UK: Economy: UK On The Global Stage (Part Two)

Last Updated: 20 September 2019
Article by Simon Burgess

As the UK's role as a leading actor on the global stage hangs in the balance, head of Alternative Investments, Simon Burgess continues to explore the state of the UK economy and that of the global backdrop.

Read part one here.

The UK is not the only country to record falling GDP and other economic headwinds; global growth is generally weaker...

In the US, the flattening of the yield curve of US Treasuries has traditionally been regarded as a signal that recession looms. This yield curve represents the spread between two and ten-year US Treasury bonds, which currently remains teetering on a dime by falling in reverse and inverting. Usually, you'd expect yields on longer dated bonds to be higher than shorter ones. The last time this inversion happened was in 2007 and as I write this, they are pretty much "even stevens". 

Given this yield curve, along with credit spreads and equity prices, Aberdeen Standard Life rates the chances of a US recession at 50%. However, there are also positives to note and given strong labour market fundamentals and resilient private sector confidence, a soft landing is predicted by some. 

Is the old Napoleonic adage that when the US sneezes, the rest of the world catches a cold playing on the minds of investors?

After the US Federal Reserve (the Fed) cut interest rates, Thailand, India, Australia and New Zealand followed suit (the latter having cut its rates to a record low 1%). The European Central Bank is also anticipated to cut rates in September 2019, a move which will be regarded as necessary given their sluggish growth, especially in terms of production and exports.

The usually robust German economy is also showing signs of faltering, with a marked downturn in industrial output reported in August 2019. This is likely to be exacerbated by the 70% expected drop in bilateral trade with the UK off the back of a no-deal Brexit, according to the German Mittelstand Association (the UK is currently one of five of Germany's largest export markets). With this in mind, the World Trade Organisation (WTO) terms associated with a no-deal Brexit will certainly worry the German Chancellor as well as German businesses.

Possibly more worrying for all however is the progression of the China/US trade war which risks building in significant market inefficiencies and risks. This, in-turn is knocking investor confidence. Of great concern is the effect of the devaluation of the yuan, which has historically been tightly managed by the People's Bank of China. If the exchange rate tips over seven yuan to the US dollar, as it did briefly on 5 August 2019, there are a range of potentially disruptive consequences. It could even threaten a global devaluation and could help push the UK and other European countries into recession. 

At the time of writing, sterling has fallen to EUR1.12 and USD1.23, and we are likely to see further volatility as the market responds to the political turmoil playing out in the British Parliament (prorogued or otherwise). Many will say further falls in the pound are a direct response to higher expectations that Prime Minister Johnson will exit Britain from the European Union without a deal and therefore defaulting to WTO rules. That said, recent drops in the pound don't compare with the double digit drop that occurred in in the immediate aftermath of the 2016 referendum and arguably, Brexit has already been largely priced into exchange rates. 

Currency falls are generally considered a bad thing, but this isn't necessarily the case; following the significant devaluation of sterling in 2016, the UK experienced a boost for its exports and the trade deficit moved from £13.7 billion in Q3 to £4.2 billion in Q4 that year.

Typically, cutting rates has a devaluing effect on currencies and will make imports more expensive and exports cheaper. As such, when sterling drops, there will be both winners and losers. Those importing goods and services will suffer as their costs go up and businesses exporting goods and services will benefit as their prices will be lower to foreign buyers. However, given the UK imports more than it exports, the effects in aggregate are regarded to be marginally negative. 

The drop in the pound will have other domestic ramifications; the increasing cost of imports should result in buyers seeking out more British-based goods and services and sellers should see their exports increase. Together, these two factors will be good for the UK economy and should have a positive impact on domestic employment. However, these effects take time to feed through so more are likely to suffer in the immediate term before gains are felt. The inflationary effect is one immediate result, so we should watch out for the possibility of the Bank of England (BoE) reversing its expected interest rate cut with rate increases in order to protect jobs.

Many of our clients are interested in the effect that sterling has on the value of their real assets or private equity investments. For those holding both GBP-denominated assets and GBP liabilities, a change in exchange rates does not in itself have an adverse effect. Only those holding GBP assets with non-GBP liabilities (or vice versa) will be directly impacted.  

This position also applies to the UK's state owned assets and liabilities. This is due to a higher proportion of UK foreign liabilities held compared to UK-held foreign assets. The former tend to be fixed and held in GBP (valued in January 2019 at £125 billion), typically made up of foreign currency hedged positions - these remain unchanged when the pound drops. By comparison, the latter (valued in January 2019 at £180 billion) consist mainly of foreign currency, which increase in value when the pound falls. Britain wins.

Dr Gerard Lyons, the economist tipped to succeed Mark Carney as the next Governor of the BoE advised in August: "one needs to retain perspective about the UK economy, where the solid labour market and stronger wage growth with easing inflation should underpin consumer spending in coming months. There is also scope for policy easing. Of course, how Brexit is resolved will be key".

Trying to second guess exactly what will happen during the final quarter of 2019 and then into 2020 is nigh on impossible. The best that investors can do is scenario-test their portfolios and de-risk where possible. Many have already done so, evidenced by the hike in the value of gold, the perennial safe-haven asset. Other precious metals, like silver, are following suit.

There is everything to play for and all without a script, but whatever happens, the show must go on...

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