Recent positive UK data surprises have caused economists to revise up UK growth forecasts and BoE Governor Carney recently hinted that the February Inflation Report would follow suit. Despite that, my argument from last October that UK net exports were likely to disappoint, even with sterling’s sharp depreciation, has proved accurate thus far (Q3 UK net exports were the worst since 2012). This piece dissects the recent data and expands my previous analysis. It draws on a variety of data – GDP, trade, export order surveys, investment, corporate external financing, credit demand surveys, PPI and CPI inflation.
While cyclical headwinds headwinds to UK trade show signs of abating, although Trump-generated protectinism represents a known unknown, there’s initial evidence of the structural headwinds again kicking in (see charts below, they can be exacterbated by Brexit uncertainties). Given that there’s more than J-curve effects going on, hopes for more balanced UK growth (less reliant on consumption) will likely be dashed although there’s obviously consideable uncertainties. Moreover, with the inflationary pressures from sterling’s depreciation set to grow, given that higher risk premia and monetary policy easing have helped drive it, with consequent slow-burn hits to real wages and consumption.
This poor tradeoff of sterling’s fall means that, in the current environment of high uncertainty and weak investment dynamics, MPC will likely be wary of further depreciations (although if asked they’ll undoubtedly reiterate that they don’t have a target level). MPC will thus likely want to send a ‘balanced’ message in the February Inflation Report, although they face communication challenges given recent poor forecasts. While near-term downside risks to sterling have faded, it remains vulnerable to the slow-burn costs of Brexit becoming more evident or negotiating difficulties arising. So sterling rallies will likely continue to be seen as selling opportunities.
Disappointing UK net exports unsurprising despite sterling’s depreciation
Last October I argued that structural and cyclical headwinds mean that Brexiteers’ hopes that UK net exports would boom after sterling’s sharp post-EU referendum depreciation would likely be disappointed. And subsequent UK trade data have fit that relatively-pessimistic pattern, with distinct signs of the headwinds I highlighted.
Specifically, in Q3 UK net exports put in their worst performance since Q2 2012, knocking 1.2pp off quarterly GDP growth (see Chart), as export volumes fell an eye-watering 2.6% and import volumes marched ahead with 1.4% quarterly growth. Moreover, there’s only limited signs of exports recovering in the (partial) Q4 data (see Chart) with the UK trade deficit again widening in November. And the big picture is that while UK growth has remained steady, including again rising 0.6% in the preliminary Q4 GDP data, it appears unbalanced in being reliant on consumption (the positive contribution to Q3 GDP from investment mainly reflected the volatile “valuables”).
While such weak UK net export performance might be viewed as puzzling given sterling’s sharp depreciation, it’s actually unsurprising given the UK’s disappointing historic experience and the structural factors underlying those disappointments. Moreover, those structural factors seem more likely to be amplified in the the post-referendum world rather than suddenly and conveniently disappear. There’s more than the well-known J-curve effect going on here, so the net export disappointments seem likely to persist.
Muted impacts of previous sterling depreciations: exporters raising margins not targetting new markets
In particular, UK net trade in general doesn’t tend to benefit that much from sterling depreciations– even in the “successful” case of the 1992 sterling depreciation (ERM ejection) net exports only eventually raised UK GDP by around 1.5pp (see Chart). This accords with academic studies finding that export market conditions have bigger impacts: demand elasticities of around unity versus price elasticities of -0.4 to -0.7. Moreover, the UK net export performance after the 2007/8 sterling depreciation was particularly disappointing, consistent with a structural shift in the determinants of the impacts.
One of those structural shifts was that UK exporters responded to the 2007/8 sterling depreciation by raising export prices and hence their profit margins rather than seeking out new export markets. And my October view, given current circumstances, that exporters would do the same again seems to be being vindicated. Specifically, UK sterling export rose 13.7% y/y in November (see Chart above) – only a little less than the £ERI depreciation and substantially quicker than the import price rise (10.2% y/y). This probably reflects many UK exporters adopting pricing to market behaviour, naturally leading to FX variations feeding into margins.
