Britain Investment Club

The UK macroeconomic outlook – Lent 2017

The UK sits in uncertain economic waters at the moment and this uncertainty is breeding volatility in the markets. 2017 has been dominated by unpredictability politically just as 2016 was before it and market volatility has risen due to political turmoil shown by the pound fluctuating between 1.20 and 1.30 USD. The currency market is more stable than the immediate Brexit aftermath period but investors are still wary of the UK due to the threat posed by rapid devaluations of sterling diminishing the value of foreign investments. PWC is predicting growth of 1.6% in 2017 slowing to 1.4%. This forecast could be downgraded greatly however dependent on Brexit. The long 2-year period of Brexit negotiations is prolonging a period of transition, which won’t aid volatility fears in the UK market. The government’s Brexit stance is still unclear and the markets could rally in the event of a soft Brexit involving free market access or even a withdrawal from the process to leave. In the short-term a hard Brexit policy could devalue the currency more and damage the market, but long-term volatility would decrease, which would allow more accurate forecasting and precise earning predictions. Therefore stocks could reflect true future value post-Brexit more accurately, as a lack of clear direction is currently only depressing market performance, given the complete lack of knowledge regarding Brexit’s future impact.

The decrease in the value of sterling has aided exporters due to an increase in the volume of sales, which has decreased the current account deficit and boosted exporters’ stock prices, however uncertainty in the UK market has slightly negated this gain for those companies and these are only short term gains. Also, according to the Office for National Statistics 44.6% of UK exports of goods and services go to the EU, and Brexit, once implemented properly, could lead to a decline in this trade and without new trade deals, which take long periods of time to complete, exporting firms are likely to suffer. Alongside this, imports are becoming more expensive due to the devalued currency, which is raising costs for UK firms in importing factors of production, and therefore revenues are falling. Oil prices are also rising steadily since the huge slump in 2016.

The UK’s macroeconomic climate could also be greatly influenced going forward by potential interest rate rises. The most recent Bank of England MPC vote was 5-3 against a rate rise but this was still a hawkish shock which aided the pound, strengthening UK positions briefly for foreign investors. The rate rise could occur due to rising inflation, with CPI hitting 2.9% last month, up from 2.7% in April. However, economic growth is already weakening post-Brexit amidst the political turmoil and increased rates could strengthen the currency but decrease growth in companies due to the increase in the cost of borrowing. There are also fears current growth in the economy is fuelled by underlying debt and so companies with high leverage ratios, or a reliance on variable rate factoring schemes due to a large cash conversion cycle, could be affected severely by a rate rise as it filters through to bank rates. However, the rate could well stay at 0.25%, as one voter for the increase to 0.5% is leaving the MPC and won’t be replaced until after the next vote, and Mark Carney is still strongly pushing for a stable rate in order to counter economic depression even though inflation is reaching the 3% upper bound of of the MPC’s target. Also, the BoE is seeking to normalise monetary policy and gradually cut back on QE, which could depress growth. However, the decrease in demand for government bonds caused by this could decrease their price, increasing their yield making them more attractive, incentivising investors to move back into more conservative buy-and-hold bond strategies and would decrease stock market growth.

Finally, the UK macroeconomic climate could be affected significantly by inflation. The UK economy has recently been plagued by increasing inflation, above the MPC 2% target. Last month, inflation reached 2.9% and has nearly breached the MPC upper bound. This inflation has been fuelled by the poor pound raising importing costs, thus increasing the cost of production, and by ultra-low interest rates This inflation can affect firms as consumers have less real wealth to spend on goods and services and so demand could fall, diminishing growth and therefore returns. Also, inflation domestically is decreasing the gains exporting firms are making due to a weak currency and thus negating some of the few positives of the Brexit announcement. Also, with the exit of the common market likely in the future, inflation will only increase, as import tariffs take their toll on firms reliant on importing and trade which could decrease their attractiveness to investors due to decreased profit margins and therefore lead to a decline in demand for UK stocks and a subsequent fall. However, the UK runs a trade deficit mainly with the EU and so exit from the common market could diminish the current account deficit and therefore limit UK companies’ exposure to exogenous shocks which look likely in Europe due to volatile political climates and conflict over monetary policy across the Eurozone which is causing clashes. Therefore less European exposure and a current account surplus could be a good thing for UK businesses, which may be forced to focus more on UK sources of raw materials.

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