Keeping a Stiff Upper Lip

The next time you find yourself lounging by the pool and sunning on a springtime getaway, take a moment to chat to the British tourist who may be reclining to your right. He may have temporarily escaped Britain's coldest winter in 30 or so years, but there's no forgetting the chill economic and political environments buffeting that famous British stiff upper lip.

Given the global and domestic importance of British banks, the UK economy was battered by the financial crisis of 2008/2009. Britain has just exited its longest period of economic contraction in the post-war period, but with only anemic growth of 0.3% in the fourth quarter. As the world economy picks up steam again, the British economy should accelerate too. But in Britain's case particularly, there are a few stumbling blocks still strewn in its path.

Inflation has ticked up over the last few months, driven by rising energy and commodities prices—which are particularly hard on resource-poor Britain. Currently, inflation sits above the target rate of 2%—triggering that humiliating law requiring the Bank of England Governor, Mervyn King, to write a letter to Parliament explaining what he's going to do about it. Meanwhile, King faces a very sticky (and common) central banking dilemma: If he raises rates now, he risks stalling the nascent economic recovery (and raising a few political hackles). But if he leaves them at their current historically low rate, the pound may come under increasing pressure as cash flows from the lower yielding British currency to other higher yielding ones. A weakening pound sterling (notably against the US dollar in which oil is priced) could raise inflation by making imports more expensive for Britain. (Don't be surprised if the gentleman next to you has just declined that chilled beverage you're now sipping—Britons' purchasing power abroad has also been diminished.) Given weak economic data, that's not a great combo.

Heightened political uncertainty is compounding Britain's economic woes. Prime Minister Gordon Brown's administration hasn't been especially kind to British banks (e.g., bonus taxes) and British Financials' prospects—especially important due to their heavy relative weight in British capital markets—remain dim for the time being. Meanwhile, Brown must call a general election within the next few months. Brown's generally unpopular Labour government looks to be on the way out, and uncertainty is high as the country wonders what future economic policy will look like. Though the conservatives still lead, narrowing polls have increased that uncertainty and have some folks fearing a hung parliament (where no party has an absolute majority) could limit the government's ability to act.

Despite all this, one must remember: Though British inflation may be ticking up now, it has yet to reach disastrous levels. Unemployment rates are still relatively high and capacity utilization still low. Both rates would need to reverse to trigger a stronger likelihood of sustained inflation in Britain and abroad. Political uncertainty should also wane this summer with more clarity about the next government. And though some fear a hung parliament, it creates delightful gridlock in our view—alleviating the risk of extreme policy favored by either side of the political spectrum.

Most importantly, Britain's economy represents only 4% of global GDP, and its global stock market is only 8%.* With resurgent growth in Emerging Markets pulling the US and other developed economies along, global investors can add portfolio value by underweighting the UK. If the UK does indeed lag, that should help relative portfolio performance. If the UK surprises and is a strong performer, you've not gone bare in a small area that turned out to have strong performance.

If you notice a slight smile on the face of the gentleman next to you, chances are, he's aware of this too.

*As measured by MSCI ACWI