Brexit, the UK economy and the folly of forecasting

04/06/2019

‘An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.’ Laurence Peter

Economists are easy targets for critics and comedians since their forecasts are nearly always proven wrong by events. A popular joke is that economists exist to make weather forecasters look good.

Glossary

For explanations of the investment terms used throughout this article.

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At the time of the UK’s referendum on European Union membership in 2016, for instance, there was a lot of media debate and scepticism about the conflicting views of economists. Sure enough, the consensus outlook for the UK’s post-referendum economic prospects turned out to have been far too pessimistic. All in all, it has been a challenging time to be an economist.

However, when the Bank of England published its regular inflation report in May 2019, Governor Mark Carney stated that the UK’s economic growth “appears bang in line with [the Bank’s] forecast” from February 2018. He did admit, though, that what had been going on under the bonnet of the economy was surprising.

Although consumption spending had been stronger than expected, supported by growth in employment and wages, business investment had fallen by 2%, in stark contrast to the 4% growth forecasted.

The Bank’s report highlighted that this downturn comes in spite of supportive conditions, not least the low cost of finance (with interest rates being so low), and limited spare capacity in the UK economy. These would normally encourage firms to invest.

The fall was attributed to uncertainties relating to Brexit, which the report said is “having a particularly pronounced impact on business investment”.

Interest rates and gilt prices

Although the Bank of England expects weak business investment to detract from economic growth this year, its May forecast does predict a pick-up in investment and in the growth of demand, as the impact of Brexit-related uncertainties is assumed to wane.

Based on this assumption of a “smooth withdrawal” from the EU, the Bank expects the annual rate of economic growth, as measured by gross domestic product (or GDP), to nudge up to 1.6% in 2020 and then rise to 2.1% in 2021.

The Bank has a mandate to keep annual inflation in line with a target rate of 2%. As the economy strengthens, the Bank expects to raise interest rates from their current level of 0.75%. But if the UK economy softens, perhaps amid a disruptive Brexit, such rises would be unlikely, even though it is possible that a weakened pound will result in higher inflation through more expensive imports, in the short-term at least. 

Inflation expectations matter for investors in bonds - which are loans issued by governments or companies that pay fixed interest, or coupon, periodically throughout the life of the bond. Rising inflation diminishes the real value of income paid through the fixed coupons. Other things being equal, we would expect this to be reflected in bond prices. These move inversely to the yields, which represent the interest received as a percentage of the bond’s price.

With limited prospects of inflation falling, the other way for investors in UK government bonds, or gilts, to achieve positive returns is for yields to fall further. But when we consider that the yield on the benchmark 10-year gilt is barely above 1%, this already offers prospective investors a real return that is negative, in the context of inflation at around 2%.

With Laurence Peter’s words ringing in my ears, I should be wary of making forecasts – after all, we cannot know what the outcomes from Brexit will be, especially in the short term. That said, I believe it is hard to escape the conclusion that gilts will at best provide investors with a low nominal return in the current climate.

The views expressed by the author should not be taken as a recommendation, advice or forecast.

Neither past performance nor the current situation are guides to future performance. The value and income from the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.