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A PUBLICATION FROM REDMAYNE BENTLEY

SUMMER 2022

HARD TIMES BRITAIN AND THE ECONOMY

BORIS AND THE MARKETS What Effect Did The PM’s Resignation Have?

PERSIMMON Is There Light At The End Of The Tunnel?

BRITAIN’S ECONOMIC HEADACHE The Wrong Kind Of Economic Exceptionalism

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CONTENTS HARD TIMES

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BORIS AND THE MARKETS

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What effect did the PM’s resignation have?

PERSIMMON

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Is there light at the end of the tunnel?

BRITAIN’S ECONOMIC HEADACHE

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The wrong kind of economic exceptionalism

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“Inflation is the key concern, main caused by supply side issues, so it is t inflation, namely ‘cost push in

nly as it is being the worst kind of nflation’.”

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HARD TIMES JAMES S. ANDREWS | PARTNER & DIRECTOR OF INVESTMENT MANAGEMENT

The UK finds itself in a precarious position. Leaderless (at the time of writing), with inflation (CPIH) running away at 9.4% to the 12 months to June 2022, seeing interest rates rise and facing up to slowing growth.

Inflation is the key concern, mainly as it is being caused by supply-side issues, so it is the worst kind of inflation, namely ‘cost-push inflation’. The key contributors being rising energy prices, grocery prices and disruption from supply chains due to both the COVID pandemic and the ongoing effects of Brexit.

The top 100 stocks listed in the UK had until recently performed well on the back of a large exposure to Oil & Gas companies as well as other commodities via mining companies. However, we are now seeing a pull back here too as the increasing possibility of a recession is factored in.

Interest rates are now 1.25% which is up from just 0.1% back in December as the Bank of England (BoE), along with other central banks around the world, look to curb inflation. In fact they could go as high as 2% over the next 12

months as the BoE attempts to bring inflation back to the target of 2%.

For the consumer the bad news looks set to continue as, in addition to rising borrowing costs thanks to the increase in interest rates, the energy price cap is set to rise again in October; that price rise looks to be as high as 65% which does not bode well for UK retailers.

A tough economic period for the UK looks set and so it will be incumbent on the new Prime Minister to look to act and offset some of this pain. A UK election within two years should help focus minds on improving the situation, and on the positive side the markets will start to look past the near-term pain quickly if they see inflation coming under control.

It is fair to say that the next six months are likely to be turbulent whichever way you look.

“A tough economic period for the UK looks set and so it will incumbent on the new Prime Minister to look to act and offset some of this pain.”

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BORIS AND THE MARKETS WHAT EFFECT DID THE PM’S RESIGNATION HAVE? BEN STANIFORTH | RESEARCH ANALYST

Leadership pressure on Boris Johnson is nothing new. Even before the June vote of no-confidence, the former Mayor of London had been reeling from alleged COVID-19 mismanagement and multiple scandals that eventually led to his position being challenged.

A rebellion had been slowly bubbling underneath the surface of the Conservative party as resentment grew over spiraling inflation and what many Tories saw as more liberal macroeconomic policies.

The no-confidence vote required over 50% of MPs to vote in favour of retaining Boris and this was achieved with a 59% share of the vote, although it was both much lower than

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expected and also lower than Theresa May in 2018 who achieved 63%. It was fairly obvious that Johnson would face a wall of scrutiny from his peers, but the extent to which they rebelled against him was unexpected. The groundwork had, therefore, been set for further pressure in the coming weeks, unless he could win over his key cabinet members.

This created a sense of unease after the vote and certainly contributed to a lack of momentum across government as civil servants started to revolt. Less than a month later, Secretary of State for Health and Social Care Sajid Javid announced his resignation, starting a domino effect amongst both high ranking and junior members of government. One of Johnson’s

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closest allies initially, Chancellor Rishi Sunak also resigned just nine minutes after Javid in a move that is unlikely to have been a coincidence, with the number mounting to a staggering 53 names over just two days.

