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UK Secular Outlook: Morphing Into the Carney Era

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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.

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So how do policymakers react to this tepid growth environment? Three areas of interest immediately strike us:

Fiscal policy, voter fatigue and the rise of the protest party

The UK, like many eurozone countries, has seen the rapid rise of a new political party. However, unlike many of the other protest parties across Europe, the UK Independence Party (UKIP) has a clear focus: The UK leaving the European Union (EU). Already, this has elicited responses from the Conservative Party. It seems likely the disruptive new fourth party will remain a part of the political scene, but does it mean a UK exit is likely over the secular horizon? We doubt it, but it does serve as a useful reminder that, while the UK is likely to be mired in its own stable disequilibrium, there are potentially disruptive elements out there.

The politics of UKIP also have important implications for UK fiscal policy over the secular horizon. Not because UKIP has a strong stance on the austerity versus spending debate, but a possible split in the Conservative vote does raise the prospect of a change of government in two years. While there is much political rhetoric in the current debate between the ruling Conservative coalition and the opposition Labour Party, as Figure 2 amply demonstrates, any actual shift will likely be a reduction in the pace of austerity rather than a policy reversal and higher government spending (as is happening in Japan).

Monetary policy – further hyperactivity?

With fiscal policy likely to remain constrained, it appears highly likely that the onus of responsibility for growth will remain with the BoE. Somewhat conveniently, the three- to five-year secular horizon coincides with soon to be incumbent BoE Governor Mark Carney's five-year term (he starts 1 July 2013). Should we expect a reinvigorated and augmented array of stimulus tools? Forward guidance linking the policy outlook with prospects for growth or (more likely) the labour market does seem likely. Similarly, we should expect further attempts to direct lending to the capital-constrained small- and medium-sized enterprises (SME) sector.

However, there are two potential elephants in the room: The scope for the BoE to buy private sector assets and the scope for sterling to fall further. Each remains plausible over the secular horizon, and we will be monitoring Governor Carney's early exchanges for signals on timing. Either taking sterling down or conducting more quantitative easing (QE) would be easier to implement; these are the most likely initial forms of aggressive monetary policy (once the well-flagged forward guidance has been implemented). Given the stickiness of UK inflation, and its sensitivity to higher import prices, UK investors should stay alert to the risk of higher-than-expected inflation.

Investment implications

A world of weak growth, further monetary stimulus and weaker currency points to an economy unlikely to escape what Mohamed A. El-Erian has coined "assisted growth". Look for asset prices to continue to front-run the real economy; investors should remain wary of buying risk assets purely on the premise of a "Carney put". Financial repression, protection of real purchasing power and tail risks of accelerated currency weakness will likely dominate UK markets. Gradually reducing exposure to risk assets is likely to be a dominant secular theme – with risk defined by both duration and exposure to the lower parts of capital structures. Short-dated income-generating products backed by high quality collateral, non-sterling assets in markets offering positive real yields and, if you have to "stay local", shorter-dated nominal and longer-dated inflation-linked products remain attractive.

Risk management should also continue to evolve to recognize the low probability, high impact events that may intermittently beset investment markets. In the last few years, the dominant risk for UK markets has been European problems within the eurozone; however, now that risk seems more balanced against risk from without in the form of a "Brexit". This is certainly not our central expectation, but the fact that there is such disillusionment with the existing political arrangements is a reminder that the UK remains in a stable disequilibrium, one that in time needs to either transform into growing economy with narrowing income differentials or risk a more aggressive policy response. The latter would likely involve an explicit reversal of fiscal policy, a semi-open recognition that sterling needs to go lower and a much lower degree of policy control over the ultimate outcome. Over to you, Dr. Carney.

This article originally appeared on PIMCO.
No positions in stocks mentioned.
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