How serious is the UK’s twin deficit problem?

Another month, another negative note from Société Générale chief global strategist Albert Edwards.

This time the UK was the perma-bear’s target, as he compared the economy to a ‘ticking time bomb’ that is set to explode after the general election. The current coalition government will end five years in power with ‘grotesquely wide deficits still in place in both public sector finances and external imbalances’, was his stark warning.

Edwards points out that the UK’s ‘twin deficit’ – at over 10% of GDP – is far worse than other nations’ following the financial crisis. By comparison, Japan’s twin deficit stands at 8%, the US’s at 5% and the eurozone’s at close to zero.

‘The government has quietly abandoned all pretence at fiscal cuts, kicking the can into the next parliament,’ the strategist noted.

Edwards is particularly concerned about the current account deficit, which stood at 5.5% of GDP in 2014. This represented the largest annual deficit as a percentage of GDP at current market prices since annual records began in 1948.

So, should investors take heed of Edwards’ concerns? And if so, does it mean that whichever party or coalition takes over faces an impossible task when it comes to balancing the books?

The current account deficit is of particular concern for Bill O’Neill of UBS Wealth Management because of the potential impact on currency and domestic demand.

‘The key question that should be on the lips of investors is whether the UK is facing another balance of payments crisis,’ he said.

Historically, this has happened when the UK imports more goods than it exports and does not have the means to do so. Overseas investors can ultimately lose patience and withdraw funding, causing the currency to weaken significantly.

Nevertheless, he points out that the potential for a serious problem does not lie with the UK’s trade position at -2% of GDP, but rather the primary income account, which was running a £12.6 billion in deficit in 2014. This was down to a significantly lower net investment income component of the current account due to poor returns on fixed direct investment abroad.

Retaining foreign investor confidence

Although O’Neill believes stronger growth in foreign markets should improve this aspect in the future, he said: ‘While a full-blown crisis is unlikely, investors need to tread carefully. The UK depends on overseas investors to fund the current account deficit and this will continue until the economic cycle reverses.

‘Such investors should remain happy to continue funding the UK’s balance of payments, but if there are any shocks to the economy, this source of funding could evaporate.’

Richard Jeffrey, Cazenove’s chief investment officer, expects fears concerning the twin deficit problem will prove overdone. He highlights the frequent revisions that are made to current account numbers and suggests the deficit figure could be revised down in the future. He also anticipates a pick-up in investment income. Although the trade imbalance is an issue, he points out that sterling has so far lost value due to dollar strength rather than the deficit itself.

The budget deficit has not fallen as fast as many expected, partly because income growth has been low and so therefore, the tax take. But Jeffrey is encouraged by signs of wage growth. Over the next 12-18 months he expects to see revenue growth potentially exceeding expectations.

‘It might be that the budget deficit begins to improve more quickly than the government anticipated. At the moment things still look difficult. There is a fine line for whoever forms the next government,’ he said.

‘We have certainly got to be vigilant on expenditure and the key is to improve the efficiency of spending within government.’

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Wednesday, April 29th, 2015 EN

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