Upside to gloomy forecast
US and Europe tremors could boost British assets
by Ben Robinson
Thu 24 Nov 2016
Brexit-related uncertainty was a main cause of the weaker growth and increasingly strained public finances forecast yesterday by the Office for Budget Responsibility ahead of the chancellor’s autumn statement. There may however be some positive changes over the coming months. The uncertainty caused by Donald Trump’s election as US president, and the rise in support for protest parties across Europe, could enhance the UK’s status as a safe haven. This would create a boost for UK assets, improving the current account position and helping to fund the chancellor’s plan to increase borrowing by £23bn over five years to fund increased spending.
Since Britain’s June referendum to leave the European Union, sterling has fallen 16% against the dollar and 10% against the euro. This has caused import prices to rise, pushing up inflation forecasts, despite the temporary drop in inflation to 0.9% in October, which was below the 1.1% forecast. As retailers begin to pass higher prices on to consumers, the Bank of England expects these costs to be reflected in inflation figures later in the year.
While creating challenges for monetary policy and a risk to real wages, weaker sterling has boosted returns on the UK’s foreign investments and reduced outflows associated with sterling-denominated foreign investments in the UK, improving the UK’s current account position.
The OBR estimates that these changes in the UK’s investment earnings will create a surplus of 1.1% of GDP by 2021, against 0.3% in its previous forecast made before the referendum. The current account deficit is now expected to improve from a forecast of minus 3.4% in 2020 to minus 2.8%.
There are reasons to believe sterling may also strengthen as political uncertainty in Europe increases the UK’s relative stability and boosts demand for UK assets. France, Germany, Italy, Austria and the Netherlands all have elections or referendums over the next 12-18 months. Markets fear that parties which are anti-immigration, anti-trade, anti-EU and anti-globalisation could accrue significant power.
The UK, however, is one of the few core European countries not scheduled to hold an election within the next few years, though the government may still choose to call an early election relating to Brexit negotiations. If it does so, the ruling Conservatives are likely to win since Labour, the main parliamentary opposition party, is undergoing an internal crisis that could see it split.
Unlike other European countries, the UK does not have a populist opposition party – the United Kingdom Independence Party has lost its force after the Brexit vote. And unlike in Spain, where the new government rules in a fragile coalition, or in Germany, where wide coalitions are the norm, the Conservative party wields a parliamentary majority.
In the face of Europe-wide dislocations and uncertainty, this relative political stability could lead to a surge in demand for UK assets, including investments in the ‘real’ economy, as well as equities and other investments. This would strengthen sterling, reducing risks of inflation overshoot and a premature raising of interest rates that could otherwise stifle growth.
Some increase in investment is likely to occur in any case to compensate for market overreaction following the Brexit vote. Net foreign direct investment declined from £71bn in the first quarter of 2016 to under £2bn just after the referendum. ‘Others’, including currency and deposits and loans to the rest of the world, saw outflows of £107bn.
In place of these assets, foreign investors piled into UK portfolio debt, which saw a large inflow of £87bn, up from £34bn in the first quarter, providing the majority of total capital inflows. Over 25% of this came from overseas purchases of gilts as investors sought safe assets. Net gilt purchases increased by £15.7bn, the fifth-largest quarterly increase on record. The latest monthly figures show overseas purchases of an additional £13.3bn in September.
Continued foreign purchases of government debt would help to finance the UK’s plan to increase borrowing, announced yesterday. This would ease the aim of running a larger budget deficit for longer, boosting infrastructure and real estate investments and providing a long-term lift to the UK economy. Rising bond yields could however make this borrowing more expensive.
The downgraded forecasts released yesterday highlight the challenges faced by the UK economy over the coming years. The UK’s negotiation over Brexit will provide ups and downs over the next two years which will be reflected in financial markets. Rising uncertainty in Europe and the US could also negatively impact the UK, which is exposed to trade and investment flows with these countries. However, ahead of an uncertain time for the two largest global economic regions, the UK’s relative attractiveness and status as a safe haven is likely to increase. This may provide some relief to the chancellor.
Ben Robinson is Economist at OMFIF.
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