Previous Bank of England analysis highlighted that the 2007/8 behaviour was driven by service sector exports, which tend to compete on the basis of product quality/reputation rather than price (lower prices can be taken as a signal of poorer quality). And services make up a large share of UK exports (the services trade surplus contrasts with the goods trade deficit).
Existing foreign exchange hedges can help facilitate/drive such behaviour in the near term. But uncertainties about the persistence of sterling’s depreciation and the UK trade deals which eventually follow Brexit seem likely to make such behaviour more persistent.
Brexit uncertainties inhibiting investment needed to exploit new markets
Specifically, uncertainty about the eventual trade agreements which follow Brexit will likely make UK exporters reluctant to undertake the investment required to enter into new export markets. So it’s notable that while overall growth has surprised positively (including the 0.6% q/q preliminary Q4 GDP growth), fixed investment has remained been weak (annual business investment growth of -2.1% in Q3). And surveys of UK corporate investment intentions also generally remain weak: the Charts below shows that there’s been no recovery in the BOE Agents’ survey while the Deloitte CFO survey reports continued expectations of capex cuts (as CFOs reportedly remain very risk averse) although the BCC and and CBI surveys report parial rebounds.
Moreover, recent weak UK corporate external financing, with bond and commercial paper issuance looking particularly muted (see Chart below), also points to continued weak capital expenditure. Indeed, such pessimism is reinforced by the BoE credit conditions survey revealing very muted expected demand for credit to fund capital expenditure since (see chart below), within an overall picture of weak expected UK corporate credit demand.
Previous sterling falls haven’t halted rising import penetration: lack of UK substitute products
Returning to the main theme, likely continued strong UK imports despite sterling’s depreciation represent a further structural headwind to UK net trade improving in the post-referendum world. Put simply, there’s now fewer domestic substitutes for the more-expensive imports because: (i) UK manufacturing output lies 5% below it’s pre-crisis level (see Chart) and recent growth has been slow (1.2% y/y in December); (ii) outsourcing and greater specialisation have reduced the range of products which UK manufacturers produce. Re-entering such markets, to provide UK consumers with domestically-produced alternatives for them to switch from the more expensive imports, again requires investment and will take time. And, as discussed in the previous section, it’s a difficult call for UK corporates for UK firms to undertake such investment given high uncertainrties about the UK’s post-Brexit trade deals and whether sterling’s recent depreciation will persist, extend or reverse.
These current Brexit-related uncertainties again reinforce a UK structural weakness – the UK’s previous poor record on substitituting domesticlly-produced goods for imports when sterling depreciates. Specifically, the second chart above illustrates that the general upward trend in UK import penetration over the past few decades was not reversed when import prices have risen sharply (relative to domestic prices). Here import penetration is defined as import volumes as a share of UK total final expenditure weighted by import intensity (adopting the methodology used by the Bank of England). It’s notable that a gap between import penetration and relative import prices opened up after 2007. This probably reflects a combination of post-crisis uncertainties and credit supply constraints together with greater globalisation (specialisation, outsourcing).
But it’s also apparent that import penetration has continued rising in the past couple of quarters despite import prices rising after sterling’s depreciation: import volumes rose 1.4% in Q3, despite import prices , whereas import-weighted UK total final expenditure fell 1.2% (unweighted TFE fell 0.5%). Clearly it’s early days here, but both history and the current situation suggest that it would be unwise to assume that import penetration will decline after sterling’s depreciation. Moreover, like exports, the evidence is that UK domestic demand is a more powerful determinant of overall UK import volumes than the sterling (real) exchange rate. So, given the likely weak expenditure switching effects generated by the supply side issues, the corollary of resilient UK demand (consumption) seems likely to be continued strong UK imports (the UK will likely continue ‘sucking in imports’).
Export order surveys up, signs of improved global demand
There are, however, several challenges to this relatively-pessimistic UK net exports narrative – essentially that the cyclical headwinds from weak world trade growth I highlighted last October (see here) show signs of receding.
