Better the Devil you Know …. ?

Better the Devil you Know …. ?

Well the result of the most closely contested election for a generation is known after weeks of intense campaigning. Except the election was, in the end, not closely contested at all but it is notable for a number of reasons. First and foremost, an issue which has escaped most political commentators is that the gains made by the Conservatives compared to their 2010 election showing are incredibly rare – throughout history, subsequent terms in office are usually only achieved with a diminishing majority.

The other issue to emerge is the fallibility of market research and opinion polls but this does not surprise us at CDC, and without wishing to bore anyone, the key lies in statistics. For any sample to carry a degree of accuracy it must achieve two things a) the sample must be robust, or sufficiently large and b) it must be a close approximation of the wider population it aims to represent, known as the statistical frame. Opinion polls are often drawn upon a sample of as few as one thousand people which is almost certainly too small to be indicative. Furthermore the pollsters say nothing about the ‘frame’ meaning a disproportionate number of one particular gender, income group or age range can undermine the survey. Even the ‘exit polls’ on Thursday evening were based on a sample of 22,000 – more statistically robust, but still failing to accurately predict the outcome.

The surprising feature for us was that (at the time of writing) it is looking like the Tories will have an overall majority. Whilst we felt they would capture most seats, we had resigned ourselves to a more ‘continental’ style of politics where a single party governs, but without an overall majority. Less surprising was the routing of Labour in Scotland, which has the propensity to alter the political landscape indefinitely, and the fact that the Liberal Democrats were decimated.

So what does this all this mean ? Well the market reaction has been positive with the FTSE All Share up almost 2% on Friday morning, an acknowledgment that financial markets see the Conservatives as a ‘safe pair of hands’ with the economy. This is likely to be a knee-jerk reaction and once the immediate euphoria dies down, we think there will be a realisation that some extremely tough fiscal decisions need to be made. So let’s have a look at the key components of the UK economy, starting with the most significant.

It’s a sweeping generalisation but Britains love to spend. Collectively, in the good times, we have developed a habit of living well beyond our means, accumulating a substantial burden of household debt in the process. Prior to the financial crisis, household debt peaked at almost 170% of disposable income, substantially higher than normal levels. Debt levels did moderate in the immediate aftermath of the crisis but debt remains at an elevated level in the UK. What is perhaps more worrying is the household savings ratio has declined again as consumer confidence has returned. The burden of household debt in the UK appears manageable when interest rates are close to zero as they are now, but would look increasingly unsustainable when interest rates start to normalise.

Moreover, the benign economic conditions forecast by the Office for Budget Responsibility and embedded in George Osborne’s recent budget, are built upon a staggering increase in household debt of £800bn over the course of the next parliament. Household spending may continue to contribute positively to the UK’s economic performance but we would worry if it were to do so as a result of a further increase in debt levels. The rapid decline in energy and food prices both represent something of a recent windfall for UK consumers but it would be healthier for the economy in the long run if this windfall was saved rather than spent – something the Tories will need to be cognisant of.

Historically, public spending has been used as something of a counterweight to consumer demand, with relatively low government expenditure when private demand is buoyant and vice versa. The fiscal response to the recession that followed the financial crisis was somewhat different though. A prolonged period of low volatility in growth rates had lulled politicians and central bankers into a false sense of security and the notion that “boom and bust” was over, crept in to policy-makers’ thinking. In the years leading up to the financial crisis the UK government of the time consistently ran a budget deficit in the good times, rather than a budget surplus and this meant that when the business cycle ultimately reasserted itself, there was nothing in the public coffers with which to substitute the collapse in private demand.
As a result, we saw a rapid deterioration in the public finances, followed by a prolonged period of austerity as the long process of healing the public finances started. This process is not yet complete and it seems inevitable that another wave of austerity awaits us over the next five years. This doesn’t necessarily mean the government spending has to fall – after all, it didn’t decline over the last five years – it could simply mean fiscal restraint. The implication though is we should not expect the government expenditure to contribute much in the way of growth in the medium term.

In contrast to the rest of the economy, debt levels for British businesses are quite low and balance sheets are in good shape, at least they are among the largest British companies. To put some numbers on this, the average FTSE 100 company could theoretically use profits and existing resources to pay off all of its outstanding debt within 1 year if it wanted to. Prior to the financial crisis, this ratio stood at 5.5x, suggesting that large corporates have been risk averse and they have generally been reluctant to invest, paying down debt and hoarding cash.

Companies remain risk averse and tend not to embark on ambitious investment projects in anticipation of an improvement in final demand, preferring to wait for solid evidence that the environment is sustainably improving before committing capital. As far as much of the economy is concerned, we are still waiting to see this evidence and it is therefore plausible that businesses will continue to hoard cash. This not just a UK problem, but one that afflicts all developed world economies. The political uncertainty that has surrounded the recent election process may well have acted as a deterrent to overseas businesses investing in the UK so on the face of it, this issue has been removed but question marks over the UK’s relationship with Europe remain and could also put a brake on business investment growth in the short term.

The last major component of the UK economy is trade. Britain’s manufacturing and engineering expertise has been in decline for decades with services becoming more dominant. We import substantially more than we export, so ‘net exports’ actually detract from UK GDP to the tune of about 2% at present. For a long time now, the UK has tended to run a current account deficit but in 2014, this deficit was the largest it has been since records began, and it is difficult to see how net exports can contribute in any significant way to the UK economy any time soon. The notion of ‘rebalancing’ the economy has been much discussed since we emerged from the financial crisis but it is a very long process and there is simply no evidence of it. In the near term, the most conceivable way in which our exporters could be given a boost is through a rapid depreciation in sterling but the initial reaction of the currency markets to the election result, has been the opposite.

As exporters will testify, sometimes we have to be careful what we wish for !