UK economy – green shoots

Investment Notes

Over the last ten quarters to March 2013, the UK economy has produced essentially zero growth due to a combination of (i) the UK government’s austerity plans encompassing both spending cuts and tax increases, (ii) severe economic weakness in the Eurozone, the UK’s largest trading partner, (iii) weakness in North Sea oil production due to essential maintenance work, (iv) a large banking sector engulfed in a series of scandals, which have damaged their profitability, and (v) declining consumer real incomes.

During this period the UK economy has consistently disappointed the expectations of the Bank of England, the Office of Budget Responsibility and the IMF, as well as many private sector forecasters. In recent weeks however, this trend of disappointing expectations has come to an end, and the Bank of England, in Mervyn King’s last presentation of the state of the UK economy, upgraded its growth forecast for the UK in 2013 from 1.0% to 1.2%.

Beneath the headline figure of zero growth, there have however been two important improvements in the UK economy, which give encouragement to longer term recovery prospects as follows:

  1. The structural budget deficit (that is after allowing for the extra government spending and lower tax revenues that arise from a weaker economy) has been reduced by over 4% of GDP in just 3 years (or 1.3% per annum) .Given that state spending is about 40% of the economy, it has required the other 60% (the private sector) to grow at about 1% per annum over this period, merely to offset the public sector weakness and achieve zero growth for the economy as a whole. This 1% growth from the private sector is quite an achievement in the face of so many headwinds for consumer and government spending. Though the structural budget deficit remains too high, there has been good progress in reducing it.
  2. The flexibility of the UK labour market has surprised many. Despite the economic weakness, unemployment has stabilised at around 2.5m rather than the 3m that many commentators expected to see when the crisis first hit. The major reason for this has been workers preparedness to take pay cuts or not demand pay rises to preserve their jobs – UK wages are only growing at about 1% currently, and have been well below the rate of inflation for four years. By contrast, French unemployment (France has essentially the same population and size of economy as the UK) has gone through 3m and is still rising.

The weather has played a surprisingly key role in the UK economy over the last twelve months – last summer was extremely wet (excepting the period of the Olympics) and both of the last two winters have been very cold and wet. This has had a very serious effect on the construction industry, which had already been extremely weak over the life of this government, first from a cutback in government investment programmes, and secondly from weakness in UK housebuilding. Just a return to normal weather over the summer and next winter should see a sharp improvement in construction spending, and with it the demand for construction workers, and the prospects for an improvement in overall economic growth.

There are other reasons though for being more confident. The electoral clock is now audibly ticking, and though the government will not reverse course on their austerity programme, they will be more sympathetic to ideas, which boost economic growth in the shorter term, particularly if they can be labelled as “investment”. Importantly too, the new Governor of the Bank of England has been selected because he is an activist who believes that monetary policy can make a difference to the real economy. He has already been granted a more flexible mandate than just the control of inflation. Growth is now almost as important, and more emphasis on getting funds into the hands of industrial borrowers can be expected.

In the run-up to the 2015 election, there will be a more marked policy bias to boosting growth, and with the underlying improvements that can already be seen in the UK economy, it is likely that growth will exceed the (very low) expectations that currently exist. Note though that this is a forecast of modest improvement rather than of a boom.

The investment implications of beating the low expectations that exist for the UK economy are that, after two decades of performing much worse than either large or mid-sized companies, smaller companies in the UK, who are most exposed to the strength of the UK domestic economy, may be about to benefit most from the improving economic trends. Where client portfolios do not have specific smaller companies exposure, we will be seeking to include it in any recommendations, as appropriate.