Feel good is back: UK economic sentiment is about to perk up

UK equity markets have seen some pronounced swings over the last few weeks. Sentiment over global economic growth has shifted between cautiously optimistic, cautious and concerned, with almost a different narrative every week. While the short-term market watchers scour the data for hints about the direction of travel, the longer-term narrative regarding “secular stagnation” (low growth, low inflation and negative demographics) seems to be growing in popularity. But I believe a different state of play may start to emerge over the next six to 12 months, which will bring some sort of feel-good factor to the UK economy.

 

Of course, understanding why an optimistic turn in sentiment may be just around the corner requires some examination of why it has been (surprisingly) absent, given Britain’s impressive levels of headline economic growth, falling unemployment and a recovery in the housing market.

 

In short, it’s because the recovery has simply been too narrow. The requirement to use monetary stimulus to reflate the economy following the collapse of the banking system has meant that, while the stock market and house prices have risen, the overcapacity in the economy has led to income levels falling in real terms. And this has given rise to a sense of low participation in the recovery – and hence the absence of a feel-good factor. 

 

While the conflation of longer-term factors (demographic trends, impact of automation) combined with very evident shorter-term observations (low inflation, lower than historic trend growth, and close to zero policy rates) has stoked the sense of fragility in the underlying economy, it is worth remembering that, at points of “extremes”, it is particularly challenging to distinguish between what is cyclical and what is structural.

 

A feel-good factor in sentiment comes from the rising confidence of individuals in the economy. This spans how that effects them personally and how optimistic they are about the future. Usually, it requires some distance in terms of time and a sense of material change since the last downturn. Although many years have passed since the nadir of the last recession, it is this second factor that has been elusive – contributing to an ever-present sense of fragility.

 

So what will bring the feel-good factor back, and what evidence will there be for it? 

 

The first key thing is that real wage growth has turned positive, driven by rising employment coupled with the policy-driven increase in wages for the lowest paid. This will, in time, feed through to some inflation in wages more broadly.

 

Second, as the regulatory burden on the banking sector starts to subside (and the evidence of this is already there at the margin), we will see a return to a more normal lending environment – meaning that the multiplier effect which has been somewhat muted in the UK will begin to return. Again, I would suggest that the greatest change here will be in household rather than small business lending (which has actually been more robust), and hence will broaden the perception of improvement.

 

Third, a continued recovery in the economy will lead to a modest pickup in inflation, bringing the case for rises in policy rates back into focus. Yet many consumer-facing products and services will face ongoing disinflation, as new business models with lower cost structures (often technology enabled) will offer more for less. The obvious result of this is that small changes in incomes will lead to a greater change in perceived purchasing power (see chart) – again, contributing at the margin to a sense of improved financial well-being.

 

Finally, although government spending will continue to be constrained over the next 6 to 12 months, we will edge closer to what will essentially be the end of austerity. And evidence of investment in infrastructure and the built environment more generally is one of the factors that individuals cite as being indicative of a healthy economy.

 

But what are the investment implications of such an improvement in broad sentiment? 

 

First, there would be a greater upward pressure on policy rates, which might challenge the valuations being accorded to some of the perceived-to-be-safer “bond-proxy” stocks in the market (those high-yield, defensive equities). Second, while it will continue to be a challenging regulatory environment overall for the banks, the scenario above should be helpful for dividend growth for the sector as lending volumes start to normalise. 

 

The third point to consider is that an improvement in sentiment would also be a source of margin pressure for companies that have protected profitability through the downturn by constraining both costs and investments. A pick-up in both labour costs and activity levels may mean that the current position cannot be sustained. It will clearly, however, be a tailwind for firms that have both made investments and taken market share during the downturn, or where industry structures have materially improved – and a better demand environment should result in these advantages compounding.

 

In conclusion, we can think of the return of a feel-good factor in the economy leading to a strong recovery in volumes rather than prices, and confirming the long overdue “normalisation” after the financial crisis. It will prove to be an environment of significant winners and losers, as opposed to a fair wind for share prices across the board. But given the overwhelming consensus of the secular stagnation narrative, it is important that we consider what the implications are, if the nation finally cheers up.