No! Jeremy Corbyn

Boris Johnson has won a strong mandate to get on with his Brexit deal, sending sterling shooting higher. But what else will his government do in the next five years? 

For once the polls were right: the Conservative Party has secured a large majority in the House of Commons. Markets tend to like continuity, especially when the alternative is near unprecedented change. The UK’s future relationship with the EU remains uncertain, but arguably less than if the Conservatives had won with only a small majority. We do not expect all of the GDP growth lost since the referendum to be recouped, especially as the large fiscal stimulus didn’t make it into the manifesto as promised.

Nevertheless, this is a positive development for the UK’s financial markets and we expect international investors to start to return to this unloved corner of the globe.

The Conservative Party produced a very modest manifesto with few new policies. In fact we would be calling it modest if this were a one-year budget, let alone a five-year plan. Perhaps this belies the party’s conviction that its Brexit deal is “oven ready” and conducive to making concrete plans. Or perhaps it means additional policies have been deemed too unpopular to put in a document intended to garner votes.

On economics, the manifesto leaned a little more to the left compared with other recent editions (more NHS funding, more public investment, very generous minimum wages, no net tax cut), while tacking right on cultural and social security (Brexit, migration and crime). Of the 53 seats the Conservatives gained from Labour at the time of writing, 49 were in Leave-voting constituencies that hadn’t turned blue in decades. This despite a raft of studies over the last two years showing a clear preference among voters for more socialist economic policies than free-market ones. This sets up an interesting tension for Prime Minister Johnson: how does he keep those seats blue once the UK has left the EU? It’s a difficult tension to resolve, and may involve a larger state. The alternative – a pivot to protectionism – cost the party dearly in the 1850s and early 1900s, and we very much hope this doesn’t happen.

Minimum wages

If not for the radically leftward shift of Labour’s manifesto, the Conservatives’ minimum wage policy may have received much more attention. It’s extremely generous, proposing to increase it to over £10 by 2024 and extending coverage to 21-year-olds. Expressed as a percentage of the median wage, only France, New Zealand and Portugal have more generous policies out of 20 of the largest advanced economies we’ve compared it to. We’re not concerned about the overall impact on employment or inflation (the evidence from a Treasury report by renowned economist Arindrajit Dube published earlier this year is very compelling), but there are some sectoral implications that investors need to be aware of.

Firms are unlikely to wear all of the cost, they could probably manage it by some combination of lower profits, lower non-wage benefits and price hikes without resorting to the firing squad – just as we have seen in previous instances. The Dube report suggests a large role for firms passing on higher wage costs through higher prices. Of course, investors need to assess a firm’s ability to pass on costs – their ‘pricing power’.

The impact across sectors is highly varied. According to the IFS, by 2024 around 30% of employees in agriculture, wholesale and retail, and support services would be covered by the new minimum wage. That compares with around 15% today. Over 50% of employees in accommodation and food services would be affected (c.17.5% today). Politicians claim that higher minimum wages help those on low incomes, but in reality middle-income households are the largest beneficiaries. Many individuals with low hourly wages are not in especially low-income households; many have a working partner and two-earner families don’t tend to have the lowest household incomes. Less than 20% of beneficiaries live in the poorest fifth of working households. Many of the very lowest-income households have no one in work at all, and those that are working often find that increases in wages are partially offset by resulting reductions in means-tested benefits.

Public spending and finances

When he campaigned to become leader, Mr Johnson made promises that, in conjunction with the subsequent September Spending Review, suggested that an unusually large peacetime fiscal loosening was on the table regardless of the outcome of the election. But the manifesto had no such ambition. The promise of large tax cuts has not materialised; personal income taxes will be cut by around £3.5 billion, yet the tax bill for the economy as a whole will actually rise to the highest proportion of national income since 1985.

Total public spending will also increase, but only modestly. Excluding the NHS, the Conservatives’ plan still leaves day-to-day spending of government departments 15% lower than it was in 2010 after adjusting for inflation. In other words, things are getting a little less austere, but the age of austerity is not over. There is no new money for social care. This is a strange omission: Mr Johnson promised to “fix the crisis in social care once and for all” in his first speech as PM. There are a few other omissions from the manifesto costings (promises made to the police or the military) and these will need to be funded by higher taxes or cuts to other public spending if they are to meet the government’s new fiscal rules.

