The UK is concerned with an increasing number of indicators in the red, and investors are showing increasing distrust of the country. Do we still have to invest in it?
The Living Standards of the Suffering British
For the first time since 1961, the British public debt exceeds 100% of GDP. Energy subsidies have contributed to a deterioration in public finances (to help households cope with soaring energy prices) and rising social spending.
Unfortunately, the practical effects were limited: inflation in the United Kingdom stopped falling to 8.7% in May. And the underlying index, which excludes energy and food, is even at a new peak, at 7.1%, against 5.8% at the end of 2022. And for a good reason, in an economy dominated by services, the labour cost is of capital importance.
However, the very tight labour market and the lack of labour (due to Brexit, which has meant that the country has lost easy access to the continent’s abundant labour force) drive wage growth of more than 7%.
The purchasing power of the British has been better preserved than elsewhere. That’s not the case. On the one hand, inflation is high and will likely remain high. On the other hand, in a country where households are highly indebted, the sharp rise in interest rates does very, very badly.
For their home loans, the British usually have a fixed rate period (2, 3, or 5 years) before moving to a variable rate. In the coming quarters, many will see the interest rate on their mortgage drop from around 2% (which prevailed until 2021) to about 6% (the rate on current mortgages).
Voilà qui ne se fera pas sans mal, d’autant plus que des hypothèques pour 100% de la valeur du bien acheté, ainsi que des hypothèques interest-only (sans remboursement du capital) existent toujours sur ce marché.
The tenants are hardly better off. In May, rents were up 5% compared to May 2022, and as homeowners shift increased credit costs to the tenant and housing supply remains very tight, all indications are that the upward trend will continue.
With high inflation, which weighs on the available yield on wages and an increasing debt burden, households are put to the test. This will weigh on domestic demand.
London has no options
Unfortunately, in the face of this flood of bad news, the London authorities' room for manoeuvre is minimal on fiscal and monetary policy fronts.
By the end of the summer of 2022, Liz Truss' government’s decision to let the deficits slip had led to a downward spiral of British debt. And since then, investors have been wary of London and reported that they would oppose any further slippage in the public accounts: While the 10-year bond rates in the Eurozone and the United States are essentially unchanged at the beginning of the year, UK rates fell over the same period from 3.7% to around 4.4%.
With public indebtedness at 100.1% of GDP and growing difficulties in obtaining financing at a reasonable price, Downing Street’s room for manoeuvre is minimal.
The Bank of England has little choice. Very worried about the rise in inflation, it has just increased its key rates not by 0.25%, but by 0.5%, towards 5.0% (the highest level in fifteen years) while pointing out that it will increase them further.
Investors are now anticipating a peak close to 6.0%, a painful development for the economy, which will be plunged into recession, but necessary to anchor inflation attacks. In such a peaceful environment, it can be challenging to convince companies to invest.
Yet the country needs it. The country’s competitiveness is at a loss. Without investment, the weakness in productivity, which has long been the Achilles heel of the British economy, will remain problematic in the medium and long term.
Growth remains weak, and the British economy must still recover its pre-pandemic size. At the same time, bond interest rates are still on an upward trajectory, showing how difficult it is for the country to finance itself. Therefore, London has little room for manoeuvre, both fiscal and monetary policy, and the sky is darkening for British assets.
The bond market suffers as rising interest rates translate into lower bond prices.
On the other hand, on the foreign exchange markets, these higher interest rates allow to support the price of the English pound, in a 4% gain against the euro since the beginning of the year. The equity market is not left out, also improving since the beginning of the year (by 5%, in €), a performance that has declined compared to other markets but remains interesting. As is often the case, some multinationals in this market get off the hook.
This is the case for Rolls-Royce Holdings, which benefits from the restart of the aviation sector and the rebound in military spending following the war in Ukraine or BAE Systems (buy), which also benefits from the latter factor. This is also the case for Sainsbury (sell), which, like many other players in distribution, took advantage of the surge in inflation to inflate its profit margins.
Well-diversified, the British market will still have champions among companies listed in London, such as Anglo American (buy) in the base resources.
But, the risks of an investment, especially for buyers of funds and ETFs seeking to replicate the performance of the UK market, are more critical as the economic environment deteriorates.
That is why we must keep a close eye on this market and not exclude any further separation shortly should other investment opportunities emerge.