Over the course of these two days, the Pound fell reasonably heavily against the Dollar, down -1.22% on the Tuesday and -0.23% on the Wednesday, before rising +0.76% on the day of Boris Johnson’s resignation announcement. This initially caused a rise in the Cboe UK 100 index (the largest 100 companies listed in the UK) which rose 2.5% from the Tuesday to the Thursday. While this may seem odd, there are a number of reasons why this was the case. Given that approximately 75% of Cboe UK 100 revenues are generated from overseas, a weaker Pound means that they are able to exchange fewer of the overseas currency to gain £1 than they had to before, resulting in a larger number of Pounds overall and increasing revenues. There is likely to be further speculation for tax cuts also priced into the rise in the index as the incoming Prime Minister, whoever they may be, looks to implement a more conservative approach to fiscal policy, which is likely to come in the form of tax cuts.

The 11 or so candidates for the top job in government have now been whittled down to two – ex-Chancellor Rishi Sunak and Foreign Secretary Liz Truss. While the original cohort of candidates agreed that tax and spending cuts were the way forward for the UK, they continually locked horns along the campaign trail over the degree to the extent and timing of such cuts. The most aggressive of pledges originally came from the newly-appointed Chancellor, Nadhim Zahawi, who positioned himself as an ultra-low tax, low-spending candidate. Zahawi pledged to cut income tax 2p by 2024, while also suspending all VAT and green levies on energy bills for two years and promising to block the scheduled increase in corporation tax. This was to be funded by a 20% cut to every government department’s costs, which would likely have

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come from a combination of staffing layoffs and departmental spending curtails.

Rishi Sunak, on the other hand, favours a far less aggressive fiscal stance, ruling out immediate tax cuts and instead opting for a strategy to stamp out inflation before focusing on tax cuts, which he views as potentially inflationary. The former Chancellor has hit back at his lower-tax rivals, accusing them of telling “fairy tales” in order to win the vote at a time when the UK public purse is as stretched as it’s ever been.

Whoever is elected, the key long-term objective is likely to focus on lower taxes. This is expected to provide a boost to companies and, by association, markets; however, the impact on governmental departments is likely to be reasonably high, potentially causing more strain on already strained resources.

The new leader will also likely need to focus on restoring both credibility and stability to the Conservative party which may entail repairing relationships with the EU and resuming UKUS trade talks amongst others, all to help improve the Tories’ reputation, which, based on opinion polls, stands at nearly a three-year low of 31%.

Given that Boris’ popularity had started to plummet, dragging down the popularity of the party as a whole, the new Prime Minister, whoever they may be, is likely to boost Conservative chances of winning the next election, at least somewhat - the traditional anti-inflationary fiscal policies typically favoured by the Tories may help tame the ever-increasing inflation, which, coupled with potential tax cuts, may lure voters their way again. Labour will, however, be chomping at the bit to attack the incumbent Conservatives and it certainly has plenty of fire power to do so. A smooth transition, then, is key for the new Prime Minister and with voters now largely disenfranchised with Boris, they will, in all likelihood, aim to set their own agenda and implement their own favoured policies.

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PERSIMMON IS THERE LIGHT AT THE END OF THE TUNNEL? OSCAR SHEEHAN | INVESTMENT EXECUTIVE Housing has been far from immune from the political turmoil that has permeated British culture as of late.

We have seen six Ministers of State for Housing over the past five years, and it remains unclear if Boris Johnson’s plans to boost home ownership will survive the current Conservative party leadership election in which fiscal policy has taken centre stage. Against this backdrop, home builders have had a tricky year. In the year to date, Persimmon’s share price is down almost 39% and

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revised forecasts seem to place its dividend in murky, and potentially unsustainable, waters. With the government’s Help-to-Buy scheme ending in March 2023 and the threat of a recession looming large over the country, it is not unreasonable to ask if there is light at the end of the tunnel.

Fortunately for builders such as Persimmon, one thing that is in no danger of changing is Britain’s chronic shortage of housing.

