Scottish Vote Highlights UK Macro Vulnerabilities…

The IEA commented in its latest monthly report that the recent slowdown in oil demand growth was ‘nothing short of remarkable’. With Brent oil testing a two year low at $97, perhaps a price chart should be put on billboards by the Scottish referendum ‘no’ campaign to remind undecided voters of the economic risks in becoming a northern Emirate. It seems a very long time since peak oil pundits dominated the financial media; over the past year, the oil market has shrugged off geopolitical volatility, comforted by clearly weakening EM demand growth as subsidy regimes are reformed and the surge in US shale output. An independent Scottish economy would be hugely reliant on the oil sector (the largest source of revenue after income tax, with the UK’s national statistics agency estimating £120bn in North Sea tax revenues through 2040, the Office for Budget Responsibility about half that). US shale oil drilling was once described to me by a Texan geologist as like ‘trying to draw blood from a junkie’ i.e. you have to drill lots of wells. Each delivers a few hundred barrels of oil a day but with rapidly declining wellhead productivity. Operating costs for a shale oil well add up to about $30/bl, but including land acquisition, financing and the need to replace 50-70% of output each year with new wells, the lifetime breakeven cost for an individual well drilled today approaches $75-80/bl. If we take that level as the floor on global prices, an independent Scotland would face huge budget deficits or have to slash promised social spending.

The rather dismissive London media elite attitude to Scottish independence (a ‘banana republic with kilts’ etc.) has certainly helped boost support for the nationalists. The radical devolution of powers now being offered to keep the UK together means the bill for subsidizing Scotland will at least double from the current £10bn a year and exacerbate already weak fiscal trends. Indeed, the UK’s constitutional structure is no longer tenable regardless of the outcome; a move to some form of devolved Federal structure now seems inevitable, perhaps along German lines. It’s ironic that a key Scottish nationalist argument for going it alone has been to escape Westminster austerity, because there’s actually been far less UK austerity than widely assumed and the combined fiscal and current account deficit is worse than any Eurozone peripheral member and all but a few emerging economies.

The merchandise trade deficit reached a near record £10.2bn in July while the deficit including services reached £3.3bn; recently revised data shows the positive investment income balance surplus on the current account disappearing in 2008 rather than 2012 as previously thought – we get the more recent annual revisions at the end of this month and they’re likely to be grim. While the current account deficit has improved from its 5.7% of GDP peak in Q4 last year to about 4.5% this year, combined with persistent fiscal weakness sterling remains acutely vulnerable to any shift in global investor risk perceptions. UK austerity has stalled for the past couple of years despite the political posturing, and government spending has continued to rise in cash terms; it’s up about £100bn since the crisis to over £600bn in the last tax year ending this April.

Tax revenues in the first four months of the 2014/15 tax year are almost 2% below their level in July 2013 in nominal terms; fiscal deficits have improved far faster in the US and Eurozone than in the UK since 2012, despite faster growth in the latter. In the last few months the underlying Public Sector Net Borrowing was higher than at this stage of the last three fiscal years, which is remarkable given the acceleration in growth to 3%. Spending will have to be cut by about 1% of GDP a year through the next parliament to approach a balanced budget by end decade, even assuming a very benign macro backdrop for rates and growth. The Eurozone as a whole and the US are both currently running a budget deficit in line with levels seen in 2004/5  –  Germany expects to balance its budget this year (whether that’s desirable is another matter). The UK in contrast has barely begun getting its fiscal house in order and once the referendum is over, that will become a focus for global investors as we head into the election next year and the EU referendum in 2017. Perhaps it’s not surprising that a record number of one-term MPs are leaving at the next election, because whoever assumes power in the UK will be inheriting a poisoned fiscal chalice. 

UK Economy Reverts To Type…

Like a Christmas pantomime show, the actors might change, but the UK economic script has been painfully predictable in recent decades. The economy has seen productivity collapse versus global peers since 2008, private investment is still 20% below levels five years ago, and yet the consensus which in Q1 feared a ‘triple dip’ recession is now scrambling to upgrade 2014 growth forecasts to 2.5-3%. The delayed impact of the BOE’s liquidity schemes, the controversial government mortgage guarantees as well as a frenzied London housing market creating a ripple effect largely explain the sudden change in fortunes, but even a brief consumer led growth spurt risks highlighting the country’s unresolved structural imbalances.

The UK, which has already seen remarkably sticky cost push inflation since 2008 well above the 2% BOE target, may be the first major economy to make the transition to the excess demand variety of inflation, as domestic credit demand and availability rebounds. Mortgage lending is flat lining in y/y growth terms, but that is distorted by on-going debt reduction by existing mortgage holders –  gross mortgage lending hit a 5-year high of £17.6bn in October, a five-year high and up 9% m/m and 37% y/y; total gross lending looks set to reach £170bn this year. No other major developed country aside from Australia has experienced sustained residential price inflation of the magnitude seen in the UK over the past 20 years, and that boom has been focused on the capital and wider Southeast corner of the UK. London prices have risen 120% in 8 years and roughly quadrupled since the late 1990s; depending on whose data you use, London prices are now 20-25% above their 2008 peak. Prime London real estate has joined the collectibles and bullion hoarded in free ports and bank vaults globally by the super wealthy elite as a tax efficient repository for surplus capital. While on a national level there is no sign of overheating, prime London has attracted global excess liquidity flows, particularly from Asian investors, and is increasingly vulnerable to a reversal if local funding costs or UK capital gains taxes rise (as planned and/or local currencies weaken versus the GBP.   On ONS regional data, several peripheral UK regions are seeing flat to falling prices and prices in the North are still 10% below their 2008 peak. House prices fell 14% from the end of 2008 to the middle of 2009 across the UK but have now returned to their previous peak nationally.

The ratio of household debt to incomes is now projected by the independent Office of Budget Responsibility to rise to 160% by 2018. Households are already running down precautionary savings and revolving credit appetite is picking up, and the OBR expects that trend to continue, one forecast I’d unreservedly agree with. Meantime, corporates are hoarding cash (in the case of banks, by regulatory diktat), and the declining ROE on the FTSE 350 index helps explain its underperformance against developed world peers this year.  Is a current account deficit likely to be in excess of 4% next year GBP positive?  As I’ve noted before, the UK has a lot more in common with India than a taste for curry including very weak corporate investment and productivity trends. At some point, investor perceptions will shift and focus on the structural macro imbalances reflected in sustained twin deficits rather than cheering the high frequency data, with adverse implications for sterling and gilt yields.