Paul Diggle

Hello and welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Paul Diggle, Chief Economist here at abrdn and today we're going to talk about UK politics and the outlook for the UK economy. And there's been an awful lot going on in the UK over the past few months. Back in March, we had the spring budget. Recent IMF forecasts pick the UK as the worst-performing major economy in 2023. There are upcoming UK local elections in May. And we're in the very first innings of 2020 for general election build-up as well. So, a lot to talk about. I'm delighted to be joined by Luke Bartholomew, regular guest and indeed co-host of the podcast and Lizzy Galbraith, our political economists to talk about the UK government's economic priorities and the outlook for the economy. So, Lizzy, why don't we start with you? And can you tell us what this government's political economy priorities are?

Lizzy Galbraith

Yeah, so the government's trying to go back to basics really, after what it’s fair to say has been quite a turbulent year in British politics. So, there are five key commitments that Sunak has made that are going to essentially see the government through from now until manifesto writing time next year. Three of those have to do with the economy. So halving inflation, growing the economy, and getting national debt falling. And then we have one related to the NHS, which is to reduce waiting lists. And the final one is to do with immigration, which is just to address small boats. So very broad-brush commitments, quite a lot of wiggle room in those for the government crucially, but they are very closely aligned to what the polls tell the government are Conservative voters’ key priorities. So, when polls ask Conservative voters to name their top three issues facing the country, the economy, the NHS, and immigration are the top three, so Sunak is tacking very close to what the country is essentially telling him he should be focusing on. In terms of what that means, at the moment, we saw the government at the budget a couple of weeks ago, focus quite strongly on stability, not doing anything too radical after what we've seen before and essentially using it as a confidence-building measure. In terms of what that means for the NHS, we're actually seeing the government focus more on trying to address the strike action that's been taking place. And it's going to be very difficult for the government to actually get the waiting lists down while we have so much strike action ongoing. This is a tricky area for the government and we've not actually seen them make too much progress there yet. Nurses and junior doctors are still actively taking strike action. And it doesn't look like the government's made much headway in finding a resolution there. And finally, on the immigration point, there is a bill going through Parliament at the moment. So we are seeing the government make progress there. Whether it results in tangible progress, and actually reducing illegal immigration numbers by the next general election, however, is going to be another matter. And that will be something certainly to watch as we get further into this year and into next.

Luke Bartholomew

So one other priority that the government seems to be focusing on at the moment, Lizzie,I maybe it has less of an immediate political payoff, but it's trying to cobble together some sort of industrial strategy, some sort of green energy strategy in response to what's happened in the US around the Inflation Reduction Act and the Chips Act. And we can talk a little bit in a minute about what the UK’s response has been so far. But maybe it'd be useful in the first instance, to set out why there is suddenly this feeling in Whitehall and the Treasury that perhaps some sort of industrial strategy is now required as a consequence of what the US has been doing.

Lizzy Galbraith

Yeah, so the Inflation Reduction Act actually passed in August last year in the US and initially the government in the UK seem to be quite willing to essentially try and ignore it really. It's a very large package of measures that are designed to spur investment in green technology in the United States, principally by targeting over $360 billion worth of subsidies at companies that are willing to invest in manufacturing green technologies in the US. So there are two main goals that the US was trying to achieve with this. The first is to reinvigorate the US manufacturing base by incentivizing greater production of these goods in the US. And the second is to reduce strategic dependencies on overseas actors, by making sure that some of these critical resources that the US government believes it’s going to need to remain competitive in the global economy are produced in the US or by its allies. So, the IRA, crucially for the UK has introduced up to $7,500 worth of tax credit for electric vehicles that are sold in the US market, as long as manufacturers meet two local production requirements criteria. So a certain proportion of the battery critical minerals must be extracted or processed in the US. And some of the assembly also has to be done in the US or in a country in North America. Crucially, the UK is neither in North America and does not have a free trade deal with the US. So, it's currently exempt from being able to benefit from those tax subsidies. And that means that the UK is in a fairly vulnerable position going forward in terms of ensuring that its car manufacturing industry can remain competitive. And to compound this, we've also seen in more recent months, the EU develop its own response to the Inflation Reduction Act, which doubly compounds the problem for the UK in that it now has two very large markets that are putting a lot of investment into invigorating their own manufacturing base. And the UK government is currently unwilling to match the kind of government expenditure, that we're seeing some of these other markets sort of level at the green economy at the moment.

