Broadening, Not Balancing

One day after headlines hounded Germany for having the “wrong kind” of growth, the UK got a gold star for achieving the “right kind.” After months of jitters over the UK’s “unbalanced,” “unsustainable,” “credit-fueled” growth, slower spending—coupled with growing exports and business investment—led some to breathe a sigh of relief when the second estimate of Q4 GDP hit. Don’t get us wrong, the optimism is welcome—even at the slower pace, consumer spending grew just fine—but it rests on some rather misguided notions. The UK economy is simply behaving like any other healthy, service-based economy in the developed world—it isn’t “imbalanced.” Improvement in business investment and exports is certainly welcome news, but it simply means the recovery is becoming more broad-based—a good sign of the UK’s strengthening, and more fuel for this bull market.

Overall, the latest Q4 2013 GDP data were encouraging. Headline growth remained unchanged at 0.7% q/q, but the report provided the first glimpse at the underlying components. Exports rose +0.4% q/q, bouncing back from Q3’s -2.8% decline, while imports fell -0.9%—not wonderful news, but imports have been choppy for a while, and domestic demand certainly isn’t weak across the board. Gross fixed capital formation and business investment each rose +2.4%, with previous business investment revised up to show growth in every quarter of 2013—the first time that has happened since 2007. Consumer spending also continued its steady rise, notching +0.4% growth.

UK growth is becoming increasingly broad-based, with all major components contributing—the recovery is gathering steam. But headlines see this differently—not as broadening, but as balancing. After 2008, many (including the current government, which took office with pledges to re-engineer the economy) began to believe the UK is too dependent on financial services and consumer spending—less “sustainable” sources of growth. This view became increasingly widespread as the recovery progressed only slowly, with production, manufacturing and construction continuing to decline as services grew. The same meme held on the expenditure side, with consumer spending the one consistently growing component. After several quarters, many just assumed the Financials sector was spiraling out of control, fueling a credit bubble that could pop at any time—and to these folks, slowing consumer spending amid rising business investment and exports is a sign the UK is starting to depend less on banking and a potentially unsustainable credit binge.

If a credit bubble were the only thing underpinning the recovery (or even existed), it wouldn’t be great—but that just isn’t the case. Incomes have grown, though they’ve lagged inflation, and credit hasn’t grown leaps and bounds. Nor is there anything inherently bad or unsustainable about an economy driven by services and spending. It’s what we have in the US, and it’s normal for advanced economies. It’s also what Emerging Markets strive for. Rather perversely, China has what the UK wants—an economy with a large manufacturing base, high exports and growth, with a less dominant service sector and smaller contribution from consumers. But China wants what the UK has—officials are engineering a shift to a services and domestic demand-driven growth model. To us, that the UK would see its globally envied model as something to do away with doesn’t make much sense.

That said, it’s easy to see why UK pols and pundits feel the way they do about Financials. Most believe the sector’s large share of the economy made it extra vulnerable in 2008—and still too prone to boom and bust. Most believe that if the UK can reduce dependence on that one sector, growth will be sustainable. However, the finance industry isn’t any more inherently prone to wobbles than any other industry. It just feels that way since the financial crisis is the freshest wound. But that doesn’t mean the sector can’t recover and do just fine in the future. Tech recovered, after all. So did Energy after the 1980 bubble. Having a large financial sector isn’t bad and doesn’t make the UK inherently weaker than other nations. Different countries have different comparative advantages, and the countries that can use these to their, well, advantage typically have a leg up on global economic integration. The UK’s strong suit just happens to be finance (along with period dramas, Dame Maggie Smith and David Beckham’s right foot). The country benefits from being the global financial center, the world benefits from having a specialized hub, and other nations benefit from being able to concentrate on what they do best. This is just how our globalized world works.

Those who clamor for more balance are missing the bigger picture, in our view—they might not realize it, but they’re arguing for the UK to handicap itself rather than embrace its strengths and position in the world. The UK’s results over the past year are nothing to sneeze at. The largest components of the economy have grown steadily—now, the smaller ones are too. Sure, more export growth will be nice, but that comes as external demand improves—particularly in the eurozone, a key trading partner. Looking ahead, there are plenty of signs domestic demand should continue broadening. Services and manufacturing new orders are rising, housing is steadily improving, and rising demand for a limited supply of homes is driving new construction. Nominal wage growth has picked up lately, and with inflation trending down, real wages should start turning up, too. On the business side, firms are profitable, allowing them to boost investment without spending down cash balances. Many are still credit starved, but banks are well-positioned to lend more now that recent regulatory capital raises are largely behind them—another economic tailwind.

In a way, the ever-present yearning for economic rebalancing has done investors a favor—it helps keep expectations low, and it helps the UK remain one of the world’s more underappreciated growth stories—and, likely, a continued source of positive surprises for stocks looking forward.