of regulation, but these would face political opposition and choices will involve some trade-off between economic efficiency and concepts of ‘fairness’. At present there is little indication that the coalition government is prepared or able to promote economic growth by taking steps that will roll back Labour’s measures that were couched in terms of morality, fairness and entitlement.