UK economic outlook – Enjoy the sugar high

January 3, 2014 Categories: Investment Strategy

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The UK economy has continued to develop momentum over the course of 2013 and is gearing up for a strong 2014. This is a positive development that we applaud.

From here it is not, however, smooth sailing. In fact, the economy is on a bit of a sugar high—fuelled by consumer spending and housing. To transition into a truly sustainable recovery investments and wages have to rise. The UK might just pull it off, but it won’t be easy.

Gearing up for a strong 2014

It is common knowledge that the UK economy had fallen behind its developed peers on account of severe austerity and the recession in the euro zone. Over the past year the British economy has finally been able to overcome these factors with positive momentum built in the consumer spending and housing sectors. We expect this positive momentum to last well into 2014 with GDP growth coming in at 2.0 – 2.5%.

The drivers of the recovery in 2013 will also drive growth in 2014. Consumer spending will remain robust on the back of a pickup in employment and strong consumer sentiment. In addition, there is the benefit of a positive wealth effect from financial markets and home prices. Separately, housing contributes positively through a pickup in construction, which is expected to carry into 2014 (see chart). Housing may be akin to a fly trap, the positive trend is unlikely to change soon.

Besides consumer spending and housing, the UK economy should also be able to profit from a rise in net trade and investments. Trade should be boosted by a return to growth in the euro zone, as well as through continued expansion of exports to emerging markets. On the investment front, it is key that fixed capital investment continues to improve beyond the construction industry. High levels of producer confidence and favourable tax policies indicate it is likely that the tentative increase in 2013 will be extended into 2014. An additional boost will come from a large program of infrastructure investment by the government.

Beyond 2014: Challenges remain

Despite strong growth momentum and the positive outlook for 2014 we are not sounding the all-clear. This is for a simple reason: The current growth drivers are not sustainable. At the moment, consumer spending is boosted by falling savings, not wage growth (see chart). In fact, despite robust increases in employment, real wage growth—net of inflation—has remained negative. To make the recovery in consumer spending sustainable, real wage growth has to turn positive.

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House price increases at the current +10% annual rate are also not sustainable. Price increases above inflation do not generate wealth, they transfer wealth. So beyond the current increase in construction, a more broad-based increase in investment is required. The government is doing its bit by increasing its own investments as well as incentivizing the private sector. If this is successful, a virtuous cycle of rising employment, spending and investment can develop.  It won’t be easy though, especially since the government will have to continue to push down its still-high budget deficit.

Strategy outlook:

  • Valuation: With a dividend yield of 3.5% and a forward PE of 12.5, UK equities are still attractively valued, especially relative to the U.S. market. The global exposure of UK equities, especially with respect to the troublesome materials sector is something that should be taken into consideration. Government bonds with a 10-year yield at 2.9% are still somewhat expensive and will likely provide a total return of around 1-2% in 2014.
  • Business cycle: UK growth is set for a strong 2014, but moving beyond the sugar high will be important. This is a positive for equities and a small negative for government bonds.
  • Sentiment: Neutral for both equities and bonds. However, whereas bonds are firmly neutral some indicators are flashing amber for equities.
  • Conclusion: Remain invested, but be aware of the sensitivities of the UK equity market to the commodity cycle; we are not very positive on the outlook for this sector. We expect UK gilt yields to rise in line with the economic recovery. Fixed income investors will probably experience elevated volatility in rates due to the impact of policies such as QE tapering. However, the absolute level of rates should end the year within a range of 3.0 – 3.5% for the 10-year gilt because of downward pressure on inflation and accommodative monetary policy.

Wouter Sturkenboom – Investment Strategist, EMEA

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