By Hetal Mehta and Willem Klijnstra
Economic forecasting is tricky at the best of times. Under current circumstances, the range of outcomes is wide and highly dependent on financial variables: particularly sterling.
We expect the UK to experience a mild technical recession in the second half of this year. This would be transmitted through a number of channels.Firstly, the weakness of the pound is likely to push up import prices and cause inflation to pick up. This, combined with job cuts, could squeeze real incomes and cause consumption to grind to a halt. In turn, we also expect house prices to weaken.Additionally, the ‘confidence shock’ that results in elevated uncertainty could hurt both hiring intentions and capital spending. Credit conditions could also be a key channel. The Bank of England’s policy response has focused on maintaining market functionality. Further policy stimulus – in the form of interest rates cut to zero, more quantitative easing and possible credit easing schemes – is expected over the summer. This ought to counter a significant tightening of credit conditions.UK politics have been thrown into turmoil by the EU referendum result, with chronic uncertainty on the process of withdrawing from the EU a principal factor undermining the confidence of potential foreign investors in UK assets. Theresa May’s public statements suggest she will reach a less eurosceptic result, favouring a later and softer withdrawal from the EU.Under the Fixed Term Parliament Act, it is difficult for the government to trigger a new general election before 2020. In this context, the disarray in the Labour party feels like a sideshow. More important are the efforts by the Scottish National Party to use the Brexit vote as a pretext for a renewed independence push in Scotland. In the wake of the EU referendum, Scottish polls have unsurprisingly swung in favour of independence and the risk could now persistently overhang UK markets.Increased political and economic uncertainty makes finding a fair value for the pound difficult. The pound could struggle to stabilise until there is more hard data on the impact of Brexit on the real economy or more visibility on the new relationship between the UK and the EU.The UK is running a large current account deficit, the financing of which relies on continuing material capital inflows. Brexit is likely to have a negative impact on foreign direct investments into the UK and portfolio inflows may also be impacted. There have recently been redemptions across UK property funds and we know the UK commercial real estate market had previously experienced strong inflows of capital from overseas for many years. The clear risk is that these redemptions spread to other UK assets.There are a number of ways to estimate the fair value of the pound. Any attempt that uses other financial market variables is erroneous as those prices are affected by the same heightened risk premium. Looking at the level of the pound that would sufficiently reduce the current account deficit misses the point that the deterioration over recent years is not really driven by net trade, but by net income from abroad. Since the Great Recession, we have also learned sensitivity of trade to the level of the pound is low. For capital flows to return, UK assets would have to cheapen sufficiently. However, an important part of this process is a weaker pound itself, so this approach becomes circular.Given the central economic outlook and ongoing political uncertainties, we believe weakness in the pound is to be expected – but we do not think the pound will fall to extremely cheap levels. As such, we do not expect the pound to trade sustainably below 1.20 to the US dollar.The European economy is likely to be negatively impacted as well, but it is mainly the political uncertainty about the future of the EU that keeps a lid on the euro against the US dollar. This uncertainty is stoked by national elections and possibly more referendums across Europe.Hetal Mehta (pictured) is senior European economist, and Willem Klijnstra is a strategst, both at LGIM“We do not think the pound will fall to extremely cheap levels. As such, we do not expect the pound to trade sustainably below 1.20 to the US dollar.”
Hetal Mehta and Willem Klijnstra
