2021 Grey Swan #11: Unexpected UK Outperformance

There was much to worry about in the UK during 2020. The response to the Covid-19 pandemic was slow yet chaotic. The ponderous approach to lockdown and restrictions caused the deepest recession in 300 years yet was relatively ineffective in controlling cases. On top of this, the seemingly endless Brexit uncertainty also held back both the economy and markets. To add insult to injury, PM Johnson’s own unpopularity in Scotland risks the breakup of the United Kingdom. Truly an annus horribilis.

But this has been a very strange type of recession. The shocking economic drawdown was caused by government restrictions on mobility that made viable activities unsustainable overnight. It has not been the result of hundreds of thousands of economic agents quietly reducing their spending nor the result of inappropriately tight monetary or fiscal policy. But, amid exploding government debt, a growth in company failures and an expectation that unemployment will double, not all is doom and gloom. Below are a few factors that could drive upside surprises.

Areas for Unexpected Optimism in 2021

A limited Brexit agreement is almost within reach. And even if not concluded before year-end, it is now hard to imagine that the relationship with Europe will be stuck in WTO terms for long. There will also be plenty of scope to enhance the deal as time progresses. While no arrangement will be as economically valuable for the UK’s regional trade as the single market, it will now be far easier to benefit from a Biden-led Globalisation 2.0 without the dragging anchor of a 28-member decision-making political club. True, some uncertainty will remain in the post-Brexit economy. But it will be at much lower levels than we have experienced over the past four years.

Banks In Better Place To Drive Recovery

Banks are also in a better place. There is no lack of loss-absorbing equity capital that contributed to the 2008 global financial crisis (GFC). The lending schemes developed during the pandemic have not worsened bank balance sheets; the government has provided guarantees for much of the new bank lending. This could enable insecure businesses to make it through the crisis, but it will certainly help support the banks if some of these businesses fail. If Covid-19 cases come under control, the vaccine programme is successfully rolled out in H1 2021 and mobility returns almost as suddenly as it disappeared, then the banks’ ability to increase lending again will be significant for the recovery’s dynamics. The UK’s early vaccine approval will give this recovery ‘plan’ a head start.

Positive Wealth Effect

Wealth has avoided taking a hit during this recession. The raising of the Stamp Duty threshold and surging mortgage approvals mean that house prices are rising. And that’s despite it being normal to see a 20% real decline in residential property prices during recessions. Most global stock markets have already reclaimed start-of-the-year levels after a very decent global rally in 2019. Bond yields at historic lows make the funding of additional government debt manageable for now, and the authorities are lining up to promise no tightening of monetary policy and no austerity in fiscal policy. Consumer and business sentiment are normally strongly correlated to wealth, so it is very reasonable to expect a particularly strong upswing next year.

QE 2020 Boosts Cash Balances As Well As Financial Market

Moreover, unlike post-GFC QE, the £280bn in Bank of England asset purchases since 1 April have largely found their way into household and non-financial business bank accounts rather than to financial institutions. The increase is equivalent to 10% of UK GDP, meaning that, net of (govt-guaranteed) bank loans, there is an additional £150bn of private money balances just waiting be spent. Also interesting is the £89bn of cash in circulation, which is over £3,200 per household and, in the internet shopping age, probably 10 times the normal average family cash balance. That additional demand for cash suggests some of the furloughed service sector has been able find work in the unofficial sector of the economy and that the official downturn has been overestimated.

The Consumer Is The UK’s Comparative Advantage

Often seen as a UK structural economic weakness, consumer spending will be a particular strength for the UK in 2021 as households power 70% of UK GDP. There is very little chance that a 30% household savings ratio will be anything other than a temporary phenomenon. The Eat Out to Help Out Scheme and retail sales seen after the first lockdown suggest that, as in the past, the UK consumer will spend eagerly when allowed and that the service sector can recover quickly. As the first developed nation to approve a vaccine, the likely reduction of fear in consumers and improvement in mobility implied by the loosening of restrictions can start in earnest during Q1 next year. It used to be said that Britain was a nation of shopkeepers; next year we will again be a nation of shoppers.

In market terms, the 2020 results were stark. Nominal and real interest rates are at all-time record lows, the main FTSE index remains 15% below pre-crisis levels – a significant underperformance against other markets. Sterling’s broad trade-weighted index remains at historical lows, and the pound remains very weak against the Euro. The story in 2021 is likely to be very different and surprisingly positive.