UK Economy Continues to Suffer

The next Bank of England meeting is January 30 and it will be Governor Carney’s last. He has made some very dovish comments recently, and other MPC members have followed suit. The economy is slowing significantly and so markets should be bracing for a potential cut then.RECENT DEVELOPMENTS

Outgoing Bank of England Governor Carney has become increasingly dovish. Last week, he said that a rebound from Brexit uncertainty is not assured, and that “persistent weakness could require prompt response.” He added that “The economy has been sluggish, slack has been growing, and inflation is below target.” Lastly, Carney noted that “All told, a reasonable judgment is that the combined conventional and unconventional policy space is in the neighborhood of the 250 bp cut to bank rate seen in pre-crisis easing cycles,”

Other external MPC members have followed suit. Last week, Silvana Tenreyro said she would vote for a rate cut if Brexit uncertainty lasts and weighs on growth. This week, Gertjan Vlieghe said he would vote for a rate cut this month if there are no signs of improvements in the economy. At the November and December meetings, external members Saunders and Haskel both dissented in favor of a 25 bp cut.   If Carney, Vlieghe, and Tenreyro were to now favor a cut, then those five doves would represent a majority on the MPC.

BOE Governor Carney’s extended term ends January 31. He was recently appointed UN Special Envoy for Climate Action and Finance and he will be replaced by Andrew Bailey, former Chief Executive of the Financial Conduct Authority. Bailey does not have much central bank policymaking experience, so we expect he will rely heavily on the more experienced Ben Broadbent (Deputy Governor, Monetary Policy), Jon Cunliffe (Deputy Governor, Financial Stability), Dave Ramsden (Deputy Governor, Markets and Banking), and Andy Haldane (Chief Economist).

The BOE meets January 30 and it’s going to be a close call. There are reasonable arguments for both hiking and leaving rates steady. The economy continues to struggle under Brexit uncertainty, and we see little scope for improvement near-term.  Why wait? On the other hand, there is fiscal stimulus in the pipeline. Why not wait and let fiscal policy carry the load and keep its powder dry for later? Chancellor Javid is scheduled to unveil his budget March 11, whilst the next BOE meeting is March 26.

This will be the last meeting under Governor Carney, whose extended term ends on January 31. He was recently appointed as UN Special Envoy for Climate Action and Finance, and he will be replaced by Andrew Bailey, former Chief Executive of the Financial Conduct Authority. As Bailey does not have much central bank policymaking experience, we expect he will rely heavily on the more experienced Ben Broadbent (Deputy Governor, Monetary Policy), Jon Cunliffe (Deputy Governor, Financial Stability), Dave Ramsden (Deputy Governor, Markets and Banking), and Andy Haldane (Chief Economist).

Ahead of the BOE decision, there has been a raft of weak UK data this week.  These include November IP and GDP as well as December CPI. Retail sales data will be reported this Friday. Readings have been uniformly weak in Q4 and consensus sees growth easing to 0.8% y/y vs. 1.1% in Q3. Weakness is likely to continue as another year of likely protracted Brexit uncertainty (hard or soft?) weighs on the economy. Investment, hiring, and other business decisions are all likely to remain on hold.

UK Prime Minister Boris Johnson pushed his Withdrawal Agreement bill through the final hurdle in the House of Commons last week, as expected. The UK will leave the EU on January 31.  The focus now shifts back to the details and strategy of the trade negotiations. Johnson’s initial position is to seek a Canada-style trade relationship (where 98% of goods are tariff-free), but the EU says this is impossible to achieve by the year-end transition period deadline. In other words, Johnson is looking for access to the single market while preserving the spirit of Brexit by avoiding “any kind of alignment” with EU rules. But this brings us back to the old EU adage: you can’t have free movement of goods and services without free movement of people and a level playing field. It will be a long year.

Indeed, markets are starting to get a taste of just how difficult it will be for the UK and EU to strike a trade deal by year-end.  The European Commission just issued its demand that existing reciprocal access to fishing waters be maintained.  One EU official said this is the first time that a fishing accord has been a pre-condition for a trade deal, and totally goes against Johnson’s stance that the UK will reassert control over its fishing waters.  Elsewhere, global investment banks are lobbying to maintain their easy access to the EU market, asserting that EU rules could damage business and threaten financial stability.  These two issues are just the tip of the iceberg and so our base case remains an extension for Brexit beyond December 31.    

 

A BRIEF HISTORY LESSON

The Bank of England is one of the world’s oldest central banks. It was founded July 27, 1694 and began its life as a private bank that acted as banker to the government. It was initially founded to help build a more powerful navy after its crushing defeat to the French back in 1690. Apparently, the credit rating of King William’s government was so low that it could not borrow the GDP1.2 mln that was needed. He and Queen Mary were two of the original stockholders. The original charter granted by William and Mary established that the Bank was founded to “promote the public Good and Benefit of our People.”

Arguably the most important change in the bank ‘s long and storied came in 1997. After Labour won its first general election since 1979 that year, incoming Chancellor Gordon Brown announced that the Bank of England would be granted operational independence to conduct monetary policy. Prior to this, the Bank of England was the least independent major central bank since monetary policy was set by the Chancellor. Interestingly, the prior Tory governments led by Thatcher and Major had opposed independence.