First, surveys of UK export orders have picked up.
- The manufacturing PMI export orders subcompoment rose to it’s second highest since early 2014 in December as the overall new order components rose 1.7–3.2 points in December (manufacturing 58.8, services 58.1, construction 54.9). Markit commented that “The boost to competitiveness from the weak exchange rate has undoubtedly been a key driver of the recent turnaround”.
- The longer-running CBI Quarterly Industrial Trends (QIT) survey reported the highest export optimism since April 2014 in January, up a sharp 30 points over the past 6 months (see Chart below). That said, expected export orders have rebounded less (they didn’t fall around the EU referendum) and actual export orders actually retraced in the latest obdservation.
Second, associated with this, global growth prospects have strengthened in recent months, which the February Inflation Report is likely to note. Specifically, the JP Morgan Global PMI has been edging up for a year (see Chart above), and while US growth is leading the way the Euro Area (accounting for 44% of UK exports) is also showing more signs of life and near-term Chinese prospects have also improved (albeit at the costs of continued debt accumulation).
That said, export orders rising back to early-2014 levels arguably isn’t that impressive given sterling’s x% post-referendum fall. And exporters could, given current Brexit-related uncertainties, respond to better export market conditions by raising export prices and profit margins rather than expanding export volumes (see above).
Rising Trump-driven protectionism risks: could the UK regret a quick trade deal with the US?
Moreover, the shadow of potential Trump-driven protectionism continues to hang over the global economy. Trump’s ‘America First’ innaugaral address was quickly followed by US withdrawl from the Trans-Pacificic Partnership and executive order to begin NAFTA renegotiation. Trump has yet to follow through on his campaign promises to label China a Currency manipulator and impose 45% tariffs on Chinese imports. While China doesn’t fulfill the US Treasury’s three key criteria for currency manipulation (bilateral trade suplus with US of over $20bn, current account surplus over 3% of GDP, 2% of GDP FX intervention) his ‘alternative facts’ comments and the implementation of his Mexican wall campaign promise give grounds for concern. Worryingly, Chinese officials’ comments indicate that they would retaliate with tariffs on US goods.
For the UK specifically, the big picture is that Trump’s protectionist tendencies (mercantalism) conflicts with the UK government’s apirations for the UK to be a beacon of free trade in the post-Brexit world. And while Trump recently held out the prospect of a quick UK-US trade deal, the reality is that it could end up beibng detrimental to the UK trade balance. The Navarro-Ross authored ‘Trump trade doctrine’ (see here) argues that any trade deal “must increase the GDP growth rate, decrease the trade deficit, and strengthen the US manufacturing base.” So the UK’s reasonably substantial trade surplus with the US (£3.3bn for goods in the 3-months to November, versus the overall £35.9bn overall deficit) could be at risk if that doctrine is applied to a future UK-US trade deal. There may be limits to how far the ‘special relationship’ stretches, especicially with the UK probably having a relatively weak bargaining position due to being a smaller player in need of a deal to signal progress in the post-Brexit world.
Inflationary impacts of sterling’s fall: more to come, but not mechanical
The flipside of the muted impact of sterling’s depreciation on UK net exports is a sizeable boost to inflationary pressures. This is most apparent in producer input prices, with most of the eventual impact on producer output prices and CPI inflation still to come (building on recent upside surprises). All this will in turn further erode consumer’s real purchasing power, with wage growth likely muted. Employment has stopped growing, the job vacancy to unemployment ratio has retraced, surveys of recruitment difficulty have fallem and MPC member Saunders recently argued that structural labour market changes have reduced the equilibrium unemployment rate (see here).
Mechanically examining the stages of exchange rate pass-though implies growing pipeline price pressures (given such recent upside news MPC seem likely to revise up their inflation forecasts, from the end-2017 2.7% forecast in November):
- A chart above illustrated that import price inflation had ticked up meaningfully (to 10.2% y/y in November), albeit less than export price inflation (13.7% y/y).
