Economic update with Simon French

In this latest video, Hargreave Hale AIM VCT's Lead Manager, Oliver Bedford talks to Simon French, Chief Economist and Head of Research at Panmure Gordon. They discuss:

• The short-term - more constructive - outlook for inflation
• Why economies have been resilient to recession
• Why credit and equity markets are stabilising
• The challenges for the UK’s IPO market.

Read the full transcript below.

The outlook for UK inflation and wage inflation

Oliver: Let’s start by diving straight in and talking about inflation. It remains a dominant theme. A lot's been going on in the last six months.

Simon: It absolutely has, and I think a welcome backdrop for UK investors is the fact that if we'd been having this conversation 12 months ago, UK inflation looked a big outlier to the rest of the world. And right now, actually, it's bang in line with inflation rates around the rest of the world. And I expect over the course of the next few months, it will undershoot those rates that we see in the United States in particular, but also across other major geographies.

What has been driving that? Well, the timing of energy price increases was somewhat delayed in the UK, which meant the peak came later. And that means what we describe as base effects, pushing the year-on-year change lower, are taking place in 2024 when they took place largely across the US and Europe in 2023. And that's really the dynamic. If we step back and look at inflation or price level changes over the last three, four years, they're up just over 20% across all major geographies. And I think that's an acknowledgement of where energy prices have gone, but certainly the short-term picture is really quite constructive for lower inflation and the potential for interest rates in the second half of this year.

Oliver: But we've also had quite a lot of wage inflation. Has that been a factor at all or to what extent has it been a factor?

Simon: It certainly is a factor when you're looking at business-by-business performance, sector-by-sector performance. We've had quite a lot of changes, not just in the last 12 months, but actually over the last arguably 15 to 20 years of progress on low pay. So low pay in the UK economy, the regulated sector, national minimum wage, and more recently the national living wage, has gone from when it was introduced in the late '90s at about £3.60 up to £11.44. And what that has done has meant that the bottom end of the wage distribution has moved up above the rate of inflation, and just in April, that went up 9.8% in the United Kingdom.

But also we're hearing a lot. I'd be interested to hear whether any of the companies you are speaking to have said we've had to also increase wages above that level to keep the differentials in place. And that has meant that wage inflation is still running around the economy about 5.5 to 6%. That's not consistent, at least not long term, with the 2% inflation target. So one of the reasons why despite the fact that, as we've previously discussed, inflation is possibly at a headline rate, going to undershoot the 2%. The Bank of England's not particularly confident that that's sustainable with wage growth still at that kind of elevated level. The reasons outside the regulated low pay sector is also the fact skills gaps are still pretty evident in the UK economy, still struggling to get capacity where we need it in areas like AI, in construction, in haulage. Although the acute wage and capacity or the skills and capacity gaps that existed post-pandemic have started to alleviate, there's still a structural problem there.

Oliver: Certainly we are seeing comments from companies perhaps in, say, food and beverage or leisure where they're more exposed to minimum wage, and that's gone up meaningfully quite recently, putting pressure on their profit margins. We might come back to the issue, I guess, of wage inflation and what that means for consumers as well later on.

Why economies have been resilient to recession

Oliver: There's been a lot of talk about recession in the UK but also in the US. The governor of the Bank of England forecast at 2023 would include quite a sharp recession. It didn't turn out to be that way. So market commentators and forecasters, many of them have got that wrong. The US trading market has been forecasting, as we know, recession for a long time and that also hasn't panned out. So why have economies been so resilient so far?

Simon: Well, you kindly said in the introduction, I've spoken to the VCT audience on a number of occasions, so you can pull the tapes if you like and see that we took a view, a more constructive view, on the economic outlook, particularly for the UK, for Europe and the US, than consensus. And you're right, the consensus saw quite a significant, prolonged recession.

The reason we saw things slightly differently, and I think it's aged not perfectly, but perhaps better than consensus, is that household balance sheets, so the amount of cash that they have and the amount of debt they have, are actually pretty strong by historical standards. Actually, UK households have £1.8trn worth of debt, big number, but they also have £1.8trn worth of cash in cash ISAs, time deposit accounts, or side deposit accounts. So they are, in corporate language, net debt neutral. And that is a much better position than households were, let's say, 15 years ago at the onset of the global financial crisis when they were £700bn in a net debt position.