Importantly, the Conservatives have committed to extra infrastructure spending – up to £20 billion a year. Government spending on investment should be thought of differently to day-to-day spending or social transfers. Faster railways, wider broadband coverage and so on should raise the productive potential of the economy and therefore increase the future tax revenues that can be used to repay any debt taken out to pay for such projects. Additionally, infrastructure spending can employ more people, possibly increase wages, increase the volume of goods and services bought by the government sector and utilise capital that might have otherwise been invested overseas. A recent paper published by the OECD, a development agency for mostly rich nations, found that a sustained 0.5% increase in public investment gives a long-term output gain of 0.5-2.5%. Far from ‘crowding out’ the private sector, infrastructure investment often ‘crowds in’.

The Conservatives’ attitude to government spending has shifted. Their new fiscal rules suggest that keeping in check day-to-day spending and the cost of government debt is more important than reducing the level of debt. The Institute for Fiscal Studies (IFS) estimates that public sector net debt will remain constant at circa 73% of national income under the Conservatives’ plans. We are pleased with this development. The UK has the second-lowest debt ratio among G7 economies, by really quite some way compared with France, the US or Japan, and their borrowing costs have remained very low regardless of the extra borrowing. A focus on investment spending should also increase the economy’s productive potential, thereby keeping inflation in check, which is ultimately the only constraint on a sovereign economy’s ability to borrow.

The sizeable risk to public finances under the Conservatives is a ‘no-deal’ Brexit. Its deleterious impact on growth and jobs would likely see the net debt ratio rise higher than it would under an orderly Brexit engineered by a Labour government, according to the IFS.

Brexit

The Conservative majority makes the passage of Mr Johnson’s Brexit deal a foregone conclusion. As we have said before, it is a skeletal deal with a significant attendant risk of an eventual ‘no deal’. The Conservatives had indicated that they won’t extend the window to negotiate a trade deal beyond 2020. Yet even basic free trade agreements (FTAs) tend to take much longer than that to negotiate. Looking at statistics on the last 20 trade deals signed by the US, 14 took longer than 15 months before an agreement was signed, with an average of four years between the start of negotiations and the actual date of implementation!

Theresa May’s deal committed Britain to staying within the EU’s customs territory, with some regulatory alignment on agricultural and manufactured goods. This made the negotiation of an augmented free trade agreement – which would limit more costly non-tariff barriers to trade as well as tariffs – during the subsequent transition period much more likely. Mr Johnson’s deal has the UK in its own customs territory with the right to alter trading standards. This makes negotiating even the basic FTA that Mr Johnson has set as the new benchmark more difficult.

That said, Mr Johnson’s large majority means that he no longer needs the support of the ‘hardest’ Brexiter MPs in order to get Brexit done. We noted their absence from his campaign. We believe that this makes an extension to the transition period more likely and increases the possibility of a closer economic relationship.

Uncertainty lingers, and this could continue to deter investment and trade for another year. Judging this precisely is very difficult. Most economists underestimated the effects of policy uncertainty on investment and trade since the referendum, but overestimated their effects on household consumption. We assume that business investment will start to recover, but won’t yet return to a pre-referendum norm.

A basic FTA would provide clarity. But we must be clear, an FTA scenario is still highly likely to lower the path of UK growth relative to a baseline of staying in the EU. Most independent economic researchers forecast that UK GDP will be between 3% and 6% smaller in seven to 10 years in this scenario. Academics based at King’s College London estimate that the long-run impact of Mr Johnson’s deal on UK GDP per capita is about 2.5% (or about two and a half years of growth), compared to circa 1.7% for Mrs May’s. That’s because simple FTAs without regulatory alignment don’t tend to account for non-tariff barriers to trade (e.g. complex regulatory and certification costs, quality assurance and labelling regimes, etc.)

Quantifying non-tariff barriers to trade isn’t straightforward – they aren’t explicit like a tariff – but a number of studies have thrown advanced econometric techniques at the problem. The academic literature is fairly unanimous that non-tariff costs are significantly larger than tariff costs.

To be clear, our pessimism here is in no way a judgement on whether Brexit is right or wrong for the British people, in all of its many social, economic and juridical facets. It is simply a narrow expression of the empirically grounded difficulty of substituting trade with countries further away for trade with one’s nearest neighbours. These will have an effect with or without new trade pacts, even in today’s world of overnight international shipping. And the UK is really quite far away from other potential trading partners.

