Recovery Still Fragile

Despite a mixed start to 2011, we believe that the UK economy is on course to post stronger growth this year, with scope for a significant rebound in industrial production. Having endured a number of extreme weather events towards the end of 2010 which paralysed the transport network, we warn of further headwinds that will challenge the resilience of the recovery this year. Chief among these will be the government's unprecedented fiscal consolidation programme, rising inflation and the eurozone sovereign debt crisis. On the political front, we expect further protests this year and ructions within the ruling Conservative-Liberal Democrat coalition over the contentious austerity programme.

The UK government has passed a key bill through parliament allowing universities to charge tuition fees of up to GBP9,000 per year, marking a major shake-up in higher education funding. However, far from rejoicing, the ruling coalition has taken a direct hit from disgruntled students, which has left junior coalition partner the Liberal Democrats deeply divided. Going forward, we still believe the coalition can work through this parliamentary term, though the Conservatives will need to make further policy concessions and work with their governing partner to shore up popular support.

O ur relatively sanguine outlook on the pound last year will give way to a pronounced rally in 2011, predicated in part on domestic appreciatory pressures. Despite a more bullish US $/GBP outlook, we stress that this does not entirely reflect underlying economic fundamentals. The unorthodox nature of quantitative easing has distorted the signalling power of the foreign exchange market. Indeed, a strong surge in US $/GBP is as likely to reflect a flood of new dollars entering the market as a positive UK growth story.

This is a major factor underpinning our medium-term forecasts. We believe that the Bank of England will start hiking interest rates by the end of 2011. Though policymakers are still generally apprehensive of hiking rates prematurely for fear of derailing the recovery, we believe that inflation will become an increasing headwind. As we have recently stressed inflationary pressures are building in emerging markets (particularly in Asia) and have now started to show up on European shores through higher food and energy prices.

Given that UK inflation has already been off target for a year, the Bank will be concerned about inflationary expectations becoming entrenched, which would ultimately necessitate more aggressive rate hikes to restore price stability.