So there has been a gradual deleveraging of the UK household sector, and that meant that in the last couple of years where we've hit these extraordinary price shocks through the energy route, also through the food route, households have had some resilience in their balance sheets to be able to lean in against that, to smooth their consumption by drawing down on some of the excess savings that some households, not all households, but some households made during the pandemic, and has allowed the economy to withstand those near-term pressures rather better than many had feared.

Oliver: And I guess there's been a bit of discussion about household saving rates in the UK and where they might trend, and that plays into this theme about consumer spending, and maybe also to consumer confidence as well, which we'll touch upon later on. Obviously in the UK, we had a shallow recession the back end of 2023.

Simon: Yes.

Oliver: And then quite quickly, we got data coming through from things like the PMI showing that the services sector was strong and resilient, that manufacturing construction were improving but still in contraction. So how do we think about or how do you think about the outlook for this year? We're going to get a GDP print relatively soon, which will confirm whether or not the UK emerged from recession in the first part of 2024.

Simon: Yeah. So look, we're making this recording ahead of our print, so you're perhaps setting me up for a fall, but that’s okay. We economists, we put ourselves out there with our forecasts. Look, I think you're absolutely right. The second half of 2023 was a shallow recession. All the indicators suggest that there's a rebound in the first quarter of the year. But again, GDP data, when it gets released, is somewhat in the rearview mirror and therefore investors will rightly be interested in what happens through the rest of the year. And I think this is where you come back to real income growth. If last year was about balance sheets, which I referenced in my previous answer this year, this year is about P&L, the profit and loss account of households. And with nominal incomes, so in cash terms, the average household income going up about 5 to 5.5% this year, and inflation averaging across the year somewhere between 3 and 3.5%, that's a 2% real terms increase in the spending power of households.

So that's one of the reasons why I think the outlook for the rest of 2024 is pretty constructive actually.
We also have what has worried a lot of economists, the refinancing cycle of UK mortgage debts, a £1.5trn mortgage product pool which has had to be refinanced from an average interest rate of almost less than 2% back at the end of 2021 to currently about 3.6%. And it's expected to keep rising, but we've probably been through the peak of the number of short-term two-year deals that have had to be refinanced at much higher rates. And although I think perhaps we're coming on to talk about what the bond yields mean for overall debt interest rates, actually the most acute pain that we've seen in UK housing is probably in the rearview mirror. We had data out this morning showing from the Halifax prices up north 0.1% month-on-month. Okay, nothing to celebrate, but given the potential scale of declines more widely feared, actually housing has proved remarkably resilient.
 
Oliver: Yeah, we had a meeting with the chief executive of Property Franchise Group last week, which following their results and in their outlook statement, they reported the first quarter being ahead of expectations of both revenues and profits, so perhaps the market will start to stabilise and move forward from here.

Why credit and equity markets are stabilising

Oliver: The US 10-year treasury yields perhaps seems a strange reference point for a venture capital fund, but it's been so instrumental in markets but also in the cost of capital more broadly speaking. That's been nudging up again. Last year, it touched these levels in March, and that was accompanied by a regional banking crisis. It then pushed through these levels in the autumn and brought with that a significant period of volatility in equity markets before various important people in the US made statements which restored calm and borrowing costs fell. It's picked up again more recently and back, as I say, at levels which has been a previous source of concern, but credit markets seem much more relaxed right now. Equity markets seem better. And the financial conditions index shows that policy generally speaking stays quite loose. So why is it different now?

Simon: I think it's largely that at the back end of 2023, there were widespread concerns about the slowdown in economic growth around the world, not least in China, but also fears of a hard landing in the United States, and recessions, deeper recessions, in Europe. I think this year, one of the reasons we've seen, you mentioned the 10-year treasury, the yield on that, it's a key benchmark for all global financial markets. That's pushed up largely on upgrades to growth. You mentioned PMI - purchasing managers' indices. They're all... I think eurozone right on the cusp of 50. Anything above 50 is growth. All the other major economies are comfortably ahead of 50. It's interesting, the much maligned UK economy is the top of the leaderboard, 54.1. That doesn't get much coverage, but it's worth noting.

