Sunday, January 04, 2015
Election and the current account will weigh down on sterling
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It would be nice not to have to look ahead into the reminder of 2015 at this point. Barely have we got over thinking about 2014 when another year comes along.

Nor, just a few days in, do we yet have much of a feel for how 2015 is doing. How much better, and potentially much more accurate, this piece might be if I were able to postpone writing it until after the May 7 general election or, even better, until November.

But needs must – it has to be written now - and I mention the election for good reason. There are some general election years which pass without much direct impact on the economy. These, it should be said, are usually the predictable ones.

So the elections of 1983, 1987 (Margaret Thatcher’s second and third victories) , 1997, 2001 and 2005 (Tony Blair’s three wins) all coincided with periods of strong growth and saw no significant post-election slowdowns.

John Major’s surprise April 1992 victory probably gave the economy a boost: it only really started growing after it, while Gordon Brown’s defeat in May 2010 was followed by slower growth as the eurozone crisis and austerity (Labour’s delayed measures and the coalition’s new ones) kicked in. I note, however, that the infamous snow-affected drop in gross domestic product at the end of 2010 has now been revised away by the official statisticians.

That is now water well under the bridge but, as readers often remind me, these downbeat initial estimates for GDP do have a wider effect on confidence. That late 2010 GDP estimate was no exception.

This year’s general election will have an effect, I think. Those effects could be profound if Labour were elected and proves to be as anti-business in practice as some of the party’s rhetoric currently suggests. But the Conservatives also have work to do to demonstrate that deficit reduction can be both fair and effective, and also to convince voters that they are doing the right thing. Voters and markets tend not to fret too much about the deficit as long as it is coming down.

The bigger short-term worry is over the economic impact of political uncertainty. There is a good chance that the outcome of the May election will be inconclusive. There is a possibility that there will have to be a second election within the year, something that has not happened since 1974.

Last September’s Scottish referendum provided a glimpse into the economic impact of political uncertainty. Though cause and effect cannot be conclusively proved, a 1.4% drop in business investment in last year’s third quarter could have been driven by fears of a break-up in the UK.

A more visible effect could be for the pound. Sterling’s fall in the second half of last year, from $1.70-plus to the mid $1.50s was more of a gentle trickle than a rout. But political uncertainty, in combination with a current account deficit running at £27bn a year (6% of GDP) and the prospect of the Federal Reserve hiking interest rates before the Bank of England could put significant pressure on the pound. I am normally wary of joining the pack and predicting dark days for sterling. But I would be surprised not to see it drop decisively below $1.50 over the next few months, though it could rebound after the election, depending on result.

Sterling should rise against the euro, into the 1.30 to 1.35 range I have long predicted, though that may not compensate for its dollar fall.

How will growth survive the politics? The growth numbers were thrown into some disarray by pre-Christmas revisions, as noted last week. It seems likely that 2015 will see slower growth than in 2014, though not by too much. Against the political uncertainty there are positives, including the prospect of real – after-inflation – wage rises. The consensus growth forecast for 2015 is 2.6% and 2.5% is a nice round number.

One of the lessons of last year was not to over-estimate inflation, which dropped to 1% by November and spent the whole of 2014 below the 2% target. Economists expect it to be heading back towards the target by the end of the year – around 1.7% - though this may not have fully factored in the recent weakness of prices, particularly oil prices.

I expect oil prices to fluctuate in a $50-70 a barrel range and, in spite of the risks to sterling, inflation is likely to start the year very weak – quite a bit below 1% - and end it close to 1%. Continued low inflation will, of course, help deliver real wage rises. Forecasters expect nominal wage increases – pay rises in cash terms – of around 2.5% this year. That will provide decent support for consumer spending. Business investment may weaken around the election but the hope has to be that this is temporary.

Does the prospective weakness of inflation mean the Bank of England can stand down on interest rates and leave it another year before adjusting a Bank rate that has been stuck at just 0.5% since March 2009? This is a tough one. There is no question of a big interest rate hike in 2015. The question is whether there will be a small one. Most economists think there will be, with the highest end-year prediction for a 2% rate.

I am torn on this one but think if there is a move it will be a token one, in anticipation of higher inflation to come later. So, just a quarter-point hike in 2015, to 0.75%.

Will the job market continue to perform minor miracles? As we moved towards the end of 2014 there were subtle changes in labour market performance, including what we can hope is the start of a sustained rise in productivity in the third quarter. I doubt we will see employment growth of close to 600,000, as in 2014, though 300,000-400,000 is quite likely. The wider measure of unemployment should drop from 6% to 5.5% while the claimant count, currently 900,000, should come down to 700,000.

That leaves the question of the twin deficits. Even while the budget deficit has been gradually improving – and we should see firmer signs of this when the January tax numbers are published next month – the current account deficit has been getting worse.

At one time I thought that sterling’s 25% depreciation in 2007-9 would bring a big improvement in Britain’s external position. In fact it is getting worse. The current account of the balance of payments was in deficit by £62bn in 2012 and £77bn in 2013. The £27bn deficit in the third quarter of last year puts Britain on track for a £100bn deficit in 2014. The fact that trade is less to blame than a deterioration in investment income does not make it easier to bear. There has to be an improvement in 2015, though perhaps only to a deficit of £70bn, but even that is more in hope than firm expectation.

The one thing one can say with certainty about 2015 is that there will be surprises, not all of them nice ones.