Financial conditions in the UK imply a solid tailwind for growth from the financial sector even as uncertainty over fiscal policy weighs heavily on the real economy, where hiring has slowed.
Although the RSM UK Financial Conditions Index stands at 1.4 standard deviations above neutral, the Bank of England is likely to cut its policy rate by 25 basis points at its meeting on Dec. 18.
While the economy has weathered the external shocks of the past few years, there is room for improvement in the growth equation that is linked to the upcoming budget proposal from Chancellor of the Exchequer Rachel Reeves.
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We anticipate a round of fiscal consolidation that implies modest disinflation, which will provide the central bank room to cut rates.
In our estimation, financial conditions have been bolstered by the speculative behavior of investors after a decade of historically low interest rates, and by the outperformance of tech-related industries.
Fixed income markets are operating at normal levels of risk, with returns in the gilt and corporate bond markets attractive compared with other developed economies.
The pound remains weaker compared with its pre-Brexit norms, but will most likely benefit from high interest rates and from increased confidence in the political framework even as it lost ground following the most recent disappointing labor market data.
Real GDP growth and financial conditions
The UK economy decelerated this year, growing at 1.7% and 1.4% yearly rates in the first and second quarters. Real gross domestic product growth has not cracked the 2% benchmark rate for developed economies since the aberration of the 2022 recovery.
In addition, expectations are that because of the low level of productivity, the UK economy’s potential real GDP rate has fallen somewhere in the range of 1.5% per year.
Still, the RSM measure of UK financial conditions is at its highest level since the pre-Brexit days of 2014 and, more recently, the 2021 post-pandemic recovery.
Financial conditions at these levels are indicative of low levels of risk priced into financial securities, increasing the potential of investment and setting the stage for growth.
What then is the disconnect between financial conditions and GDP growth? Why is the economy stuck in the doldrums of sub-2% growth?
We think speculative investment has taken hold of global equity markets. While speculation is necessary for growth, too much of it leads to asset bubbles and then the prospect of collapse. We see this concern priced into the high level of interest rates for long-term bonds.
The equity market
The FTSE 100 has been rising at a 20% yearly pace in a remarkable five-year run. Since the pandemic, there have been few instances where a buy-and-hold strategy did not result in a positive yearly return.
Some commentators point to the global sources of FTSE returns that better reflect the global economy rather than the UK economy stuck in the doldrums.
Many of the FTSE corporations are multinational, which implies that returns are increased when translated into pounds. And there is the banking sector that has benefited from the UK’s higher interest rates.
The bond market
The fixed income market is in the process of normalizing after the 2021-22 inflation shock.
The Bank of England has cut its overnight policy rate from its high of 5.25% to 4%, which has allowed for the drop in the front end of the yield curve.
The yield on 2-year gilts has fallen by 72 basis points from 4.11% on Dec. 1 last year to 3.81% nearly a year later, and the gilt curve is positively shaped from 2 years out to 30 years.
While the easing of monetary policy and the steepening of the front end of the curve has become attractive to traders, the selloff of 10- and 30-year gilts shows the market’s concerns for the lingering effects of inflation and the cost of servicing public debt.
By the end of last year, public debt reached 120% of GDP.
It is the same reasoning for the U.S. bond market. The two economies with the highest debt-to-GDP ratios have the highest interest rates among the major economies.
There are three things to note for the setting of long-term interest rates.
- Return of risk: First, while the damage to the UK and U.S. economies from the first China shock might not be completely over, the era of disinflation most likely ended with the pandemic. Risk has returned to the market, with investors requiring higher rates to compensate for the risk of higher inflation.
- Normalizing of rates: Second, zero interest rates and the economic and financial distortions that go with them are in no one’s best interest. They were a necessary and temporary solution to a global depression. As of now, interest rates for benchmark 10-year government bonds in the U.S. and UK have formed a center of gravity between 4% and 5%, offering investors an alternative to the more speculative markets.
- Attractiveness of corporate bonds: Third, the corporate bond markets in the UK as in the U.S. have expanded their reach and their attractiveness. The yields on UK corporate bonds have dropped in this latest cycle, but with a spread at 77 basis points over gilts, British corporate bonds remain attractive for investors looking to cover potential currency losses.
The currency market
The pound weakened this year most likely in response to the uncertainty surrounding the tariffs and the domestic political situation. At this point, the pound benefits from the highest interest rates among the developed economies.
Volatility in the foreign-exchange market has receded while the pound has range-traded within a descending corridor. The gradual appreciation of the pound is a sign of an economy that has weathered the effect of Brexit and the inflation shock.
The takeaway
The accommodative level of UK financial conditions is more a product of an elevated equity market than the stability in fixed-income markets.
The UK equity market is benefiting from increased speculative behavior and global returns translated into a weak pound.
