Jonathan Pope of RLAM Channel Islands takes a look at the UK's economic themes for 2014 which will set the investment scene for Guernsey's captive market this year.

In late 2012 many City of London analysts were predicting a 'triple dip' recession, voicing fears that 2013 would be another grim year for UK PLC. While economic activity in 2013 didn't shoot out the lights, estimated consecutive quarterly growth of 0.3%, 0.6% and 0.8% for the first three quarters illustrates that the UK economy fared a lot better than many predicted and that activity accelerated as the year progressed.

The Bank of England predicts that Q4 GDP growth will be 0.9% and, while the finalised total 2013 GDP figure will not be known for another 18 months or so, if the current estimates had been offered to the Chancellor a year ago I think that most bookmakers would have offered short odds that would have been gratefully accepted. 2014 appears to start from a much better position, although the problem is of course that the starting point a year ago was so lowthat almost any positive news was treated as a surprise. Perhaps the issue now will be that, while the recovery will continue to gather pace, the momentum may cool as quarterly GDP figures in 2014 do not match those of late 2013, although the overall growth rate for 2014 should exceed 2013.

Assuming that the Bank of England is correct and the recovery has "finally taken hold", the other issue to be grappled with in the coming year or two will be how Central Banks can "normalise" their monetary operations, which will obviously mean higher interest rates at some point or other and will involve balancing the threat of stifling the recovery with preventing another build up of cheap credit.

First of all, let's continue the positive theme with some more upbeat economic statistics. Aside from the continuing encouraging economic indicators, there have been several recent positive surveys which are worth highlighting.

122 CFOs were recently asked about prospects for 2014, and nine out of 10 reported that they expected revenues to improve and also anticipated increasing investment and hiring in the year ahead. Separately, another survey reported that the willingness of companies to invest is currently at a 19-year high with higher optimism than at any other point since 2007. The main reasons given for this optimism are improved access to funding and greater confidence in the Bank of England's policies.

Our internal base forecast (i.e. the scenario to which we attach the highest probability) for UK GDP growth for 2014 is 2.7%, which is very slightly ahead of the 2.5% forecast by the MPC. Our base case continues to assume no disorderly euro break up and is cautious on global growth relative to pre-crisis conditions. Our base forecast for inflation has been reduced slightly over the last few months to2.0%; the reason for this is due in part to the likely impact of the recent rise in sterling. We expect oil prices over the next year to remain broadly stable with the potential increase in demand caused by growth in the world's largest economies being matched by an increase

in supply. Inflation has been trending downward over the last few quarters and, while it is still above the 2.0% target, the margin of overshoot has reduced dramatically since the days in 2011 when CPI stood at over 5.0%.

This reduction in inflation together with a more robust economic outlook might offer the beginnings of an answer to the "cost of living crisis" – the fact that wage increases have not kept pace with inflation. While the Office of National

Statistics' monthly figures are reporting that pay increases were on average 1.1% over the last year, there is some hope that the gap with inflation will narrow further and may even close completely assuming inflation remains closer to target and the confidence of the various CFOs reported above is not completely misplaced. Of course, although this development would be welcomed, the actual improvement in real wages (i.e. inflation adjusted) is

not likely to be anywhere close to the 2% per annum which used to be considered normal and so households are not likely to feel very much better off in the near term, and then of course the cost of servicing debt will rise at some point. Looking further ahead into 2014 there is growing optimism that another milestone in the UK's economic recovery will be reached.

In December 2013 the British Chambers of Commerce announced its latest forecasts, which suggested that in the third quarter of 2014 the overall size of the UK economy will finally return to positive territory. In other words the economy will surpass its previous peak which was reached in the first quarter of 2008. While much has changed in the intervening period, the resumption of fresh growth will be welcomed by all.

As previously mentioned, the challenge for central banks is to remove stimulus without derailing recoveries. To that extent, the Bank of England has tried to provide some clarity with the new 'Conditional Forward Guidance' (CFG) policy, which was unveiled in August 2013 and stated that the MPC would not even consider raising interest rates until unemployment was below 7.00%. At the time this announcement was made, the MPC was forecasting that this rate was unlikely to be reached until 2016. However, the stronger economic data has meant that unemployment has fallen far faster than was expected and when the next round of MPC forecasts were published in November 2013, the Bank of England attached a reasonable possibility of the 7.00% target being reached in the last quarter of 2014. This of course poses a problem for the MPC; it appears that the introduction of CFG was designed to delay market expectations of a UK interest rate rise in 2015 until 2016.

However, the stronger than expected data threatens to do exactly the opposite and stoke expectations of an earlier rise. MPC reaction has been to state repeatedly that the 7.00% threshold is only the point at which they will start to assess whether a rate rise is necessary and they continue to reiterate that they are unlikely to sanction a rate rise for considerable period of time after this point has been reached. Some commentators think that the Bank may underline this message further by amending the unemployment threshold to a lower figure; 6.5% has been mentioned by some. This course of action would buy the MPC more time but it may cost them a loss of credibility. On balance then, it is likely that rates will remain on hold in 2014, although a move in 2015 is becoming more likely.

Of course, this is when official interest rates will rise; we would expect longer term market rates to rise in advance of this and so are hopeful that the sterling yield curve will steepen as 2014 progresses, which should provide opportunities to begin to improve returns for actively managed cash portfolios. Finally, lest this article should be considered too optimistic, we have to consider what may go wrong in 2014. Starting from a macro picture, the eurozone must still feature towards the top of most people's list of potential problems. While conditions have definitely improved and there are even tentative signs of improvement in the peripheral economies, there are still problems which could yet cause further disruption. The ECB cut interest rates in late 2013 over deflationary fears and the French economy is perhaps giving the most cause for concern at present. However, given how important France is to the EU it would be assumed that should support be required it would be given quickly.

Back in the UK it is possible that economic data will start to disappoint which will cause this fragile sense of optimism to evaporate. On the other side of the coin, there is a danger that interest rates will rise more quickly than the MPC ideally want them to; if perhaps fears grew of a house price bubble coupled with an early rate rise in the U.S. In this scenario, the fear would be that the pace of interest rate rises was being dictated by forces other than the strength of the UK recovery. In conclusion and to return to the slightly hackneyed theme of economic forecasts and bookmakers, on current estimations, the outlook for 2014 and 2015 would again have been gratefully accepted by the powers that be if offered a year ago.

An original version of this article was published in Captive Review's Guernsey Report 2014.

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