Luke Bartholomew

Yeah, as you say, there, Lizzy, the UK government, not necessarily willing to level the kind of money that other countries or regions are throwing at the issue at the moment. And perhaps that reflects long- standing scepticism in the Treasury in general, and maybe the Conservative party as well about industrial strategy and inefficiency that might flow from that. But with those concerns, notwithstanding they did still have this ‘green day’ that was meant to be a series of announcements around that. So what did the government managed to announce around that? And you know, is there the possibility of any more coming down the path as well?

Lizzy Galbraith

Yeah, so green day was an interesting exercise in government communications, as much as anything else. In the end, the government effectively over-promised what it was going to deliver on the day, and has disappointed a lot of the stakeholders that that were invested in seeing the government actually go a bit further than it ended up doing. So green day itself ended up mostly being a package of previously announced measures, and a few additional commitments, around investment in things like battery, factories, but nothing really substantive, nothing with any money attached to it. And the government did actually see a bit of a backlash from that, particularly given the detail and the scale of other economies’ commitments in these areas. So what we're going to see the government do is we're going to see them, sort of go back to the drawing board a little bit on its green industrial strategy. We're not going to see the government's try and copy the EU or the US and what we are going to see is them having a second go essentially, at trying to get some of these measures through. One of the big things that the government is trying to do at the moment is to negotiate with the US to secure an exemption to this production requirement that the IRA introduced. Japan has already successfully done that and the UK is very hopeful that it's going to be able to get a similar exemption which would allow it to benefit from some of these subsidies without actually having to have a full blown trade deal with the US. That would help protect the car industry in the UK from some of this potential risk of investment moving away from the UK over time. But we're not going to see the UK go significantly further than that. So in terms of what we're going to expect from the government on a more substantive response to the IRA, it doesn't look like we're going to necessarily see one. We are going to see the government mostly focused on diplomatic efforts to try and gain inclusion into some of the deals that are being done with some of the bigger players in the global economy that are already working on these areas as well.

Paul Diggle

So, Luke, of Sunak’s five promises that Lizzie mentioned at the top, three of them are economic in nature, halving inflation, growing the economy and bringing down the national debt. I mean, how achievable are these promises? And more broadly, how is your assessment of the UK economy's prospects?

Luke Bartholomew

Yeah, so I guess the first thing to say is that it is important to acknowledge that the UK economy has performed a fair bit better than most people were expecting over the last six months or so. The monthly GDP data is being hit by a whole series of various idiosyncratic factors from month to month - the extra Bank Holiday around the late Queen's funeral, extra spending around the World Cup, various months with more or less industrial action in. But sort of abstracting through all of that month-to-month volatility. I think the pattern is that the economy has broadly stagnated over the last six months. So far from spectacular, but that's in the context that the sort of the way in which most people were talking about the economy in winter last year was we're already in a recession. And we do seem to have avoided a recession, at least last year and into early this year. The question, looking forward, I think is a little bit less optimistic. And I do still think that the economy is going to be facing recession-like conditions. And there's a sense I think, in which maybe Sunak’s goals are a little bit in tension with each other, in the sense that I'm pretty confident that the inflation one will be met. I mean, when he made that pledge, inflation was over 10% or so. I think it is pretty likely that inflation is going to be below 5% at the end of this year. There are some extremely powerful base effects and broader global disinflation that will pull inflation much lower this year, at least at headline level. But the kind of inflation the Bank of England policymakers are more interested in and indeed, us as market participants, is in the underlying inflation rate, sort of what inflation will be like, once all these base effects and various other factors that have been driving inflation higher or lower, over the last couple of years go away. And I think there is a sense in which that underlying inflation rate is running too high to keep the economy sustainably at the 2% inflation. And the only way in which that pressure will go away is if the economy goes through a recession. So much like we think that a recession is in some sense necessary for the US, I think that might also be true for the UK, as well. And so, this goal of having the economy growing might as I say, in some sense, be in tension, with this goal of getting inflation sustainably back to target. So good news on growth could end up being bad news on inflation, just given how overheated some aspects of the UK economy are.

Paul Diggle

And I guess bringing down the national debt is also somewhat dependent on the path of the denominator in debt to GDP calculations, ie the course of the economy as well. But what does all this mean then Luke, for the Bank of England, because we have a Bank of England monetary policy decision pretty imminently. And messaging from the Bank has been a little bit mixed. What are we what are we expecting for the course of interest rates in the UK?

