Author: admin@hottinger.co.uk

The vote to leave the EU was a shock for the financial markets and the economy such that the respected NIESR thinks the UK has a 50/50 chance of falling into recession. We have dusted off our recession warning model to take a measured look at the state of play.

A Quick Word About The Model. The idea is simple. Take eight indicators which might reasonably be sensitive to the business cycle from differing perspectives and see how they stand now compared with extremes of the past.

To take one example, the UK has had two recessions since 1990 – a shallow one in 1990-92 and a deep one in 2008-09 – and the FTSE All Share fell just over 20% in the former instance and roughly halved in the latter. However, it also halved between late 2000 and early 2003 when there was no recession in UK real GDP so beware a phantom prediction.

One and a Half Out Of Eight Cats. In a rough and ready fashion, we have set recession thresholds for each of the eight indicators. Only one suggests the economy is heading into recession; another is moving in that direction. Here is a summary of the results

• Financial Markets – This is not a recession made in Threadneedle Street: the Bank of England has left its nominal Bank rate at 0.5% since March 2009 and hence real rates have been pretty stable. Nor is the stock market or money markets panicking: the FTSE All Share is actually up and the UK equivalent of the TED spread has barely moved.
• Labour Market – True, the labour market does not typically lead the business cycle but the claimant count in particular is sensitive to the economy’s ups and downs but neither employment nor unemployment is hinting at a downturn … yet.
• Housing Sector – It is tough to get timely data on the supply side of the highly cyclical housing industry. The RICS monthly survey focuses more on the demand side. However, building permits have slowed and the latest GDP data show construction in decline.
• Consumer Confidence – The old adage is that you cannot spend confidence (and it is incomes that really matter). However, nervous consumers may delay or cancel plans to buy new cars or move home and this indicator is the only one of the eight which gives a clear recession signal.
• Oil Price – Ever since the two oil price shocks of the 1970s, economists have always included the oil price in recession warning models. Whether or not it is relevant, energy prices are not driving this potential downturn.

Conclusion. The Brexit vote has sharply increased the possibility of a UK recession ahead. However, some of the commentary in the media and the blogosphere has bordered on hysteria. The economy has had a shock and there is considerable uncertainty which will affect long-term plans but not much will change in the near term. Our view remains that the economy faces a tough time but the jury is out as to whether there will be a full-blown recession.

China has suffered from misplaced fears for some while. Some thought the economy would be in recession by now, after a stockmarket crash and unexpected renminbi depreciation last year. Others have warned that the re-balancing of China’s economy also means inevitable recession. And yet others have predicted a Lehman-style financial crisis due to too much debt.

China has proved the pessimists wrong so far and will likely continue to do so. To be sure, there are problems but they look manageable.

Last week’s data showed that the economy grew by 1.8% qoq, 6.7% yoy in the second quarter, considerably better than quarterly growth of 1.2% in the first quarter. True, the numbers are not great quality but they are credible enough.

The government has halted the late 2015/early 2016 slowdown, thanks to extra public sector spending, lower interest rates, easier bank capital requirements and a weaker currency. However, it has been a balancing act between supporting growth and a delay in transforming the economy from the old manufacturing/export model to the new services/consumption one.

In its latest review, the IMF congratulated China on making progress in switching from industry to services and in freeing up its financial markets but specifically listed credit growth, corporate governance and state-owned enterprise (SOE) reforms as areas to tackle.

Here are a couple of (related) worrying signs from recent data. First, although investment spending was up 9% yoy year-to-date in the first half, private sector capex rose just 2.8% compared with state capex 23.5%. In other words, the government has stepped in to ease the effects of a very steep slowdown in private capex.

Second, M1 growth was 24.6% yoy in June versus broader M2 growth of 11.8%. This suggests that Chinese firms are building up cash deposits at a rapid rate which they are not keen to spend. The slowdown in capex and the run-up in cash suggest that either firms lack confidence or they have few worthwhile investment projects on their radar.

In some industries – coal, steel and housing, for instance – there is over-capacity which makes investment pointless. Elsewhere – for example, finance, energy, telecoms and transport – private firms are being crowded out by SOEs. We worry less about too much SOE debt, which seems to be largely owed to SOE banks, but more about inefficient state firms holding the economy back.

Looking ahead, we see the following:

• Growth will remain in a 6%-7% range over the next 18 months … we would not be any more precise than that.
• Inflation – 1.9% in June – will remain low in line with the rest of the world.
• The government will shift back towards rebalancing the economy and away from supporting growth
• SOE reforms are crucial so we shall follow the news wires for progress
• Asia-Pacific equities have had a very strong 12 months in GBP total return terms … they remain good value and attractive

Two weeks ago, Bank of England governor Mark Carney confidently said that the vote to leave the EU would lead to “a materially lower path for growth” and that “some monetary policy easing will likely be required over the summer”. Earlier today, the Monetary Policy Committee (MPC) decided to do nothing. What happened?

Wait And See. The answer is that the MPC sensibly decided to await further evidence before taking action. Ahead of the decision, market economists were divided almost equally between no change and a 25 bps interest rate cut. The former was a wait-for-the-evidence view, the latter a vote for early, decisive action.

The minutes suggest that the MPC still expects a distinct downturn in the economy but the signals so far are tentative. Business and consumer surveys have indicated a sharp fall in confidence but that was to be expected. The fear – not articulated in the minutes – is the chance of a bounce-back in sentiment. The committee would look foolish if it cut rates in July only to reverse the move a few months later.

