This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Mark McFarland, Global Chief Economist at Coutts gives his outlook for the UK.
After two years of flirting with recession the UK economy has shown some impressive signs of recovery, driven by a rebound in the housing market and improving consumer confidence. We expect the recovery to continue at a fast pace, driven by the government’s initiatives to boost lending, consumer spending and very loose monetary policy from the Bank of England (BoE). We believe the BoE could be under pressure to raise rates in the first quarter of 2015.
The UK recovery has recently gained momentum with corporate confidence in the services sector (as measured by purchasing managers’ indices) hitting its highest since 2007. After a long period of subdued growth and households reducing their borrowing, various initiatives to boost lending, such as the “Funding for Lending” and “Help to Buy” schemes seem to have had an impact on economic growth. Rebounding house and financial asset prices have supported consumer sentiment and spending. Strong private consumption and a revival in private investment are likely to surprise to the upside in the coming quarters.
However, UK households remain highly indebted, with the debt-to-income ratio (136%) currently higher than the 2007 peak in the US. We believe that renewed borrowing, which we see supporting growth in 2014, will fade in 2015 and that growth that year will fall short of expectations of 2.4%.
Inflation is likely to remain above the 2% target, but fall towards 2.5% at year-end. We expect falling food prices to offset rising electricity costs. The recent rise in sterling will also push import inflation lower, while core inflation will likely stay sticky around the current level of 2%. Strong growth without a rebound in productivity is likely to ultimately result in rising inflation as we approach 2015.
We believe the BoE will keep rates unchanged in 2014, despite stronger growth. However, higher inflation, lower spare capacity and fast growth could build pressure for rates to rise in the first quarter of 2015. This is a quarter beyond what is currently priced into the futures market, but about a year sooner than signalled by the BoE. Nearer term, inflation should fall towards the end of the year, which, with the dependency of indebted households and the government on low borrowing rates, is likely to keep monetary policy very loose for an extended period of time.
The BoE has used forward guidance to try to keep short-dated bond yields low (with significant lending such as mortgages tied to these rates). However, longer-dated yields are at the mercy of the markets and have been highly correlated with US yields. Strong growth and lack of unanimity in the Monetary Policy Committee on forward guidance has undermined its effectiveness. We see scope for 10-year gilts yields to rise to 3.5% by the end of 2015.
Loose monetary policy is likely to weaken the currency and we expect sterling to fall moderately against the dollar, but to trade in a narrow range against the euro.
