International Economic Week in Review: Early Signs From the UK Are Not Promising

Almost as quickly as the equity markets capitulated to the perceived negative impacts of Brexit, so too have they rebounded.  The US markets hit a record high this week, while other international ETFs advanced, in some cases strongly.  But other financial markets are more sanguine.  Sovereign bond yields continued to move lower, indicating, in the words of Professor Krugman, “Almost 8 years after Lehman, no sign of a really strong recovery in sight anywhere; perceived private-sector investment opportunities remain weak.”  Sterling remained at low levels relative to the dollar, euro and yen.  And while the UK has a new government, precious little is known about their strategy for disentangling the UK from the EU in a way that minimizes the economic damage (in fact, the FT reported on Friday that the UK government had no trade negotiators – none).

Economic risks were clearly at the top of the agenda when the UK’s Financial Policy Committee held their latest meeting.  Before the referendum, they determined that a vote to leave the EU would negatively impact 1.) Financing of the current account deficit, 2.) Lowering and servicing the high level of household debt and, 3.) The commercial real estate market, and 4.) Top line global growth.  In their latest minutes – the first post-Brexit meeting -- the Bank re-examined these risks to determine if they were in fact negatively impacted by the Brexit vote.

Financing the Current Account Deficit

Britain has a very large current account deficit:

 

The top chart, which comes from the Office of National Statistics, shows the quarterly tabulation while the bottom chart shows the annual figure. The number was declining before the recession and has maintained its low level throughout the recovery. In the minutes, the committee noted that the UK would need to continue attracting foreign capital to finance the deficit. Unfortunately, the immediate results are not promising:

Following the referendum, sterling had experienced its largest two-day fall against the dollar in the post-Bretton Woods era. Risk premia on UK assets had increased. This would be consistent with a reduction in the willingness of foreign investors to hold sterling assets.   

The following charts illustrates this point:

Obviously, the future is unknown. But if the UK’s economy continues to weaken expect further deterioration in the exchange rate.

UK Household Debt

UK households have accumulated a large amount of debt:

The UK’s household debt/GDP ratio (top chart) declined about 10% following the Great Recession, but the recent uptick indicates progress might be over. The lower chart plots household debt against income. The first two years of the recovery witnessed strong improvement in this metric. But improvement has been muted over the last 5 years.

While the current EU employment situation is very strong, the committee is concerned that Brexit will halt expansion plans, slowing hiring decisions, increasing unemployment, and eventually lowering wage growth.  Recent survey data from Markit shows rising uncertainty delaying projects, which may signal the beginning of this cycle.    

Commercial Real Estate

From the committee’s report:

Overall there had been a sharp slowdown in activity in the UK CRE market in the first half of 2016. In 2016 Q1, transactions had fallen by £6 billion, or 34%, relative to the previous 4 quarters. This had been largely driven by a fall in activity in London, where transactions were down by 53%. Monthly data had suggested continued falls in UK CRE transactions in April and May. CRE prices were broadly flat in 2016 Q1; rental yields had continued to fall. Valuations were vulnerable to higher risk premia and lower expectations of future rental growth.

Foreign inflows of capital to the UK CRE market had fallen by almost 50% in the first quarter of 2016. More recently, share prices of real estate investment trusts had fallen sharply, reflecting the risk of future marked adjustments in CRE prices. The Committee had previously highlighted the risks around open-ended property funds. Since the referendum, these had seen increased redemption pressures. The FPC was briefed by the FCA on the extent of outflows from these funds and on the possibility that funds could suspend redemptions in the near term.

The committee was right to be worried.  From the Financial Times:

Three more fund managers have stopped investors from leaving their UK property funds, trapping an additional £5.5bn of money and bringing to six the total funds unable to meet withdrawal requests after the Brexit vote.

More than half of the £25bn of funds committed to commercial property by retail investors are now locked down by their asset managers, which are coming under pressure to sell buildings in order to raise cash.

Over the last few days, Aberdeen has re-opened their fund.  But the basic problem remains.  UK property – specifically London, which before Brexit was strongly competing to become an international banking center – is no longer an attractive investment, forcing funds (theh UK equivalent to REITSs) to begin liquidating properties.  But commercial real estate is a fairly illiquid asset, greatly impeding the process.

On Friday, Markit Economics released a new survey of the UK commercial real estate market that confirmed the slowdown.  Now only did the confidence drop for current activity, but so did the future outlook. 

Weaker International Economic Growth Caused by Increased Uncertainty.  

Before Brexit, the EU, which was the second largest economic region in the world, was assumed to exist in perpetuity.  Not anymore.  Now that the UK has left, everybody is waiting for the next shoe to drop.  The rise of far-right parties in France and Austria could indicate either may vote for exit next.  Or perhaps the recently reported Italian banking troubles will lead to Italy leaving.  While none of these countries have said they would have their own vote, they are the leading contenders. 

The increased economic interdependence means no one is immune from a slowdown in another part of the world. But if the EU continues to break apart, a recession, perhaps global in dimension, is a given.  

It’s still very early in the post-Brexit world. But the early signs in the UK are not promising. Business is taking a “wait and see” attitude to expansion plans, which will hit investment and employment. Sterling is projected to continue moving lower, which has negative implications for the UK’s current account deficit. The London real estate market’s strength was premised on the city becoming an international economic center; that’s now clearly off the table, which will further hurt commercial real estate. The jury is still out regarding overall international growth, but it’s difficult to see how increased uncertainty could do anything except lower growth. The initial signs are at best middling and long-term ramifications concerning.