The Banks’s Agents may also have had an influence. The minutes reported that one-third of contacts expected weaker capital spending ahead: one would have expected a greater proportion. In addition, the agents said that there had been “no clear evidence yet of a sharp slowing in activity”: in other words, businesses are worried but not cutting back just yet.

Do The Math. The MPC also stressed that it wanted to wait for a fresh economic forecast due in August. This will allow access to better data and also give the opportunity for proper reflection. The next Inflation Report is due to be published in three weeks’ time on Thursday 4th August.

It is pretty certain that the Bank will lower its growth forecast and (thanks to sterling’s decline) raise its inflation projection. However, there may be a better sense whether the downturn will be sudden and pronounced or slow to materialise and mild.

Other Reasons For Delay? Here are two. One, the markets have already done some of the Bank’s easing for it. Sterling’s trade-weighted index is down roughly 9% since end-May; short rate expectations have fallen some 25-30 bps since just before the referendum; and 10yr gilt yields are down about 50 bps. These moves make Bank of England action less urgent.

Two, the old market adage that it is better to travel than to arrive remains true for monetary policy. There is a sense in which, for now, the prospect of monetary easing is just as effective as actually cutting rates. But in three weeks’ time either economic conditions will need to have improved or the Bank will have to deliver.

Market Implications. The immediate response to the Bank’s inaction was a stronger pound, higher short rates and bond yields and a weaker equity market. The key point, though, was the reasonably measured response. The markets still expect the MPC to act in August but it seems that the markets are calmer than Mr Carney.

Since 23rd June there has been a poll every hour on the hour to tell us how bad life will be. Bloomberg polled economists and found that three-quarters of them expect a recession in the UK. Retail Economics surveyed consumers and discovered that more than half plan to reduce their non-essential spending. What should one believe or not believe? Here are three initial surveys from reputable sources.

Lloyds Bank has been publishing a business barometer each month since January 2002. The latest survey was conducted in the days after the EU referendum and business confidence fell from +32% to +6% and forward-looking economic optimism sank from +26% to -11%. The chart shows that this survey tracks the economy pretty well and is indeed consistent with a UK recession in the second half of 2016.

However, the barometer gave a false signal in 2011 during the eurozone debt crisis, sinking from +41% in June 2011 to -3% by year-end but rebounding to +36% by March 2012. In addition, Lloyds point out that the industrial sector (boosted by sterling’s fall) fell by less than services and that hiring plans remained “surprisingly resilient”.

YouGov and the Centre for Economics and Business Research (CEBR) jointly publish a business confidence index. Now we do not have a track record here and opinion pollsters have not performed especially well recently but the pre- and post-referendum results highlight one key point. The business confidence index was down 7.6 points, the own company optimism index 9.3 points and the economy optimism index 18.3 points. This is an example of the “I am alright but I am worried about other people” survey phenomenon. In other words, surveys just after a shock may exaggerate the likely economic impact.

Turning to consumers, the GfK confidence survey dates back to 1974. Its post-23rd June poll showed the sharpest drop in confidence since 1994, with 60% of those surveyed expecting the economic backdrop to worsen over the coming year.

However, the chart shows that this index is not a reliable guide to consumer spending volumes. The rule of thumb in econometrics is that personal consumption is largely explained by incomes, with minor contributions from wealth and confidence. Consumers may be unhappy but that need not stop them spending. Retail therapy anyone?

Pulling these three threads together, it is clear that there will be a materially lower path for UK growth. However, this does not look like a “Lehman moment”. For now, we stick with the view that we shall see stagnation rather than a recession but, even so, the Bank of England is still likely to cut interest rates on Thursday.

Last month the biggest risk of the year turned into reality when the UK voted to leave the EU. In the aftermath of this momentous decision, we turn a spotlight on what other hazards could catch the market unawares.

But before that, how will UK politics and hence Brexit evolve from here? Our working assumption is that Theresa May becomes prime minister on 9th September after a contested leadership election and then invokes Article 50 early next year after preparatory work. There are details to consider but they may not matter much here. The bottom line is that the markets will likely accept Mrs May as a safe and competent pair of hands to guide the UK out of the EU.

We also assume that the direction of travel will be either EEA-lite or EEA-plus where “lite” is limited single market access but some immigration controls and “plus” is full access and a broken immigration promise. The former seems more likely; the latter would go down better with financial markets. And, finally, we reckon that UK growth will slow sharply but avoid a full-blown recession.

More importantly, perhaps, what other risks threaten investor portfolios? We would highlight three of the above. First, Donald Trump wins the US presidential election. If Hillary Clinton wins, then it looks like business as usual, much along the lines of the current Obama administration. If Donald Trump wins (and few thought he would win the nomination), then it is less clear what he would do in office. However, he appears to have a reckless fiscal policy (tax cuts and spending increases without regard for the budget deficit) and protectionist instincts on overseas trade. Neither is likely to be market-friendly.

Second, US profits growth worsens. It has turned negative this year both on a stock market basis and in the national accounts but we take this as mainly a reaction to the 25% rise in the US dollar against the major currencies between mid-2014 and late 2015. The US dollar has levelled off this year and the economy has picked up so we think profits growth will turn positive. However, this is a hazard worth watching.

Finally, the global expansion is seven years old and looking tired, especially in the US and the UK. Rudi Dornbusch famously quipped that expansions do not usually die of old age but are murdered in their beds by the Federal Reserve. Thus, in normal circumstances a bias to tighten by both the Federal Reserve and the Bank of England earlier this year might have signalled the next downturn. Both have backed away from interest rate hikes for now but there is not much fuel in the global economy’s tank. This is our third key risk.