It's the fact that actually the reason why central banks have not followed through with an expectation at the start of the year by some, has to be said, for five, six rate cuts, is that actually the data got better. And I think that's in contrast to last year where the expectation for rate cuts and then the impact on treasury yields was much more on concerns of a hard landing. And so I think a different diagnosis, and that's why equity markets’ risky assets have proved slightly more relaxed thus far, are on the ramp up in that key benchmark yield.

UK consumer confidence

Oliver: UK consumer confidence has, as we mentioned, is I suppose in part a function of household savings and function of real wage growth and employment markets. Back in October 2022, it was at historic lows to a deeply painful experience for many companies selling into that area. It's been trending ever higher since then. Still -19, not a great number, but a lot better than it has been. There was a little setback in the early part of this year when we learned about the recession late 2023, but it started to trend higher again. So how does that play into the outlook for companies who are reliant upon consumers? And we talked a bit about this before about consumer spending being focused on different areas, services, on white goods or technology or on travel, and demand has switched between the different categories over time.

Simon: Yes. So what's interesting about the consumer confidence data, you mentioned -19, that's the GFK measure. It's composed of three elements, and your personal financial situation is one element. Your view on the economic outlook is another one. And then your appetite for big-ticket purchases is a third element. And it is our third element that is perhaps the missing part of the jigsaw for the UK consumer. Actually, if you ask them about the economic outlook, they acknowledge that things are getting better. If you ask them about their personal financial situation, it's almost back at its long-term average. So a sense that perhaps their cost of living squeeze, if not for everybody, for a large number of people, is again in the rearview mirror. It is that third point which in previous cycles of consumer confidence you see as a lagging measure. It's when you feel sufficiently confident that it's not just the small or medium-sized ticket item that you feel comfortable purchasing, the coffee, the gym membership, the annual holiday, but the big-ticket item, the home improvement, the second-hand or indeed a new car purchase, that's the bit that lags.

And therefore I think we have decent visibility, as we said before, about real income growth. We know the balance sheets are in decent shape, but that needs to broaden and that needs to extend in duration before households feel sufficiently confident to, if you like, put that last piece in play for consumer confidence to push up towards its long-term average, which paradoxically isn't zero. It's about -7. We haven't got too far to go. You mentioned October 2022 in the aftermath of the mini budget and Liz Truss's premiership, that was a historic low point. And to retrench from there was encouraging for consumer discretionary spending, which you're absolutely right to be looking at because it tracks it very, very closely over time, as do share prices by the way. But going forward through 2024 into 2025, I think the longer this recovery in real income goes on, actually it starts to become a bit more self-fulfilling in terms of the other categories of spend that benefit from this.

UK equity markets and the UK IPO market

Oliver: Perhaps just moving on then to the UK equity markets. Well, firstly, it's very fashionable to talk them down at the moment, which is a shame. But there's no doubt that perhaps the most depressing feature of not just this last few months but more broadly speaking has been the complete lack of IPO activity. Is this a cyclical issue? We know that active managers are dealing with fund outflows and that makes it very difficult for them to support IPOs and the advisory network is aware of that. We know also that with markets low and valuations low, that for vendors of company stock, that's a fact they will want to take into account. So that always makes a very difficult environment and situation needs to improve. But then also there's been talk about structural weakness. To what extent do you think this is cyclical? Is there a structural gap that needs to be addressed through policy interventions? How do we get the UK IPO market back running again, and do you see this improving anytime soon?

Simon: Well, there's a lot in that question. The first thing to say, both. It's both cyclical and structural. Cyclical because if you look at IPOs that took place around the world in 2021 when there was a big surge of IPOs after the world economy started to open up again after the COVID-19 pandemic, the underperformance of those IPO cohorts in the United States, which by the way have done worse than the UK 2021 cohort in Europe and in the UK, that has, if you like, scarred memories for investors who are worried that the last to market is the first thing the portfolio managers sell in the event of a change in the economic backdrop, which obviously took place in 2022. So that element is cyclical. Why it's potentially most acute in the UK is there is overlaid with some structural problems here, which have been, and I've written a lot about this, the structural changes of how the UK pensions industry allocates to its home market has been very virtuous.

