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UK Secular Outlook: Morphing Into the Carney Era


The UK remains in a "stable disequilibrium," one that needs to either transform into a growing economy with narrowing income differentials or risk a more aggressive policy response.

Each May, PIMCO professionals gather for three days in our Newport Beach office to assess the three- to five-year secular outlook for global markets. As Mohamed A. El-Erian has written in the 2013 Secular Outlook, "New Normal … Morphing," amongst the key questions addressed this year was whether the global economy would exhibit signs of genuine, inclusive and sustainable growth or continue to exhibit multi-speed characteristics, with the various economic regions continuing to focus on domestic agendas.

Our core conclusion is that the world economic outlook has morphed to include "stable disequilibrium" dynamics that depend significantly on growth. Over the next three to five years, we believe the greater likelihood is that growth will remain dependent on central bank assistance, asset prices could risk outrunning economic reality, growth differentials will remain and possible "T-junctions" await key economies.

How is the UK positioned within this world outlook?

Many of the themes we identified globally resonate strongly with the UK: Disappointing growth, in turn reliant upon central bank activism; persistent income inequality; dysfunctional politics and the challenge of unlocking better (corporate) balance sheets. Indeed, at the broad level, the concept of a stable disequilibrium describes the current UK economy well: Employment levels are high, but real income growth remains negative; the export sector remains too focused on Europe and thus unable to provide meaningful stimulus; and the government remains committed to the medium-term fiscal plan. Overall, growth remains flat to moderately positive, sufficient to maintain a degree of social tolerance for the necessary economic restructuring, albeit at a painfully slow pace.

In turn, this leads us to raise several critical questions: Can UK prospects improve meaningfully over the secular horizon and will voter tolerance continue? Will the UK risk its own T-junction? Will a new Bank of England (BoE) governor or the 2015 election introduce any unexpected twists and turns? And how do we, as investors, position for these risks and opportunities?

Taking the economy first, there have been a number of disappointments over recent years which in combination leave us a lot earlier in the necessary deleveraging process than many would have hoped. In aggregate, gross debt as a percentage of GDP is little changed as the marginal reduction in private sector leverage has been balanced by the expansion of the government balance sheet (see Figure 1). When we look at the economy as a whole, there looks to be much work left to do.

That said, the news is not unequivocally grim. The banking sector has shrunk based on the amount of loans outstanding while the capital ratios for major banks have improved materially. However, the UK banking industry is not as far through the balance sheet recovery process as the U.S. banking industry, and regulatory efforts remain heavily focused on reining in aggressive risk-taking by UK banks. For the early part of the next three to five years, we expect commercial banks will remain a drag on growth as they further shrink their balance sheets. Yet, for the period as a whole, it is likely their capital raised and asset sales will be less than the previous three- to five-year period.

Sadly, the same cannot be said for the government sector, which (looking at the underlying deficit – see Figure 2) is still stubbornly high. The debate over how much of this is self-imposed (excessive austerity) rather than an unfortunate confluence of circumstance (high spot inflation, weak eurozone) will no doubt continue. Looking ahead, the most important aspect is that the government sector will likely remain a secular drag on growth.

This suggests that unlocking those corporate balance sheets may well prove elusive. Domestic demand will be hampered by weak real income growth and fiscal drag – hardly the backdrop for a rapid recovery in investment spending. This is particularly the case if the eurozone, the UK's single largest trading partner with just under 50% of exports, remains a secularly weak growth area. Net exports have persistently disappointed since sterling's fall in 2008 and 2009 and, as discussed in the March 2013 issue of UK Perspectives, "What happened to that export-led recovery?", will be unlikely to provide a robust contribution to UK GDP for much of the secular horizon.
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