The UK in Crisis? History is a Guide to What Comes Next
The UK is currently in a financial and political crisis. A sharp rise in bond yields and a fall in the value of its currency has raised questions about its current set of fiscal and monetary policies. Rishi Sunak has taken over as Prime Minister and Chancellor Jeremy Hunt is tasked with bringing calm to the situation.
We’ve Seen This Movie Before
This isn’t the first time the UK has faced a crisis. The UK has gone through several crisis episodes from 1970 to the present day. Following an initial setback, it has generally emerged stronger after each crisis. Understanding history can help us contextualise some of the policy options open to the UK today. We understand the UK through four periods of history:
- Period 1 – 1970s
- Period 2 – 1980s/90s
- Period 3 – Pre-GFC (1995-2008)
- Period 4 – Post GFC (2009-2022)
The current account is by far the most important variable through the UK crisis history. It often widens before closing again. Recent years have seen a steady widening with a narrowing after Brexit. The energy crisis in 2022 has seen a further widening. This has contributed to today’s crisis.
Period 1 – 1970s
The first UK crisis in the 1970s featured a large current account and fiscal deficit. It was ultimately solved through an IMF loan and fiscal austerity. The GBP also declined significantly. Margaret Thatcher came to power in 1979, and UK interest rates rose sharply to dampen inflation expectations. Her leadership helped migrate the economy from industry to services.
Period 2 – 1980s/90s
Services employment continued to grow while total economy debt grew sharply, led by the private sector. Government debt fell significantly. This mix allowed real GDP per capita to grow strongly. The current account deficit widened but was readily funded, given strong economic growth. When the deficit widened too much in the late 1980s, interest rates rose, and it quickly reverted back into balance. A recession followed in the early 1990s, followed by Black Wednesday in 1992.
Period 3 – Pre-GFC (1995-2008)
This was characterised by further rapid growth in real GDP, aided by significant population growth. Services sector employment grew sharply as the UK became a very attractive place to invest. Households grew their loan balances significantly, with debt rising to 95% of GDP. The household savings rate fell 4% during this period, explaining the majority of the decline in total economy cash flow (it peaked at -4% in 2008). Interest paid fell sharply as a share of disposable income from 1995-2008. This is partly explained by the persistent fall in the goods trade balance (the UK continued to persistently import ‘cheaper’ goods and export higher-value services).
Period 4 – Post-GFC (2009-2022):
After a slight improvement in 2011, the current account deteriorated again from 2011 to 2016. This was driven by a further fall in household savings (-2%). This was unusual, as all other prior periods of current account realignment included a sharp rise in interest rates. This did not happen, with UK real interest rates remaining below US real rates throughout most of the last decade. Why? It is likely due to the abundance of global liquidity and QE. Government debt rose sharply from 40% of GDP in 2008 to 100% of GDP by 2022.
Fast Forward to Today
You cannot run a persistent current account deficit if foreign investors are unwilling to fund it. Real GDP per capita needs to rise. This has not occurred in the UK since 2016. The Ukraine war and the pandemic have also exposed two structural inflation vulnerabilities:
- A large and problematic negative goods trade balance (worsened by Brexit and global supply disruption); and
- A falling pace and changed mix of population growth.
The Series Finale is Coming
We assume that the UK will ultimately bow to maintaining external credibility in the face of a flat GDP per capita. This is already playing out through political and fiscal change. It must limit its currency decline from here and will need to allow:
- Significantly higher interest rates relative to the USA; and
- A household-driven recession.
The lesson from past UK crises is that they are resolved with:
- At least a 2% positive real interest rate differential to the US (currently -1.5%).
- Fiscal restraint. The response to GFC and COVID crises was a loose fiscal policy to stimulate households. This is being attempted yet again. It will not work. The government will ultimately be restrained if it wants to preserve GBP stability.
Investment Implications for some of the companies in our universe include
Banks:
- UK interest rates should rise more than expected. This is NII positive.
- NPLs will increase. The exact quantum is unclear as the UK banks are better placed today than in prior crises (lower foreign funding, more mortgage exposure, and higher capital).
- The risk of taxes on the sector increases.
Housebuilders:
- Our base case remains that UK housing completions should fall into 2023/24 due to higher rates and pressures on household spending.
Asset Managers:
- New savings flows will struggle as household cash flow deteriorates.
If you would like to access our work, Carraighill Research Access enables you to access these and other thematic and sectoral research through our secure online portal. It also gives you access to investment ideas across the banks, payments, fintech, asset management, and real estate sectors for European and select emerging markets. If you would like to speak to a partner or analyst on the topics raised in this piece, you can contact us here.
