Too many variables

Kerry Craig

The UK economy has seen decent growth over the past year and this is expected to continue in 2015. However, investors’ attention is firmly focused on the outcome of May’s general election. But while volatility in UK assets is likely to increase, the relationship between politics, economics and markets is not always so clear cut.

The 2010 general election resulted in a hung parliament and markets seemed less than bothered at the time. Things may be slightly different this time around as a number of polls point towards the most uncertain election in recent memory. What is more, a two-party coalition is looking increasing unlikely, and a multi-party result would almost certainly be a less stable outcome.

However, the economy continues to show its strengths.The unemployment rate has fallen to 5.7 per cent, with 103,000 new jobs added in the three months to December – double the expected number. Wage growth also continues to improve, with a 2.1 per cent increase compared to a year ago – a marked improvement on the 1.7 per cent average wage growth over the past five years. Furthermore, when factoring in the weak level of inflation, real wages are on the rise and contribute to the overall picture of a sturdier consumer base.

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So, with all this good news, why is the market ruling out any action by the Bank of England this year? The low inflation caused by the decline in oil prices is one reason. The two members of the monetary policy committee who had been voting to increase rates changed their stance near the end of last year. Meanwhile, the statement accompanying the February Quarterly Inflation Report contained a surprise as BoE governor Mark Carney said rates could go up as well as down from their current levels if there was any deterioration in the economy.

Then there is what is happening on the other side of the channel. The outlook for the eurozone will be a factor in the BoE’s plans. The eurozone accounts for 40 per cent of UK exports, meaning the health of the single currency bloc has important implications for the economy.

The risk of a rate cut by the BoE should be low thanks to a likely increase in inflation over the second half of the year as the impact of the lower energy prices starts to wash out, and the fact that core levels of inflation (excluding energy and food) have been steady for the past few months. In fact, core inflation actually rose in January, illustrating just how much of the headline decline is being driven by supermarket pricing wars and the fall in the oil price. Furthermore, economic momentum is starting to build in the eurozone, with a stream of improving economic data and a strong chance that Greece will manage to avoid getting itself kicked out of the single currency club.

The one area in which the election outcome may influence the BoE’s outlook for rates would arise from any new government’s attitude towards fiscal consolidation and the possible drag is could create on economic growth. Both the Conservative and Labour parties intend to continue with some level of austerity. However, Labour is more likely to stick to the current level, while the Conservatives’ plan would see fiscal consolidation increase. In addition, there is the issue of a UK referendum on European Union membership if the Conservative party is re-elected, creating uncertainty in the lead-up to it. A ‘no’ vote could lead to a lengthy period of negotiations between the EU and the UK on accessing the single market and any financial regulatory changes, adding to uncertainty regarding the UK’s position.