2017 held more surprises for the UK than most other places. Theresa May’s election miscalculation, and the rise of Jeremy Corbyn’s star, might have been the most newsworthy. But the decision by the Bank of England’s Monetary Policy Committee to become more hawkish and raise rates was arguably more important.
Both have consequences that will be felt throughout 2018. The UK underperformed on most measures, with early consumer confidence quickly wiped out by rising inflation and consequently falling real wages.
But Brexit negotiations remain key. In particular, the faster an agreement can be reached on the fate of the services sector the better. That will have major consequences for the UK property market, and not just in the South-east. Through 2017, the price weakness seen in London spread out, impacting consumers by quickly limiting any ability to raise borrowing.
There’s potential for some positive surprises if the gloomy forecasts from the Office for Budget Responsibility prove to be too pessimistic on productivity – something many economists now believe.
The UK’s economic conditions will depend largely on external factors, particularly the spillover demand from European Union (EU) growth. If the EU fails to do as well as expected, things will be difficult. Business sentiment could be helped by progress towards a softer Brexit, although a longer process makes final outcomes more uncertain; situations can easily stall or reverse despite supposed agreement.
Still, Britain is in a reasonably good position in terms of export competitiveness – we’ve not yet left the EU, after all. Further weakness in sterling would help manufacturing, as demand from the EU spills over, which could buoy regions outside of London and the South-east, as it did towards the end of 2017.
But the MPC still has to tread a fine line. Although the rise of the retail prices index to 4 per cent year-on-year left it with little choice but to raise interest rates, inflationary pressures have fast been dissipating, despite apparent full employment.
As the impact of previous sterling weakness drops away, the MPC will have room to allow sterling to take the strain of domestic demand softness. We expect no major shocks to the value of sterling, with changing prospects of success or failure in Brexit negotiations causing only marginal moves upwards or downwards. Yet we think it likely the pound will end the year lower on a trade-weighted basis, especially against the euro.
The region to watch
The performance of Europe’s underlying economy was one of the success stories for markets in 2017. The growth was more broad-based than expected, with the eurozone being powered by the periphery as well as the ‘core’ of France and Germany. This addressed some of the structural imbalances that have previously hampered the eurozone’s growth, which is good news. Looking further ahead, the pick-up in German demand should decrease the country’s current account surplus, reducing the current account deficits of other EU nations and the rest of the world.
Banking weaknesses in Italy and Spain cleared up significantly in 2017, lifting a weight off the continent. France looks to be in good position if President Macron can push his employment reform agenda through, which could see the country take centre-stage within the union.
The European Central Bank’s continued loose monetary policy should help underpin growth, particularly in the early part of the year. However, as the central bank begins to signal an unwinding of its asset purchase program in the latter half of the year as is widely expected, some teething problems are likely as we return to the ‘old normal’. External pressures from a slowing US and China could also act as a significant drag.
Our risk case for Europe is that its good performance becomes its undoing by causing a sudden spike in the value of the euro. European exporters are sensitive to currency moves, so this could cause a retreat in business sentiment that would hamper growth. Still, our central case is that there is a slow rebalancing towards the currency as the year wears on. This will likely mean growth won’t be as spectacular as in 2017 – particularly towards the end of the year – but will still remain positive.
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The US labour market has some structural issues which seem to be stopping it from generating sustained wage growth, even though unemployment fell to its lowest level in 16 years in October at 4.1 per cent.
We also need to consider the lack of tech-skilled employees, unequal wealth distribution and the growing presence of oligopolies in sectors across the board, known as the ‘Amazon effect'. These factors severely limit the effectiveness of the traditional Phillips curve, that is, the supposed inverse relationship between inflation and unemployment. This means in order to grow their spending, consumers will need to take on more debt or run down their savings. But personal savings rates are close to the lows seen just before the financial crisis of the last decade, constraining citizens’ ability to expand their debt.
For this reason, we don’t see much potential for higher US growth into the tail-end of 2018. Trump’s tax reforms might provide some lift, but it’s likely to be quite small in terms of boosting individuals’ spending. What’s more, given the administration’s difficulty in passing this tax legislation, passing any infrastructure plan will likely be even more difficult. On the political side, we suspect the above-mentioned ‘Amazon effect’ will garner even more attention, possibly leading to calls for new anti-trust legislation.
We don’t believe US inflation will pick up and see employment growth slowing, which could well lead to a slower rate rise path than the Fed has previously indicated. All of this will likely translate into the US dollar weakening over the year – certainly if the Fed deviates from the expected rate rise path at least.
Our risk case here is that the dollar falls sharply, which could be harmful to global growth by choking US demand for overseas goods. The base case is that the dollar falls gradually as the year goes on. In terms of US equities, they may well be given a short-term sugar rush of higher profits from tax reform. But as the year goes on we expect optimism to fade, as earnings per share growth runs out of room. We foresee this to lead to underperformance relative to European and Japanese assets in particular.