Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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UK downside risks remain very high
Christopher Dembik
Head of Macroeconomic Research
Summary: The UK is in crisis as May's Brexit deal hits a wall of opposition, the pound tanks, and the leading indicators point lower.
The wave of optimism we observed yesterday after the Brexit deal was announced was clearly premature. The warning from the Scottish prime minister was already a negative sign regarding the evolution of the situation. At the time of writing, everything indicates that PM May will lose Brexit vote due to the opposition of DUP and Conservative rebels.
The political situation is still very messy, but it seems that the backstop deal was one of the main reasons pushing two senior members of Cabinet to resign in the past hours. To win a parliamentary vote, Theresa May needs an improbable number of opposition MPs to vote for the deal, which is a colossal and probably impossible task. Based on Eurasia analysts’ forecasts, there are essentially two base scenarios for a December vote: either the government is defeated by a small margin (17 votes) or it loses by majority of 37 votes. In any case, this opens the door to more political uncertainty, a chaotic exit, a new general election, or even a second referendum.
In this context, downside risks to UK growth remain very high, for three main reasons:
Leading indicators still point to lower growth
Most recent soft and hard data tend to confirm that the rather positive momentum that the UK has experienced over the summer was mainly weather-related. Q4 GDP is set to be weak and this trend is expected to continue over the course of next year. The UK OECD leading indicator, which is designed to anticipate turning points in the economy six to nine months ahead, fell in September for the 14th straight month. The year-on-year rate started the year at -0.6%; it now stands at -1.45% – quite a swing over nine months! The level, presently at 98.9, is the lowest since September 2012.
In addition, the credit cycle that fueled the UK in the post-financial crisis period has completely reversed. Our in-house credit impulse indicator which leads the real economy by nine to 12 months, is in contraction. It tracks the flow of new credit from the private sector as a percentage of GDP. Last update indicates that the trend is less negative, with credit impulse running at -1.55% of GDP versus -7.5% of GDP in the previous quarter, but it is still firmly downbeat.
Though the correlation between credit impulse and some activity indicators is rather poor (correlation with final domestic demand is at 0.52), this sharp negative trend will surely pose some headwind to GDP growth in the medium term. We expect more negative data in 2019 but it is still too early to consider a serious risk of recession as this will depend on the deal/no-deal being confirmed and implemented.
The political situation is still very messy, but it seems that the backstop deal was one of the main reasons pushing two senior members of Cabinet to resign in the past hours. To win a parliamentary vote, Theresa May needs an improbable number of opposition MPs to vote for the deal, which is a colossal and probably impossible task. Based on Eurasia analysts’ forecasts, there are essentially two base scenarios for a December vote: either the government is defeated by a small margin (17 votes) or it loses by majority of 37 votes. In any case, this opens the door to more political uncertainty, a chaotic exit, a new general election, or even a second referendum.
In this context, downside risks to UK growth remain very high, for three main reasons:
Leading indicators still point to lower growth
Most recent soft and hard data tend to confirm that the rather positive momentum that the UK has experienced over the summer was mainly weather-related. Q4 GDP is set to be weak and this trend is expected to continue over the course of next year. The UK OECD leading indicator, which is designed to anticipate turning points in the economy six to nine months ahead, fell in September for the 14th straight month. The year-on-year rate started the year at -0.6%; it now stands at -1.45% – quite a swing over nine months! The level, presently at 98.9, is the lowest since September 2012.
In addition, the credit cycle that fueled the UK in the post-financial crisis period has completely reversed. Our in-house credit impulse indicator which leads the real economy by nine to 12 months, is in contraction. It tracks the flow of new credit from the private sector as a percentage of GDP. Last update indicates that the trend is less negative, with credit impulse running at -1.55% of GDP versus -7.5% of GDP in the previous quarter, but it is still firmly downbeat.
Though the correlation between credit impulse and some activity indicators is rather poor (correlation with final domestic demand is at 0.52), this sharp negative trend will surely pose some headwind to GDP growth in the medium term. We expect more negative data in 2019 but it is still too early to consider a serious risk of recession as this will depend on the deal/no-deal being confirmed and implemented.
UK business investment is on a worrying path
Unsurprisingly, Brexit has had a sharp negative impact on business investment in the context of a lower flow of new credit. Looking at the disappointing path of business investment over the past quarters, we don’t see where the “underlying strength” of the UK economy that Hammond pointed out is hiding. As long as the political morass continues, business confidence and investment will only move lower, ultimately limiting the UK’s potential GDP growth and increasing the risk of a prolonged period of low growth.
Unsurprisingly, Brexit has had a sharp negative impact on business investment in the context of a lower flow of new credit. Looking at the disappointing path of business investment over the past quarters, we don’t see where the “underlying strength” of the UK economy that Hammond pointed out is hiding. As long as the political morass continues, business confidence and investment will only move lower, ultimately limiting the UK’s potential GDP growth and increasing the risk of a prolonged period of low growth.
UK household financial stress is increasing
This is well-illustrated by the flow of new personal loans and overdrafts since the referendum. As we can see in the graph below, it has been heading south, entering into contraction last spring. In our view, this is one of the most worrying trends since it is a brutal signal that the credit boom that drove the UK economy in the post-crisis years is definitively over.
This is well-illustrated by the flow of new personal loans and overdrafts since the referendum. As we can see in the graph below, it has been heading south, entering into contraction last spring. In our view, this is one of the most worrying trends since it is a brutal signal that the credit boom that drove the UK economy in the post-crisis years is definitively over.
Unless we see a last-minute surprise, it is hard to perceive what could change the negative medium-term trend of UK growth. This fantasy vision of absolute and unlimited sovereignty will certainly lead to one of the most striking destructions of wealth, power and confidence in a Western European country since WWII.
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