In June 2016, immediately before the Brexit referendum, a curious thing happened.
Despite the colossal uncertainty facing the UK, economic data actually started to come in above consensus forecasts. Citi's economic surprise index nudged into positive territory, which meant that UK economic data had on the whole outperformed consensus forecasts over the prior three months.
June proved to be the start of the longest period of positive UK economic data surprises since records began in 2003 (longer even than in 2009 when expectations were that the UK's banking system had a real chance of collapse). Not even some spectacularly weak Purchasing Managers' Index (PMI) readings in July last year were enough to pull the overall number below zero.
This incredible run came to a halt recently. The dip in UK economic data that began in around February has broadly been maintained. The Bank of England's (BoE) dovish tone in its February inflation report, which took markets a little by surprise at the time, has been fully vindicated.
UK Economic Surprise Index
Source: Bloomberg, 01/01/2003 - 15/05/2017. Past performance is not a reliable indicator of future results.
It is of course difficult for economic data to continually exceed expectations, as economic data outperformance would likely result in expectations being ratcheted up, and to continually beat these ever higher expectations, you would need to see the economy growing at something close to infinity after a few years. But there is no doubting that UK data has been trending downwards lately. Indeed, recent gross domestic product (GDP) numbers were worse than the BoE itself projected back in February.
We would expect this period of data underperformance to become more acute in the coming months. Firstly, in terms of Citi's index, the stronger data from earlier this year will drop out of the rolling measure. And secondly, we can be very confident that UK inflation will trend higher over the next year, owing solely to the huge sterling devaluation that occurred between Q4 2015 and Q4 2016, which will push consumer prices higher until possibly mid-end 2018 before most likely normalising.
The move higher in UK inflation could be damaging to UK growth, because the strong UK economic data since last summer has been driven almost entirely by stronger consumer spending. Business investment, which is what you need for sustainable growth, is no higher than in 2015. This is an unsustainable growth mix at the best of times, but particularly when the private savings rate is already at an all-time record low, and when the strong prospect of higher consumer prices means that real income growth may be zero or negative later this year.
Markets are partly pricing this in. Gilts have performed well since February, both outright and cross-market, and the rate hike that was priced in for Q1 2018 has been pushed back beyond Q4 2018. We had been long of UK duration, but closed this out ahead of the French election.
But what markets are not pricing in, particularly with regards to sterling, is if UK economic data weakens at such a rate that the upcoming UK general election becomes more ‘interesting' than generally thought. A quickly deteriorating economy going into the election would be expected to translate into weaker Conservative Party support, which in turn could make a unified Brexit negotiating position considerably tougher. Indeed, government worries over the economic outlook may have contributed to the decision to hold a snap election so soon.
This piece was written by Mike Riddell, Fixed Income Portfolio Manager at Allianz Global Investors. To read more from Mike and his team, please visit www.bondissues.co.uk.
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