Markets reacted to the surprising UK election result with relief. Both the currency and the UK stock market rallied at the news. Gilt prices also rose, resulting in a corresponding fall in long-term interest rates.
This makes sense. Fiscal policy under a Conservative government is likely to be tighter, on balance, than under a coalition or Labour-led government. Other things being equal, that would suggest lower interest rates over the medium term, because reduced spending by the public sector ought to give the Bank of England slightly more need to keep rates at record lows.
But over the past few years we have learned that ‘other things’ are not equal. Budget policy is only one factor influencing the Bank of England. In setting policy, the central bank also looks at the broader strength of the UK economy and – just as crucially – growth in the rest of the world. Though the Conservatives hammered home their message of economic recovery throughout the election, in reality there are still enormous uncertainties hanging over the recovery which have not gone away with this surprisingly clear-cut election result.
Three sources of uncertainty should loom especially large for investors.
The first crucial factor is obvious but still too often ignored: the health of the global recovery. Since 2010 George Osborne has learned the hard way that few things are more important to the UK economy and the long-term value of UK assets than the state of global – and especially European – demand. That is especially true for Britain, where more than 70 per cent of UK-listed companies’ earnings come from overseas.
Like the winter snows, economic momentum both here and in the US melted as spring arrived. Gone is the assumption that both economies are rolling inevitably towards an exit from the malaise of years past. Maybe we will bounce back soon, maybe not. On a short-term outlook, I’m optimistic because I think the recent deceleration in the UK should be temporary.
The larger point is that US consumption growth and the rate of domestic demand growth in the eurozone in 2015 and 2016 are likely to have a bigger impact on the prospects for UK companies than the number of Scottish National Party MPs in Westminster – or even the number of Conservative ones.
The second crucial factor hanging over the recovery is productivity growth. UK productivity – output per head – is now around 15 per cent lower than it would have been had it continued to grow at its long-term trend rate of just over 2 per cent a year since the onset of the recession. For years the Bank of England has predicted a rebound, only to be disappointed. In its latest quarterly forecast it cut the medium-term forecast for the 28th time in a row. It is unclear what is driving this supply-side problem, but the very lack of an explanation suggests some caution is in order. One cannot automatically assume it will be reversed.