As sterling's devaluation starts to reach consumers, UK inflation could see a temporary bump upward this year. But Mike Riddell says political risks and other weak economic data make the market's expectations of a rate hike by summer 2018 seem ambitious.
Strength mixed with weakness
UK economic data have been surprisingly strong for a long time. The Citi UK economic surprise index has been above zero since mid-June 2016, showing a UK economy that has been consistently beating consensus forecasts. This run has now lasted longer than the previous record run set in 2009, when expectations had reached rock bottom.
UK house prices are less strong and have even been falling in some areas of London
However, the most recent UK data have been weakening: UK house prices are less strong and have even been falling in some areas of London, and business surveys have been less robust – including the all-important purchasing managers index, which was below expectations in February.
Perhaps most crucially, there is still no sign of business investment picking up. Indeed, quite the opposite is true. As Bank of England Governor Mark Carney pointed out in February's quarterly inflation report, UK business investment today is no higher than it was in 2015. The strength of the UK economy lately has been driven by the consumer – and with UK savings rates so low, this is not sustainable.
In agreement with the BOE
We agree with the BOE's view on UK inflation. So far, the British pound sterling's devaluation has had a limited effect on consumer prices due to businesses hedging their currency exposure. As these hedges come off, inflation (as measured by the consumer price index) is likely to rise to at least 2.5% this year and possibly a little higher in 2018. This will cause real incomes to take a firm hit before inflation falls back as the temporary effects from weaker sterling and oil prices fall out of the year-on-year numbers.
Sterling's devaluation has had a limited effect on consumer prices
Against this backdrop – particularly with economic and political risks escalating, including a Scottish independence referendum – we believe it is highly unlikely that the BOE will hike interest rates any time soon. Nevertheless, the market has fully priced in an interest-rate increase by summer 2018, although part of this market-implied inflation rate may be a risk premium.
We have been broadly supportive of UK government bonds over the last few months, and we have also been bearish on sterling. We expect the pound to continue to come under pressure as political risks mount and the cyclical strength of the last few months continues to weaken.
Early on in Europe's "super-cycle" election year, voters seem to be preferring pro-EU candidates. The outlier could be Italy, which Stefan Hofrichter says is under serious economic stress and could vote to leave the EU or euro at the next opportunity.
Europe at a crossroads
On March 29, the UK triggered Article 50 to begin the process of leaving the European Union. Does this represent a crisis point for the European project, as some commentators suggest? Or will Europe's "super cycle" of 2017 elections show that voters are resisting some of the more anti-EU forces? So far, at least, the pro-EU side seems to be winning:
- In the Netherlands' elections of March 15, the anti-EU party founded by Geert Wilders lost out to Prime Minister Mark Rutte's center-right, pro-EU party.
- In France, the reform-friendly, pro-EU Emmanuel Macron is expected to beat the radical right's Marine Le Pen in the presidential elections of April and May.
- In Germany, the outcome of September's elections should be a close call, but the resulting government and parliament will almost certainly be pro-EU and pro-globalization.
Pro-EU election results would be welcomed by the markets and should offset some Brexit-related uncertainty
Such developments would be welcomed by the capital markets as positive steps for the EU, and they may help offset some of the uncertainty caused by Brexit. With Germany's economy doing well and the potential for stronger ties between Paris and Berlin, we could ultimately begin to see a stronger integration of the EU and euro area.
Italy is the elephant in the room: CDS spreads, an early indicator of severe market distress, have doubled there since 2016
Italian voters to get their say
But Italy is the elephant in the room. It has an economy with weak growth rates, a weak banking sector, a governing party at risk of splitting up and a political mood that is increasingly turning anti-European. If the country doesn't hold a snap election this year, a regular election will be held in the spring of 2018. Given Italy's challenging economic straits, it is entirely possible – or at least not easily dismissible – that Italian voters will want to leave the euro and/or the EU. The markets seem to share this view: Spreads of credit default swaps, which can be an early indicator of severe market distress, have essentially doubled in Italy since early 2016.
In the US, UK and other Western nations, the populist trend that opposes globalization doesn't seem to be abating
All told, the investment implications of Europe's super cycle are mixed. The positive view is that European political uncertainty has marginally eased and should improve further if the election outcomes in France and Germany turn out to be benign; the euro and euro-area assets could benefit from this development over the course of 2017. The more challenging possibility is that political risks will continue to impact capital markets – and not only because of Italy. In the US, UK and other parts of the Western hemisphere, the populist trend that opposes globalization and supports stronger nation-states does not seem to be abating. There may be no early respite from the ongoing uncertainty and instability for the markets.