Just as the global economy faces a number of important pivot points that investors should look for over the next several years, so some domestically generated pivot points will shape the UK economy in the coming years – largely stemming from UK politics.
The economic backdrop for the UK is generally positive: seven years of economic recovery, unemployment at a 40-year low and a government deficit back to a manageable 2.5% of GDP. Although inflation is currently above target, this is due to temporary currency effects.
However, the UK is now entering a period of significantly greater uncertainty as the political outlook has become more clouded. Whilst the underlying economy is likely to continue performing relatively well, persistently low wage growth and a growing restlessness over fiscal austerity will very likely result in higher government spending in the years ahead. This in turn presents the Bank of England with a serious challenge: Any reversal of the current fiscal stance would come when the economy is already very close to full capacity.
Politics and Brexit
Major questions remain of who will govern the country and how the government will approach the Brexit negotiations.
We continue to expect that the UK will exit the single market and probably the customs union. A much more open question is how long and how amicable the so-called transition period will be. The UK could quite conceivably maintain very close trading ties with the European Union for the next several years. Conversely, following the Conservative party’s loss of seats in Parliament in the 8 June election, it’s also possible that the current government may struggle to maintain control of Parliament, via either a dysfunctional Conservative leadership election or a fractious reaction to the handling of the Brexit negotiations. In that environment, a disruptive and damaging exit from the European Union could not be ruled out.
Whilst the central path would imply a benign economic outcome, the risk scenario is tilted toward a worse result. In short, politics will very likely dictate the economic outlook much more than it has in the past few years.
Investment implications of UK outlook
So how do we approach this as investors? We believe there are a number of guiding themes that investors can employ:
- Try to avoid being dogmatic about UK risk positions. Accept that there are a wide range of potential outcomes.
- Make sure you are paid for sterling duration risk. Real and nominal yields continue to price in a persistently weak economic outlook. Diversification into global bond markets should improve risk-adjusted return potential.
- Protect carry in portfolios. Given the uncertainty, the temptation to remain in cash is high, but lengthy periods holding cash can erode investors’ purchasing power. We suggest investors consider seeking out high quality, short maturity assets for higher return potential than pure cash instruments.
For our long-term outlook for Europe and the global economy, see our 2017 Secular Outlook, “Pivot Points.”
Mike Amey is PIMCO’s head of sterling portfolio management and a frequent contributor to the PIMCO Blog.