Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here, Mitchell Fraser-Jones, head of Investment Communications for Woodford Funds, gives his outlook for the UK economy.
The economy is always the subject of frequent, often intense, debate during a General Election and this campaign has been no exception. Regardless of the result of today’s election, the closest political contest in decades with numerous potential outcomes, we believe the UK economic outlook remains somewhat subdued. We haven’t been particularly impressed with the quality and sustainability of the domestic economy’s recent outperformance.
We haven’t been impressed with the economy's performance
Gross Domestic Product, or GDP, can be defined as the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
In terms of category of expenditure, consumption accounts for the lion’s share of the UK economy much more so than most other developed economies, in fact with almost two-thirds of our economic activity accounted for by households. Government spending and business investment account for approximately 20% each, and courtesy of our massive current account deficit, net exports currently detract from overall UK GDP as the value of imports significantly exceeding that of exports.
Consumer Spending
It’s a sweeping generalisation but, we Brit’s famously love to spend. Collectively, in the good times, we have developed a habit of living well beyond our means, accumulating a substantial burden of household debt in the process. Prior to the financial crisis, household debt peaked at almost 170% of disposable income, substantially higher than normal levels.
Debt levels did moderate in the immediate aftermath of the crisis, as illustrated by the increase in the household savings ratio below. Household debt remains at an elevated level in the UK, however, and somewhat worryingly, the household savings ratio has declined again as consumer confidence has returned.
The burden of household debt in the UK appears manageable when interest rates are close to zero, but would look increasingly unsustainable if and when interest rates start to normalise. It is therefore slightly disturbing to see debt-fuelled, consumption-led economic growth returning recently. Some would argue that any growth is better than no growth but we are not convinced.
Household spending may continue to contribute positively to the UK’s economic performance but we would worry if it were to do so as a result of a further increase in debt levels. The rapid decline in energy and food prices both represent something of a recent windfall for UK consumers but it would be healthier for the economy in the long run if this windfall was saved rather than spent, not least because, all other things being equal, savings should equate to investment.
Government Expenditure
Historically, public spending has been used as something of a counterweight to private demand, with relatively low government expenditure, characterised by a budget surplus, when private demand is buoyant, and increased government spending when private demand comes under pressure. This is classic Keynesian ‘pump priming’ with the government standing ready to substitute private demand when it falters in a recession.
The fiscal response to the recession that followed the financial crisis was somewhat different, however. A prolonged period of low volatility in economic growth rates had lulled politicians and central bankers into a false sense of security and the idea of “no more boom and bust” crept in to policy-makers’ thinking.
In the years leading up to the financial crisis the UK government of the time consistently ran a budget deficit in the good times, rather than a budget surplus. Coupled with a significant and critical injection of capital into the UK’s failing banks which took the burden of government debt to even more precipitous levels, this meant that when the business cycle ultimately and violently reasserted itself, there was nothing in the public coffers with which to substitute the collapse in private demand.
As a result, we saw a rapid deterioration in the public finances, followed by a prolonged period of austerity as the long process of healing the public finances was commenced. This process is not yet complete and, regardless of the outcome of today’s General Election, it seems inevitable that another wave of austerity awaits us over the next five years
Business Investment
In contrast to the rest of the economy, debt levels for British businesses are quite low – balance sheets are in good shape, at least they are among the largest British companies. The average FTSE 100 company could theoretically use profits and existing resources to pay off all of its outstanding debt within one year if it wanted to. Large corporates have been risk averse – in an environment of muted final demand, they have generally been reluctant to invest, paying down debt and hoarding cash.
Although at face value, this suggests that business investment could deliver reasonable growth from here, there are three main reasons why we remain cautious on the outlook for this part of the economy too.
Companies remain, quite rightly, risk averse. Companies prefer to wait for solid evidence that the environment is sustainably improving before committing capital. As far as most of the economy is concerned, we are still waiting to see this evidence. It is therefore plausible that businesses will continue to hoard cash.
While large UK businesses are generally in good shape financially, the same is not true for many small and medium sized businesses. This is a part of the economy that is much more reliant on the banking system for growth capital and evidence suggests that smaller businesses are still struggling to gain access to bank finance.
The political uncertainty that surrounds the current election process may well act as a deterrent to overseas businesses investing in the UK. The fragile state of the Union and question marks over the UK’s relationship with Europe could also put a brake on business investment growth in the near-to-medium-term.
Net Exports
Britain’s manufacturing and engineering expertise of old has been in decline for decades, with services and, in particular, financial services, becoming more dominant. Nevertheless, we still sell plenty of goods and services to the rest of the world, with exports equating to about 30% of UK GDP.
The trouble is, we import substantially more than we export, so ‘net exports’ actually subtract from UK GDP to the tune of about 2% at present. In the near term, the most conceivable way in which our exporters could be given a boost is through a rapid depreciation in sterling but that would be accompanied by a great deal of pain elsewhere in the economy.
Total Factor Productivity
So, through the ‘category of expenditure’ economic lens, it is difficult to paint a rosy picture of the UK’s economic outlook. We are not suggesting that a recession lies round the corner but, realistically, it seems more sensible to expect economic growth to remain muted in the years ahead.
Innovation is the Key
We believe productivity advances are key to long-term economic health and unlocking productivity is what makes us most optimistic about the long-term economic outlook.
We are very fortunate in the UK to have all the ingredients to benefit from innovation. We have four of the top 10 universities worldwide in the UK, generating world-class academic research. We also have one of the most advanced capital markets in the world and a rich history of leading the world on innovation.
In recent history we haven’t mixed these ingredients particularly well and, arguably, our policy makers could do more to encourage entrepreneurialism and to foster the development of a vibrant ‘knowledge-based’ economy.
Turning innovation into commercial reality can deliver successful, scalable new businesses, new industries, new jobs and help to deliver the much needed economic rebalancing with a ‘knowledge economy’ at its heart.
In conclusion, for the term of the next parliament at least, we believe the UK economic outlook remains challenging. Beyond this, however, our confidence in science, innovation and technological advances affords a much more optimistic view of the UK’s economic future.
Morningstar Disclaimer
The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com.