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House prices have more than trebled since the year 2000 and the Conservative government’s pledge to build 300,000 new homes a year in 2019 shows no sign of reversing this trend. For as long as Persimmon has been able to bring homes to the market, demand has been there. In 2021 it completed on roughly one thousand more homes than in 2020 and generated an additional £300m of revenue. A combination of never-ending demand and spiralling price rises have served the company well. Persimmon’s sales rate has risen 1% this year, indicating that demand hasn’t subsided following the post-pandemic rush.

The company’s management remain confident the strength of sales prices will more than offset the expected 10% inflation in build costs that the company has seen so far this year.

All in all, it’s a mixed bag for Persimmon. Demand remains high and does not currently appear to be collapsing, the housing market may have more in-built protections than the last time it faced a deep recession, and the company does have around £780m net in cash.

However, do not let these figures fool you - the immediate future is far from rosy for the housing sector. The cost-ofliving crisis is eating into household budgets and inflation, which already at a 40-year high, faces further pressure from a tightening labour market.

Persimmon has reduced its volume growth target from 4% to 6% to 0-3% following planning restrictions and increasing operational friction. Analysts predict this, combined with tightening operating margins, means profit forecasts could drop anywhere from 2% to 5%. The slowdown in the housing market now seems inevitable when you consider this as well as the fact that, on average, house prices are now around 7.1 times household income.

An additional concern for the predicted drop in revenue is Persimmon’s dividend. Currently in 2022 it is forecast to pay out over 95% of its total revenue to shareholders. This spread has been tightening since 2016 when the company only paid out 61% of its revenue. If profits fall further than predicted, the sustainability of this dividend must be called into question, especially when we consider that the government’s Help-to-Buy scheme is coming to an end in March 2023. Policies such as this have kept demand artificially high by providing access to the housing market to people who otherwise would be financially locked out of it. While it would be unfair to characterise the loss of this revenue stream as cataclysmic for the builder, it does make the company’s lack of free cash flow concerning and could cause it some short-term financial harm. On top of this, it is unclear what form housing policy will take after the current Conservative leadership election has concluded. It has not been a central pillar

of the race and it would be unsurprising if the newly appointed leader wanted to distance themselves from their predecessor’s policies. Such uncertainty leaves companies such as Persimmon in a difficult place as it makes planning for the future more challenging.

The ever-increasing probability of a recession in the United Kingdom also hangs over the company. There is little doubt that an economic slowdown would affect demand in the sector, yet there are reasons to be optimistic about the housing market’s overall resilience. The market is in a better situation now than it was before the 2008 crisis when many homeowners were forced into negative equity. Today, only a small fraction of mortgages have a loan to value ratio of 90% or more, compared to more than 10% in 2007 and almost all lenders now require proof of income.

These measures reduce the odds that over-stretched borrowers will be caught out by rising interest rates.

For Persimmon in particular, however, a largerthan-anticipated drop in demand could threaten the company’s dividend payments and the health of its balance sheet over the short-to-medium-term. This would undoubtably have a knock-on effect on the company’s share price. However, demand would likely return to normal as inflation eases and the economy

gets back on its feet, making the long-term impacts on the company less severe.

All in all, it’s a mixed bag for Persimmon. Demand remains high and does not currently appear to be collapsing, the housing market may have more in-built protections than the last time it faced a deep recession, and the company does have around £780m net in cash. However, the lack of free cash flow and high dividend payments do give cause for concern in the short term given the predicted drop in revenue. Government policy will also play a large role in determining the company’s future as it remains unclear what, if anything, will replace schemes such as Help-to-Buy which have supported the housing market in recent years. Whether or not such concerns justify the near 40% decline in the company’s share price is difficult to say and, if we take a long-term view, the company is not in terrible position. However, with the looming risk of recession the short-term future is far from certain for both Persimmon and the wider industry, and markets do not react well to uncertainty.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned.

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BRITAIN’S ECONOMIC HEADACHE THE WRONG KIND OF ECONOMIC EXCEPTIONALISM BEN PICKETT | INVESTMENT RESEARCH

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Meanwhile, LinkedIn reported that the average number of applications per job posting has fallen by 72% in the year to May 2022. As companies struggle to find suitable candidates, they face three choices: slacken their standards, with less productive employees increasing business costs; increase pay or non-monetary incentives, increasing business costs; or don’t hire and limit output in the face of rising demand. It is likely that businesses will pass on at least some cost increases to consumers, while supply not increasing to meet rising demand allows businesses to raise prices, both of which cause inflation.

