Macro update: UK Groundhog Day?

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    Written by Kevin Gardiner 20 May 2014

There have been three key supports for stocks since 2009: growth; valuation; and liquidity. They are all intact, but have matured, meaning the easy call is likely behind us. In the UK it’s starting to feel like déjà vu all over again, despite mid-cycle blues which do usually favour stocks over bonds.

An update on the small-cap effect 2 of 2 Compass May 2014

Residents of the United States, please read this important information before proceeding

Ongoing economic growth should support corporate profits, and underpin stock valuations

Growth pains are bearable – but most visible in the UK

Key business surveys continue to show manufacturing confidence at above-trend levels in the biggest developed economies. It has rebounded from a weather-affected first quarter in the US, and unusually is particularly elevated in the UK (Figure 1). It has stabilised even in China (where “trend” growth is much stronger to begin with).

Ongoing economic growth should support corporate profits, and underpin stock valuations, but as it starts to mop up liquidity, and threatens to normalise interest rates more quickly, it could have some uncomfortable side effects. They may not last for long, but investors used to easy money and soothing words from central banks could find that things get tougher from here – as they did during the dress rehearsal when bond yields rose sharply in mid-2013.

If/when we revisit those growing pains, the assets most at risk in the short term may be stocks (they’re called risk assets with good reason). But what usually happens at this mid-cycle juncture, is that, as investors recognise that the higher interest rates are an indication that business is indeed moving back towards normal, stocks eventually stabilise, recover and move on to higher levels as profits continue to grow, while bond prices drift lower as yields rise with interest rate expectations. And we expect something similar to happen now.

Figure 1 shows a graph of standard deviations from the trend from selected business surveys in manufacturing. Figure 2 is a graph of UK GDP growth against CPI inflation.
After spending much of the last three years seemingly in limbo, the UK may face more growing pains than most in 2014

After spending much of the last three years seemingly in limbo, the UK may face more growing pains than most in 2014. Unusually, the Bank of England is currently over-delivering on its inflation mandate: CPI inflation is below its 2% target for the first time since 2009 (Figure 2), and seems likely to stay there for a while. But the UK’s chequered track record means this cannot be taken for granted: the UK is the least likely big economy to move into sustained deflation (not that we expect much deflation anywhere, or worry unduly about it). And interest rate risk has a real as well as a nominal component: vigorous growth can squeeze rates higher even if inflation stays subdued.

The IMF agrees with us that the UK is likely to be the fastest-growing large economy this year: first-quarter data show GDP again growing at an annualised pace of around 3% for the 4th consecutive quarter. Employment data (Figure 3) paints a more upbeat picture again, hitting new all-time highs even as GDP has yet to fully close the gap with its pre-crisis peak (perhaps suggesting that the recent level of GDP is, if anything, being underestimated). Recent retail sales data (Figure 3) show a pronounced surge, and national UK house prices defied gravity through the downturn (Figure 4), and have recently picked up.

Figure 3 shows a graph of UK GDP, retail sales and employment indices. Figure 4 shows a graph of selected house prices.

That resumed surge in house prices is a little unsettling: the UK economy is solvent and productive, but our national preoccupation with property prices tends to amplify the business cycle and add to volatility. This latest upturn in prices has been deliberately fostered by the government, even as the UK economy has made less progress than the US in tempering its external imbalance (Figure 5).

Figure 5 shows a current account comparison graph of the UK and the US. Figure 6 shows a graph of Sterling real exchange rates.
In the UK as in the US, the private sector is still in financial surplus

In the UK as in the US, the private sector is still in financial surplus, and there is still plenty of slack in the economy; and as noted, the inflation picture is fine for now. But this is starting to feel like the economic equivalent of Groundhog Day, and the movie isn’t so funny the second time around, even if it’s just starting. UK policy rates may be the first to rise, possibly before year-end, and sterling is firming in anticipation, albeit from pretty competitive levels (Figure 6 – a lack of competitiveness is unlikely to be the main reason for the current account deficit). Our misgivings may not matter much for the main UK stock indices: like the Premier League, these are dominated by overseas, not local, players, and the UK is not one of our preferred markets to begin with. But local business, and the gilt market, may be forgiven for thinking that it’s a case of déjà vu all over again.

Barclays’ key macroeconomic projections

Figure 7 is a table of economic zones, comparing real GDP and consumer prices. Figure 8 is a table of Central bank policy rates.