The Bank of England Act of 1998 set up the Monetary Policy Committee. It was given sole responsibility for setting interest rates to meet the then-2.5% target for RPI inflation. The target was later replaced with 2% for CPI inflation. If inflation overshoots or undershoots the target by more than one percentage point, the Governor must write a letter to the Chancellor explaining why as well as how it will be remedied.

The MPC is made up of nine members: Governor (Carney), three Deputy Governors (Broadbent, Cunliffe, and Ramsden), Chief Economist (Haldane), and four external members (Haskel, Saunders, Tenreyro, and Vlieghe) appointed by the Chancellor. A representative from Her Majesties Treasury also sits with the MPC and can discuss policy issues but cannot vote. Lastly, it should be noted that the government sets the inflation target.

 

ECONOMIC OUTLOOK

The longer-term outlook for the UK economy hinges largely on how Brexit unfolds. For instance, the Bank of England at its November meeting raised its growth forecast for this year a tick to 1.4% but cut its forecast for 2020 a tick to 1.2%. At its August meeting, the BOE cut its forecasts for both years to 1.3% from 1.5% and 1.6% back in May, respectively. All these forecasts assume that a hard Brexit will be avoided, and yet it’s clear that uncertainty alone is having a significant impact on the growth outlook.

Indeed, the UK economy is inexorably slowing. GDP growth is forecast by the OECD at 1.2% in 2019 and slowing to 1.0% in 2020 before picking back up to 1.2% in 2021. GDP growth was only 1.0% y/y in Q3, the slowest since Q1 2010, while data so far in Q4 suggest further deceleration to below 1.0%. Elsewhere, IP has contracted y/y six months in a row through November. As such, we see downside risks to the growth forecasts. It’s worth noting that consumption and government spending have held up but have been offset by much weaker than anticipated investment (Gross Fixed Capital Formation).

Price pressures continue to fall. December headline and CPIH inflation came in weaker than expected. The former rose 1.3% y/y vs. 1.5% expected while the latter rose 1.4% y/y vs. 1.6% expected. Both are the lowest readings since late 2016. If we get a hard Brexit and a potential 10% sell-off in sterling, inflation would undoubtedly spike. However, we suspect the BOE would err on the side of cutting rates to boost growth rather than hiking rates to limit inflation.

At its last meeting December 18, the BOE delivered a dovish hold. The bank cut its Q4 growth forecast then and also saw inflation slowing to 1.25% in the spring. It warned that rates would need to be cut again if Brexit uncertainty remains entrenched or global growth fails to recover. Two external members of the MPC dissented for the second straight meeting in favor of an immediate rate cut. The BOE last hiked rates with a 25 bp move in the Base Rate to 0.75% back in August 2018. That was the second move in this tightening cycle, with the first 25 bp hike coming back in November 2017.

BOE easing expectations have risen sharply this week due to weak UK data and a more dovish BOE. The CME model has 59% chance now vs. 49% this Monday and 5% last Monday, while Bloomberg WIRP has 67% chance now vs. 50% this Monday and 6% last Monday. December retail sales due out this Friday will help cement expectations. Short sterling futures are only pricing in one cut in 2020, but we find it hard to believe that the BOE would be “one and done.”

The external accounts are deteriorating modestly. The current account deficit was -3.9% of GDP in 2018, and the OECD expects the deficit to widen -4.5% in 2019 before narrowing to -3.7% in 2020. The UK’s Net International Investment Position (NIIP) is currently around -14% of GDP, the worst since 2015. All told, the UK’s external vulnerabilities bear watching given the likelihood that the risks of hard Brexit rise as the year progresses.

 

INVESTMENT OUTLOOK

Sterling has gone back to underperforming. In 2018, GBP was -5.6% and ahead of only the worst major performers AUD (-9.7%), CAD (-7.8%), and SEK (-7.6%). In 2019, GBP was up 4% and was behind only the best major performer CAD at +5%. That outperformance was driven largely by the year-end rally after Johnson’s landslide victory. So far in 2020, GBP is the second worst major performer at -1.8%, behind only NZD at -2.1%. In addition to ongoing Brexit uncertainty, UK fundamentals have deteriorated and are likely to get even worse. As such, we expect sterling underperformance to continue.

After making a new multi-year high near $1.3515 last month, cable has sold off. Cable is on its way to testing the November 8 low near $1.2770 but the key level to look for is $1.27. Break of that retracement objective (which also coincides with the 200-day moving average) would set up a test of the October low near $1.22. With the euro holding up relatively well, the EUR/GBP cross is performing even better and is on track to test the October 24 high near .86764. Looking further out, a clean break above the .87359 area would set up a test of the October 10 high near .90196.

UK equities continue to underperform. In 2018, MSCI UK was -13.7% vs. -11.6% for MSCI DM. In 2019, MSCI UK was +11% vs. +26% for MSCI DM. So far this year, MSCI UK is -0.2% YTD and compares to +0.4% YTD for MSCI DM. Our DM Equity Allocation Model has the UK at VERY UNDERWEIGHT, and so we expect UK equities to continue underperforming.

UK bonds are outperforming. The yield on 10-year local currency government bonds is -17 bp YTD and is the best performer in the majors. Next best are Australia (-16 bp), New Zealand (-15 bp), Hong Kong (-14 bp), and Canada (-14 bp). With inflation likely to remain low and the BOE tilting dovish and likely to cut rates, we think UK bonds will continue to outperform.

Our own sovereign ratings model shows the UK’s implied rating remained at A+/A1/A+. This continues to suggest strong downgrade risks to actual ratings of AA/Aa2/AA.