Luke Bartholomew

Yeah, it's a slightly awkward time to be asked that question in the sense the day after we record this, we get the latest UK inflation numbers, and I suspect that inflation report will go a long way to answering what the Bank of England ends up doing in May. Our best guess is that the Bank of England is done with increasing interest rates at this point, but I don't think that the hurdle to do one more 25 basis point increase in May is especially high. So should this inflation number tomorrow, as it for us right now, prove to be slightly stronger, then I think it would be quite easy to see the bank doing one final hike and getting interest rates up to four and a half percent. But either way, I think we're pretty close to the end of the hiking cycle. And so in many ways, the more interesting question is, how rapidly and how far interest rates end up falling and you talked earlier about the IMF’s somewhat gloomy growth prospects for the UK. But another aspect of the IMF’s recent round of forecast analysis was that they suggested that the underlying rate of interest in the economy once all the various cyclical factors have faded away, will remain structurally lower. And we are pretty sympathetic to that analysis. So I think the combination of those very low equilibrium interest rates combined with this recession, will I think, see interest rates falling through the second half of this year into next year. So I don't expect it to be a prolonged period of high interest rates. But that's only because the economy isn't strong enough to sustain those high interest rates. So it's not exactly a good news story that interest rates will be falling.

Paul Diggle

Yeah, for better or worse back to potentially back to that familiar, post financial crisis experience of quite low interest rates although that might seem a way away at the moment. Lizzy, I want to end then on some thoughts on the upcoming UK local elections in May. Pollsters, pundits, we all like to watch local elections very carefully for signs about the more important general election. What are you expecting from the local elections? And is there really any read across from those results to upcoming general elections next year?

Lizzy Galbraith

Yeah, so we will have local elections on the 4th of May, so a couple of weeks away from when we are recording this. There will be about 8000 seats up. So it's a fairly large election this time around, and we're crucially going to see the seats that are up this time, where last elected in 2019, when both the Conservatives and Labour did relatively badly. Theresa May and Jeremy Corbyn were party leaders at the time, and neither were particularly popular. So both parties are sort of coming from a relatively low base in this election. However, what's interesting is that the Conservatives in particular are still trying to quite heavily manage expectations around this election. I think for the Conservatives, a good result is going to look probably, like they're holding their own, like they've not lost too many seats. Whereas for Labour, a lot of this is going to be about demonstrating that they actually have built upon the 2019 results quite substantially and that Kier Starmer can demonstrate he has been able to build a substantial improvement on where Jeremy Corbyn was at the same point in 2019. So, the other thing to look out for in this is going to be how parties fare in different parts of the country. Importantly, for Labour, lots of seats are up in the northwest of England, which is fairly crucial to their general election prospects. Now, as you said, there is no direct read across between a local election result and a national election result. Turnout is significantly lower. People have all sorts of different reasons for voting differently in a council election than they would in a general election. And smaller parties also tend to do a lot better as well. However, Labour will be wanting to demonstrate that they have won back voters in these areas. And this is the only test ahead of a general election that in which they're going to be able to demonstrate that, so they are going to be looking to make improvements in their seat numbers and crucially their council control in the northwest of England. The Lib Dems are also going to be trying to do the same sort of thing in the southeast as well to sort of demonstrate they can make inroads in some of those more sort of liberal Tory areas that are more traditionally Conservative/Lib Dem swing seats in general elections. So, there are going to be pockets of the country where read across into general elections will be made. But I would caution trying to read the whole result overall as an indication of any sort of general election outcome. It's a nice temperature check for where the sort of the mood of the country is. But it certainly isn't going to be any indicator of what we can expect in a general election next year. And I don't think it would necessarily be something to, you know, trouble either party in terms of, you know, leadership or political direction. This is more of a test of can their key election messages land? How do they play on the doorstep? And can they translate that into any meaningful progress on that low bar that was set in 2019?

Paul Diggle

Yes, usual health warnings about reading across from local to national elections definitely apply. But Lizzie, Luke, thank you very much for your insights on the podcast and thank you to you for listening to Macro Bytes. Next time we have US academic and author Chris Miller on the show, talking about the geopolitics of microchips, silicon chips, so I'm really looking forward to that episode. In the meantime, don't forget to like and subscribe to the podcast on your platform of choice. But until next time, goodbye and good luck out there.

This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for information purposes only and should not be considered as an offer investment, recommendation, or solicitation to deal in any of the investments or products mentioned herein and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of abrdn. The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested. Past performance is not a guide to future returns, return projections or estimates and provides no guarantee of future results.

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