Signing new FTAs with non-EU nations could help, but we need to negotiate new deals with 50 countries and our conversations with experienced trade negotiators don’t leave us optimistic about the ability to do so swiftly.

The economy

Our favourite leading indicators of activity are severely depressed. In November, our aggregation of consumer and business confidence fell to a level not seen since the double-dip recession of 2011, although it recovered a little in December. These surveys have a track record of exaggerating weakness at times of sharply elevated uncertainty. Assessing the data more broadly, a recession doesn’t appear likely, but there is a distinct lack of growth forecast by the data going into the new year.

We believe a new Conservative government and the passage of Mr Johnson’s Brexit deal improves the outlook for growth and business investment in 2020, even without a meaningful fiscal stimulus. But we do not expect the growth and investment lost since the referendum to be recouped.

Since June 2016, the UK economy has performed as poorly as the Office for Budget Responsibility and the Bank of England each predicted just after the result. Forecasters’ pessimism was widely derided at the time, and indeed the shock in the first 12 months was nowhere near as severe as they had suggested. But the damage to business confidence has played out with much more persistence. Business investment has grown by just 0.4% since June 2016, compared to an average of 12% in the other G7 economies.

Conservative politicians like to say that the economy is strong, citing record low unemployment. But economic growth is weak relative to past performance. The global slump in productivity growth has been particularly acute in the UK. Even the labour market doesn’t appear that rosy when you consider that it’s still undergoing the longest stagnation in inflation-adjusted wages – a measure of the standard of living – for 150 years. 

The UK isn’t the only country to have done worse than predicted since 2016, but its performance still looks weak in an international comparison. We employ an oft-used methodology for comparing the performance of an economy relative to a statistically determined benchmark of its peers (a doppelgänger economy, if you like). This suggests that the Brexit “shock” has left the UK economy 3.4% worse off overall.

Investment implications

The pound hit a 35-year low against the dollar in September, but has since risen to $1.34. It seems easy to attribute this to the government’s unwillingness to press for a ‘no-deal’ Brexit or to the Conservative Party’s polling. But that isn’t nearly the full picture. The pound is a highly ‘cyclical’ currency. A large portion of the increase in the value of the pound can be explained by better investor sentiment as global investors became more confident about the global cycle. In other words, much of it had little to do with UK politics.

We believe the pound could still rally further over the next year, albeit in fits and starts, especially considering that a large Conservative majority decreases the risk of an eventual no deal compared to a small Conservative majority. It is up just 1.6% against the dollar since the exit polls. On the other hand, we aren’t convinced that the weight of information suggests a decisive turning point in the global business cycle has been reached. A global risk-off episode could weigh on the pound despite today’s result.

Due to the weak UK economy, we still expect the Bank of England to keep interest rates very low. The relationship between interest rate expectations and the exchange rate is ephemeral, so we don’t use it to make forecasts. The trade-weighted pound would be 15% higher had it continued to move with the trade-weighted interest rate differential.

On a long-run basis – the only timeframe over which we believe currency forecasts can be made with any certainty – sterling is very undervalued, according to a number of analytical frameworks. We expect the pound to appreciate on a three-year-plus view, in all but the most disastrous of Brexit scenarios.

Ordinarily a stronger pound would weigh on the performance of the UK stock market, because the FTSE is dominated by multinational companies earning money in non-sterling markets. Small and mid-capitalisation stocks tend to outperform larger companies. But we believe that new inflows will lift all valuations. Surveys of institutional fund managers indicate that international investors are underweight the UK to an unusual degree. A Brexit deal – a removal of a political risk that’s difficult to hedge – may entice those investors back to British assets.

The UK market-implied equity risk premium is still near an all-time high, telling us that investors demand more compensation for the risks around future earnings than they did at the height of the financial crisis. Across a number of valuation metrics, the UK market trades at a discount to the global market not seen since the mid-1970s. Our bottom-up equity analysts often struggle to see such discounts on a company-by-company basis. There are large companies with grave, idiosyncratic problems that deserve to trade below international peers. But the bulk of the UK market’s underperformance started shortly after the referendum. We believe that holdings of UK equities across all market capitalisations should do well. As the global business cycle finds its floor, markets may continue to favour less cyclical indices. Historically that has been the FTSE 100.  Perhaps now it will be again.

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