Is the UK a spent force or a coiled spring?

In the foreword to a major new piece of research, the Resolution Foundation pulls no punches in describing the economic state of the nation:

“The UK has great strengths, but we are now a decade and a half into a period of stagnation. The combination of slow growth and high inequality is proving toxic for low- and middle-income Britain, with living standards under strain well before the cost-of-living crisis.”

When people think about the UK’s ‘productivity puzzle’, they typically fall into one of two camps.

They either view the UK as a ‘spent force’ or a ‘coiled spring’. The ‘spent forcers’ see the UK’s growth problem as exogenous and impossible to reverse, with an ageing population and slowing regional activity both at fault. The ‘coiled springers’ put much of it down to things that, in principle, can be reversed by the right policy.

Hidden shallows

We’re in the coiled spring camp, and we see the smoking gun as the lack of investment.

Economists like to talk about capital deepening as one of the keys to improving living standards. If investment across the whole economy outstrips depreciation, then the capital stock grows. If that growth outstrips that of the population, then you get more roads/infrastructure/machines per worker. Such capital deepening can allow workers to be more productive.

However, since 2009, the UK has seen ‘capital shallowing’. The stock of capital per worker has been falling due to underinvestment. The UK has consistently had the lowest share of investment in GDP of any country in the G7. In 2021, it ranked 35^th out of 38 OECD countries on the same metric, coming in just above Poland, Luxembourg and Greece.¹

Identifying the problem is the first step to fixing it. Why has investment been so weak? We turn to our old friends demand and supply.

On the demand side, the UK consumer’s reliance on housing and the economy’s reliance on financial services means investment was hit harder by the 2008 financial crisis than other economies. The following austerity in public finances also took a toll on UK capital expenditure. Brexit, and the political turbulence around it, reflected in sterling volatility, also chilled investment.

On the supply side, the UK’s arcane system of discretionary permitting makes the development of physical capital uncertain and expensive. Exacting legal standards have also inflated costs in physical infrastructure: environmental compliance alone for an expansion of a nuclear power station runs to over 30 times the complete works of Shakespeare.

Which levers might the government pull?

Until UK investment picks up it’s difficult to see the economy’s structural growth issues easing. However, without spending large sums of public money, there are policy changes that could move us in a positive direction in the near term. If the UK’s productivity dilemma persists, these are levers the government might pull.

Policies such as making permitting for physical infrastructure like roads and housing much easier are being considered, but will be politically difficult to secure.

More fundamental challenges, particularly changes to the UK’s scientific research ecosystem, have been tried but not expanded more fully.

The portfolio perspective

What does this all mean for investors? Implication number one is that global diversification (with decent amounts of foreign currency exposure) is set to be more consistently rewarded than concentrated UK risk, in our view.

Implication number two is that the weak growth backdrop acts as a constraint on gilt yields from rising too far, even if inflation worries resurface.

We remain watchful that a change of government might herald new approaches to tackling the UK’s productivity shortfall, through both demand and supply-side measures. With the right policy blend, a greater inflow to UK alternative assets (real estate, infrastructure) could produce a win-win for investors and the economy alike.

1. Source: https://www.ons.gov.uk/economy/grossdomesticproductgdp/articles/ananalysisofinvestmentexpenditureintheukandotherorganisationforeconomiccooperationanddevelopmentnations/2018-05-03