Monday digest
Posted 19 February 2024
Overview: The UK is not growing in real terms or nominal terms
The UK is in a technical recession, defined as two quarters of real growth contraction. Meanwhile, last week’s release of UK jobs market data for December showed surprising tightness. The unemployment rate fell back to 3.8% rather than the expected rise to 4%. Both labour force data and GDP data are suspect, but price data are a bit more reliable. The measure of prices used to compute GDP data on a real basis is called the deflator and differs from the more usually quoted consumer price indices. Last quarter’s deflator growth was very low at less than +0.7% quarter-on-quarter annualised, indicating that nominal growth is now very weak as well.
The market is pretty convinced interest rate cuts will have happened on or by the 20 June Bank of England Monetary Policy Committee (MPC) meeting. We think there is enough fuel for a rate cut either at the meetings scheduled for 21 March and 9 May, but the dynamics of the MPC make this unlikely. As we discuss later, there is a high probability that tax cuts will happen on 6 March and that the ensuing small fiscal boost might lead the MPC to delay.
A number of emerging market central banks have already started easing rates. but developed markets are being dominated by the path of US rate expectations. Perhaps the similarities in the tightness of labour markets in the UK and Europe might cause one to think this is reasonable. Yet the paths of domestic inflation and money supply growth are differing enough to suggest that the European Union and the UK will have to forge their own paths, and that the US be stuck at higher rates.
Meanwhile, for Europe and the UK, energy prices are a big factor in business input costs. The rise in oil prices might make one think things are going badly, and that energy costs are rising. The good news is that natural gas prices continue to decline, and that is a decisive factor in the downswing in electricity prices. This will benefit manufacturers as long as demand holds up. Signs are that manufacturers are feeling less awfully negative, but there’s a long way to go to get to outright positive. Part of the story ought to be that central banks recognise the declining inflation environment and don’t allow real interest rates to become higher through neglect.
The anatomy of asset bubbles
Since the release of ChatGPT in late 2022, the tech-heavy Nasdaq index has gained nearly 50%, and no stock encapsulates the AI (artificial intelligence) fever better than Nvidia. If you had bought Nvidia stock in 2019 and held on, your stake would currently be up 17-fold. As in any bull market, sustained price increases make investors nervous that stocks are, or will soon become, overvalued. But AI-related companies keep pushing ahead, with the Nasdaq already up 6.6% year-to-date at the time of writing. Naturally, warnings of an AI bubble abound in financial media.
The biggest fear with bubbles – indeed, the reason people call them bubbles in the first place – is that they will suddenly burst, leaving investors with severe losses. Even if the current AI craze is a bubble, it could fizzle out or gradually unwind. That might take some time, and in the meantime, AI investors may well be in for some more stellar returns. This is not to say that all is well. US stocks, particularly the mega-tech sector, are extremely expensive even if they have solid fundamentals. The best strategy for the long-term, as usual, is diversification. We have to keep an eye on AI stocks, and particularly their volatility. But without any glaring warning signs usually observed with bubbles, there is no reason to think things are about to burst.
The UK’s fiscal bind tightens
With the Spring Budget fast approaching, tax cuts are reportedly top of Chancellor Jeremy Hunt’s agenda. According to multiple news outlets, these giveaways might have to be funded by additional public spending cuts – though the latter would likely be delayed beyond an upcoming UK election. Hunt will not want to do anything that might get in the way of Bank of England (BoE) interest rate cuts. Even so, the UK will almost certainly need to tighten fiscal policy after the election. According to the Institute for Fiscal Studies (IFS), Britain is in a fiscal bind and needs tough action. High public debt means spending is severely constrained which, in turn, means that public institutions are stretched thin. These institutions might just about cope in normal times, but when shocks and crises break, there is no more capacity to pick up the slack. This can be clearly seen in the long-term stresses on the National Health Service (NHS), for example.
Tight funding makes budget rebalancing extremely difficult. The Labour Party has said it wants to divert more funds to preventative services if elected, but doing so would either mean spending increases or cuts to non-preventative services – neither of which politicians are willing to do. Whether money is being reallocated across departments or to different regions of the country, rebalancing will inevitably mean short-term costs that no one seems willing to bear. Again, these decisions would be so much easier if the UK could generate strong growth. That needs investment in productive sources – both public and private. But according to Oxford Economics, the UK’s public and private investment over the last three decades ranks 32nd out of 34 major economies. Only the severely constrained economies of Argentina and South Africa see less investment as a percentage of GDP than our 17.4%.
Unfortunately, the dire state of public finances means investment is likely to fall in the short term, rather than rise. Both Labour and the Conservatives have made promises to increase or incentivise investment, but these plans are usually the first to go when confronted with difficult budgetary decisions – as seen in Labour’s abandonment of its green investment targets. These moves stave off short-term pain and, hence, might increase electoral chances. But they make the longer-term problems worse. Addressing Britain’s long-term malaise requires bold changes – but these are extremely hard to implement thanks to a cocktail of fiscal and political realities. Heading into an election, both parties are preaching caution when courage is arguably needed more. With finances already so tight, politicians will have to confront these issues sooner rather than later.