If you go to do any finance course, any basic economics, removing the home bias, so a bias towards your home market, is, if you like, finance 101. So UK portfolio managers, and I think we heard last week from Coutts who are moving their allocation to UK equities from 35 to 40% down to the global benchmark of low single digits. That's all very fine and well if the rest of the world is doing it. Unfortunately, the UK has been doing something structurally which looks a bit like unilateral nuclear disarmament or unilateral free trade. Again, we'd love nuclear weapons not to exist. We'd love to have tariff and non-tariff barrier free trade around the world, but it requires everybody to play that game. And the reality is when you look, and I've worked a lot with policymakers on this, it's the Canadian equity market, the Australian equity market, the US, Japanese, Italian, French, they retain a strong home bias, which gives them a natural buyer of equity that underpins valuations.

And obviously to your point on IPOs, initial public offerings, there is a core buyer for equity that underpins valuations and incentivise private companies to make that next journey in terms of their capital stack towards getting public equity into the mix. Do I sense, being a bit negative in terms of the cyclical and structural, that we are close to that inflexion point where policymakers have acknowledged the problem and are starting to do things about it? Yes, I do. I think we, and I say we because I think there are others in both the buy side and the sell side getting into this debate. I give a lot of credit to Charles Hall at Peel Hunt, my contemporary as head of research who's got into that debate. I like to think I've also been pretty vocal in that debate. I think policymakers on both sides of the political aisle are listening.

We saw Mansion House reforms last July. I understand the Chancellor is speaking again this July about Mansion House one year on with more to come in terms of what we would describe as the demand side stimulus to equity markets. The crucial line for capital markets in the March budget this year was when the Chancellor said that he wants all pension funds to report their ownership of UK assets going forward. Does that roll the pitch for potentially de minimis allocation as a quid pro quo for getting tax relief, UK tax relief, UK taxpayers providing tax relief? I think that's a journey, an ideological journey that if this government doesn't do it, I'm pretty confident an incoming government in what I think is going to be an autumn election, there you go, another prediction, that will happen and that will be really very material for that natural buyer of UK equity that starts to close that long-dated valuation gap.

The outlook for UK interest rates

Oliver: My final question is to what extent do you think then that the interest rate cycle and when it turns might be a factor in that. Are we right or wrong to think that as interest rates start to fall in UK and elsewhere, that that might be supportive too to equity markets?

Simon: I think of the margin, yes, because certainly at the mid to small cap end of the spectrum, that appetite for risk in a falling rate environment is something we can see very clearly in previous cycles, which I would expect to operate again. But also, it's your, and I don't need to tell a fund manager this, your competitor for capital. If the risk-free rate is going down, your hurdle rate for attracting investment also goes down. So there is a support, and largely speaking towards the mid and small cap end, the distributions, the evidence are a little less rich. Not universally the case, but across the complexities. So I think that is right.

But I would come back to the point you very eloquently said about confidence here. It's not just about arithmetically reduced borrowing costs. It's also by the sense that economically, things are getting better. And strategically in terms of the health of capital markets, we have policymakers who are doing things about it and acknowledging that it is a really crucial part of getting growth back into the economy. There's jokes galore about economists. You get two economists in the room, you get three different opinions. All economists would agree that getting growth back into the economy is crucial if you want to afford the NHS, you want to afford education, you want to afford defence spending of the types we want over the coming decades. A healthy capital market that actually provides a hurdle rate or a cost of capital environment that encourages people to go out and innovate, be productive, that is a key part of any industrial strategy. So I think getting that in place then starts to generate the liquidity and the performance that investors are really desperate, I think, to crowd into, but they need to see that initial stimulus.

Oliver: It won't surprise you to hear from me as someone managing a venture capital fund that we believe the UK's just as capable as innovating as anywhere else and continues to do so. It's just I suppose at the moment that that narrative isn't finding its way into the public domain so much. It's being crowded up by other issues. And we need to resurface that growth opportunity. And if we can deal with that and if we can deal with the flow dynamic, then hopefully we can move forward onto better times.

Simon: Yeah.

Oliver: Well, we're well out of time, so thank you so much, Simon. As always, it's been an absolute pleasure to talk to you and thank you again for your support.

Simon: My pleasure, Oliver.

Oliver: Thank you.

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