It is essential, then, to understand why the labour market is so tight. The pandemic saw many older people leave the workforce who have not returned. The number of people who are economically inactive simply because they don’t want a job has risen by nearly 600,000. Given the large fall in the employment of older people, this may account for a change in lifestyle choices, with the ability to draw on private pensions, or take their tax-free lump sum from 55, supporting this decision. This may have been a reflection of soaring asset prices over the pandemic giving older people the confidence to retire, but as these continue to fall, and prices continue to rise, these people may be forced back into work, or come back if the price is right. An ONS survey found that about half of over-50s who have not returned to work would consider doing so for the money, while flexible working was considered important to two in five of the 50–64-year-olds who would consider working.

Quantitative easing (QE), which ended in December 2021, is when the central bank creates money and uses it to purchase assets, primarily UK government debt (which lowers the cost of debt), injecting cash into the financial system which then flows into the real economy. This will not help the inflation picture, as it increases the amount of money in circulation and, if more money is chasing the same number of goods, prices must rise to determine who will be able to purchase them.

Of all the things pervasive in British culture, a sense of exceptionalism to the rest of the world is one of the most enduring. As the inhabitants of the proud birthplace of the industrial revolution and a global hub of financial services, Britons often see their economy as a global leader, with historical roots to justify that claim. While the UK may be the world’s sixth largest economy, its economic outlook is increasingly dire, with the IMF forecasting its growth to be the lowest in the G7, and the OECD predicting UK growth to outperform only Russia in the G20 in 2023. Why then is the UK so exceptional?

As any corporate headhunter can attest, the UK labour market is red hot; the number of vacancies has reached a record 1.3m. Figures from Indeed show a 72% increase in postings within the food-preparation and service sector since February 2020, and a doubling in positions at warehouses.

But what if not much more money is chasing the same number of goods? The policy uses financial markets as a transmission mechanism, increasing asset prices, which has been associated with higher inequality. Usually, their participants are wealthier individuals and institutions who spend little of the additional money that they earn, because they do not need to, and instead reinvest the proceeds to compound wealth faster. This means very little trickles down into the real economy unless the government takes advantage of its artificially low cost of debt to borrow and spend more, which it did through pandemic support schemes, though the effect on asset prices was self-evident. Meanwhile, high inequality can have negative long-term consequences by reducing growth – as a lot of money rests in the hands of those who will not spend or use it productively – and productivity, by making birth an ever more important marker for success than merit.

High public spending on a plethora of pandemic support schemes and COVID-19 response measures amid a period

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104.00 102.00

Employment rateYEAR 55-64 year olds EMPLOYMENT RATE 55-64 OLDS

100.00 98.00 96.00 94.00 92.00 90.00 88.00

2019-Q4 2020-Q1 2020-Q2 2020-Q3 2020-Q4 2021-Q1 2021-Q2 2021-Q3 2021-Q4 2022-Q1

UK

USA

OECD

France

Germany

Italy

Japan

Source: https://data.oecd.org/emp/employment-rate-by-age-group.htm

The UK 55-64 year old employment rate is below pre-pandemic levels and lags the OECD (100 = Q4 2019) of lower tax revenues has caused public debt as a proportion of GDP to reach 95.8%, though the UK is not unique in this. Recently, rock-bottom interest rates and inflation have meant debt has been essentially free, but as central banks increase rates to fight the inflationary fire, and investors’ expectations of inflation rise, this looks set to change.

Estimates from the OBR, a fiscal watchdog, suggest that, for every 1% increase in gilt rates, debt interest spending as a proportion of GDP grows by more than 0.3%, and for every 1% increase in short rates, this figure is 0.45%. Given that a quarter of the UK government’s debt is linked to inflation, and, due to QE, its debt half-life, or the length of time it takes for half of the government’s debt to be refinanced at prevailing interest rates, is two years, debt servicing looks ready to become much more costly. Whether the next Tory leader is a fiscal conservative or not will decide if this results in lower spending and higher taxes or borrowing to meet debt-servicing payments. Regardless of its cost, borrowing causes inter-generational inequality by forcing the generations of tomorrow to sacrifice spending to pay for the spending of those today.