- Producer input price inflation spiked to 15.8% y/y in December, the fastest since September 2011 (up from -10.4% in December 2015), driven by oil and imported inputs. The chart below illustrates that imported input price inflation is very closely correlated with sterling’s fall, and that the rise in imported input inflation has been broad based.
- Thus far the uptick in producer output price inflation has, as usual, been more muted – only rising 2.7% y/y in December, albeit still the strongest since March 2012. A key question is whether/how long the implied squeeze to producer margins, limiting the impact on CPI inflation, can continue.
- Surveys point to sterling’s depreciation generating strong inflationary pressure: (i) BCC manufacturing price expectations rose sharply, to a record high; (ii) the manufacturing PMI reported that 75% of respondents attributing higher costs to sterling’s depreciation; (iii) the services PMI output price inflation subcomponent hit a 68-month high.
- While CPI inflation has also recently been stronger than expected (headline of 1.6% y/y was the highest since July 2014) the second chart below illustrates that’s mainly reflected energy and CPI components with relatively-low import contents. Intuition indicates that, following sterling’s depreciation, higher import-intensity CPI components should put increasing upward pressure on inflation in the coming months.
While the November Inflation Report bought into that narrative, some caution is required given the complicated (and time-varying) nature of exchange rate pass through. The February Inflation Report will likely examine this in detail, but some important high level points are:
- The chart below illustrates that, counterintuitively, CPI components with higher import contents tend to be less sensitive to sterling’s movements than low import-intensity components (the chart is taken from Forbes (2015)). That suggests weaker upside inflation pressure than mechanical pass-though analysis.
- But taking account of my previous findings that the eventual CPI impact of a sterling move depends on the fundamental shock hitting the economy (see article and 2009 QB Article) suggests greater eventual inflation pressure. Specifically, sterling’s depreciation seems to have been driven by a combination of higher FX risk premia and looser monetary conditions (see Sterling becomes unlovable), which my research showed tend to be associated with larger eventual CPI pickups. Forbes, Hjortsoe and Nenova (2015) reach similar conclusions. That said, weaker UK domestic has also probably contributed to sterling’s depreciation, ameliorating the inflation upside.
Recent sterling stabilisation, but market will likely continue to sell rallies
The bottom line from the above analysis is that sterling’s depreciation generates a poor tradeoff in that it probably won’t substantially stimulate UK net exports yet puts upward pressue on inflation and consequently hits UK growth prospects as household’s real wages are slowly eroded. The corollary is thus that further sharp sterling depreciations wouldn’t be particularly helpful and hence MPC should be hoping that the worst is over for sterling, even if they reiterate the mantra that they don’t have a target level.
Fortunately, sterling’s depreciation seems, for now, to have halted. After suffering a torid couple of weeks in January, with £/$ falling close to historic lows on PM May’s Brexit statements (see chart) and ignoring positive UK data, more recently sterling has stabilised on a combination of: (i) PM May’s 17 January speech assuaging market fears that the UK government lacked a meaningful Brexit plan; (ii) dollar strength unwinding as markets have started registering Trump’s protectionist tendencies; and (iii) growing expectations of MPC rate hikes (see Chart) following resilient UK growth and upside inflation news.
Those developments have ameliorated the downside risks to sterling, although the market may well be getting ahead of itself on MPC rate hike expectations. The February Inflation Report and MPC minutes will likely try and strike a more neutral tone, likely arguing that much of the Brexit-related growth hit has been delayed rather than avoided (I’m hoping to write a separate blog on this, focussing on UK consumption prospects) although they face challenges in pulling off that balancing act given their recent poor forecast record.
While near-term downside risks to sterling have probably faded, it remains vulnerable to the slow-burn costs of Brexit becoming more evident or negotiating difficulties arising. Overall the FX market will likely continue to see sterling rallies as selling opportunities, constraining any meaningful streling upsides (reiterating my October view, see here).