UK government bond (gilt) yields have been on the rise in anticipation that the Bank of England (BoE) will increase rates on November 2 in response to high inflation. Third-quarter UK growth picked up, but we see economic fragility holding back further BoE tightening.
Higher prices (headline inflation hit a five-year high in September) are hurting consumer spending, as wages are not keeping pace. This is reflected in third-quarter retail sales falling to levels last seen in 2013. Our BlackRock Growth GPS for the UK has ticked down, as the orange line shows in the chart below, suggesting 12-month consensus estimates for UK gross domestic product (GDP) will move slightly lower. This is in contrast to an upward shift in our Growth GPS for other G7 economies (the green line), and makes us cautious on many UK assets.
The UK’s muted growth outlook stands in stark contrast to 2016, when the UK sat close to the top of G7 growth charts alongside Germany. Brexit negotiations in particular are weighing on the UK economy. Significant progress on three key issues is needed for discussions to move on to the post-Brexit trade relationship between the UK and European Union (EU): the rights of EU citizens in the UK and vice versa, the UK’s financial obligations to the EU, and the Irish border. Progress has been made in recent weeks on these issues, but not enough to advance talks, the EU leaders concluded at their recent summit.
The key to supporting UK investment and business confidence is an agreement on a transition that would cushion the UK’s departure from the EU in March 2019 by allowing the UK to keep trading on existing terms. At this stage, we see an “in principle” agreement for a transition period being reached by the end of the first quarter of 2018, though this is not a given. Uncertainty is high, and the longer it persists, the more it will stymie the domestic economy. The closer we get to March 2019 without an agreement, the more UK-domiciled businesses will start executing contingency plans for a potential Brexit with no deal in place.
This subdued growth outlook has implications for UK assets. We hold a cautious view on UK duration in the near term, with the BoE likely to raise rates this week. The central bank’s next moves are less clear and may leave UK gilts taking their cues from global bond markets. Similarly, we see the pound supported in the short term but risks skewed to the downside as it acts as a barometer of Brexit anxieties over the medium term. We see similar risks to domestically exposed companies in the UK equity market, and we favor UK and eurozone companies geared to sustained growth in the global economy. Bottom line: We are cautious on most UK assets as Brexit-related economic challenges loom. Read more market insights in my Weekly Commentary.
Listen to Kate Moore discuss the uncertain path forward for tax reform in Washington in our latest episode of our podcast, The Bid.