A key element of Britain’s growth problem is its sluggish productivity growth. Productivity growth measures the ability of an economy to produce more for less and underpins its ability to sustainably raise the living standards of the people within it. Productivity growth was healthy in the UK before the Global Financial Crisis (GFC) but never recovered to trend after, and GDP growth in the decade before it stood at 2.7% per annum. Now, the OBR projects a rate of 1.7% to be the norm.

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The reasons for this are many. Uncertainty over Brexit depressed business investment by as much as 11%, which has weighed on productivity growth, while high barriers to trade have reduced the efficiency of cross-border supply chains. Forecasts by the OBR predict that productivity will be 4% lower than it otherwise would have been because of Brexit, not to mention the importance of migrant workers to the logistics sector, which supports the productivity of all the industries it services. This is not to say all was perfect before 2016 – the USA, France, and Germany all have had higher investment and R&D spending as a share of GDP for the past 30 years – but the project is one nail in a coffin filled with them. Restrictive planning laws supress the expansion of innovation hubs like Oxford and Cambridge, while the same planning laws, and homeowners protecting the value of their homes, keep urban density low, which reduces the effectiveness of public transport and productivity growth.

To give meaning to the numbers, had productivity growth not fallen since the GFC, GDP per person would have been £6,700 higher in 2019. The slowdown in productivity growth in financial services and insurance account for as much as a third of the economy wide drop between 2007 and 2019, though it could be argued that the 2000s’ figures were inflated by untrammelled risk taking which has been reined in by regulation. This underscores the importance of financial services to the British economy, which have been undermined by being largely ignored in the Brexit deal.

Productivity also comes from effective managers: a 2021 study found that around 11% of firms in the UK were as wellmanaged as the top 25% of American firms. High regional inequality is also a problem - according to the University

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of Sheffield, Britain is less equal than France on 15 out of 21 measures, and Germany on 17. Part of the productivity equation is laggards catching up with innovators, but those laggards struggle when they are in ‘left behind’ areas. How can a company catch up if it’s not in a business hub with a rich network of customers, suppliers, and ancillary firms?

How can it poach talent from wealthy regions if local public services are underfunded, the area has few transport links, or lacks amenities such as green spaces or pleasant town centres?

All else being equal, low productivity equates to higher prices, and higher prices reduce international competitiveness, a fact that makes the UK having the highest inflation rate in the G7 all the more painful. The current account, which measures trade in goods and services, has been in (long term) structural deficit, in large part due to the productivity puzzle, and has expanded to 8.3% of GDP. The challenge posed by current account deficits is that countries must finance them by selling off their assets to balance their payments, and they detract from growth.

“High regional inequality is also a problem according to the University of Sheffield, Britain is less equal than France on 15 out of 21 measures, and Germany on 17. ” The expansion is partially explained by the Sterling ERI, which measures the Pound Sterling against a basket of its most important trading partners, depreciating by -5.9% since 2016, and -1.8% year-to-date. A currency depreciation reduces the price of exports for foreigners, increasing exports, and increases the cost of imports, in theory reducing imports.

When the UK is an importer of essentials such as food and energy, however, this leads the value of imports to rise as people continue to buy, even though their Pound can buy less of the foreign currency they need to make payment. This dependence on energy imports is also a cause for concern by promoting economic instability, with 77% of gas imports coming from Norway. Though Norway is an ally, a diversion in gas supplies to Europe could quickly see energy shortages, causing inflation to rise and growth to recede. This problem is made acute by Britain’s anaemic gas storage capacity, which stands at 2% of annual gas demand, compared to 25% in Europe.

When reading about Britain’s economic exceptionalism, one could be forgiven for feeling gloomy, yet hope lies in the fact that so much malaise can be attributed to one single factor and therein lies the key: productivity.

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