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With the large Conservative majority in government, both UK markets and the economy are likely to enter a honeymoon period in the months ahead. While many are focused on Brexit as the main shock that could hit the UK economy, there are at least three other potential shocks that could be as significant.
And crucially they could all materialise in the next five years during the term of the newly elected UK government:
1. Recession shock
Since the 1950s there has been a recession every nine years on average. The last UK recession was in 2008 around the global financial crisis, and we are now entering 2020. So on that metric, we are overdue. Perhaps the UK facing no inflation problem (allowing the Bank of England to keep interest rates very low) has kept a recession at bay. Equally, perhaps the US fiscal stimulus of recent years has prolonged the global business cycle, and the UK has been a beneficiary.
But the odds of a UK recession in the next five years are very high. There is no new large China-sized economy that will emerge like it did in the 2000s. Nor are tech advances having the same economy-wide productivity boosts as they were in the 1990s. At the same time, UK debt levels are high, the UK current account deficit is widening, and unit labour costs are on the rise. All these factors suggest the foundations for a recession are being set. And though the timing is unclear, within the first term of the new UK government looks probable.
2. Market shock
No economies escaped the trauma of the 2008 financial crisis, not even the UK. It was caused by credit-fuelled asset bubbles, notably in real estate. Banks were at the heart of this and, ever since 2008, they have been regulated to ensure such a crisis will not repeat itself. However, crises typically do not follow the script of their predecessors. The next crisis will probably occur just where regulators fail to focus, or worse, because of mistakes regulators make where they have been focused.
The most obvious candidate would be a crisis in the non-bank financial sector. Regulators have constrained bank balance sheets, while asset managers have more freedom. Moreover, private markets – where private equity and leveraged finance live – have exploded. And these have even fewer constraints.
Perhaps the biggest advantage these players have is that they can more easily invest in illiquid assets. And much like banks incorrectly valued their ‘level 3’ assets in the run-up to 2008, private equity and asset managers could be overvaluing their illiquid assets. Their potentially obvious error would be to assume those assets have liquid markets into which they can be sold.
Already in the UK we have seen the Woodford fund and M&G property funds suffer on this score. In the US, we have seen spikes in the repo market as pools of liquidity have been segmented. If these are the early signs, then we could be in for a much larger market liquidity shock. This could have far-reaching consequences for the economy, especially business investment and household wealth.
3. Pension shock
The long-heralded pension crisis is almost upon us.
Twenty years ago in the UK, one in eight people were over the age of 65. Today that number is nearing one in five. Throw in people in their fifties and early sixties, then close to 40% of the population are worrying about their pensions.
What makes matters worse is that people are expected to live well beyond the statutory retirement age of 65. For example, on a cohort-basis, women in the UK are now expected to live to 92 years. That means – at the current age of retirement – potentially 27 years living off their pensions.
The trouble is that current pension schemes will only offer on average 28% of earlier earnings in retirement. This is well below the OECD average of 60% and closer to what is seen in Mexico and Lithuania than France (74%), Germany (52%) or even the US (49%). This is a recipe for social unrest.
But what will trigger a crisis in the coming years is the collapse in bond yields. In the 1990s and 2000s, UK 10-year bond yields (adjusted for inflation) averaged over 4%. As a pension fund, if you compounded this out, funding future retirement benefits was straightforward.
However, in the 2010s, the real yield has collapsed to 0.15%. Worse still, since 2017 the real yield has been negative. Now the compounding accelerates against pension funds.
Of course, many pension funds, especially in the public sector with its crippling defined benefits, have diversified into private equity and other riskier investments. The trouble with these are that their returns are falling too.
If anything, they appear to be converging to those of public equity markets. This begs the question, why is the public sector paying the high fees of private equity to get an illiquid version of public equity returns?
In the end, public sector workers and others will need to increase their contributions to make up for any shortfalls. One of the largest pension schemes in the UK, the Universities Superannuation Scheme (USS), did try to do just that.
However, their request was met by university lecturers and support workers going on strike. This is likely just the beginning. And lest one think this a UK problem – French workers have recently taken to the streets over sweeping pension reforms.
The UK is not only facing the potential of a Brexit-related shock, but there are three other plausible shocks and crises the UK government will face in its five-year term. This will require adept and creative central bank policy – that crucially will have to differ from the post-2008 policies that have led to these coming crisis. Moreover, with the central bank policy toolkit severely constrained, the onus will be on the government to avert or mitigate these. But is it ready to do so?