UK Economic Update: What Lies Ahead?

One of the many areas of current uncertainty for financial markets is what lies ahead for the UK economy. Recent economic data has been mixed. Such mixed data can sometimes be an indicator of a turning point for an economy. If it is, then does that mean things are about to improve, or deteriorate? Or, has the economic data been mixed because of the weather, as well as many conflicting domestic and external economic and political influences?

The economy slowed in the first quarter

The economy grew by a quarterly rate of only 0.1% in the first three months of the year. In the previous six quarters since the June 2016 Referendum, the economy had grown at an average quarterly growth rate of 0.43%. This was virtually the same as the rate of 0.45% in the previous six quarters from the beginning of 2015 to mid-2016. Thus the question is whether the sluggish first quarter data was a turning point. Weak data during the same time in Germany and France supports the argument of a weather-related impact. But the reality is that we need to wait and see.

We expect a rebound in coming months but this seems unlikely to reverse all of the shortfall seen in the first quarter, and instead could return the economy towards its recent trend, with growth of around 0.4% in the second quarter. Sometimes, GDP figures can be revised significantly, often higher, but this can happen many years later, so it is unlikely to throw fresh light on the present debate.

The employment data remains impressive. Since peaking at 8.4% in December 2011, the unemployment rate has fallen steadily to its current 4.2%. While low, there is as yet little sign of this changing, even though employment is at an all-time high, both in terms of the numbers in work and as a proportion of those eligible to work. There were 197,000 more in employment in the three months to March, which is the highest three monthly rise since the end of 2015.

Retail sales rose strongly in April, and excluding autos and fuel, were up 1.5% year on year. While this continues a steady recovery from a year-on-year fall of 0.1% last October it is hardly an impressive growth rate. Also, while there was a strong year-on-year rebound in new car registrations in April this partially reflects weakness at this time a year ago. We are of the view that as wages creep higher and inflation decelerates, there will be a boost to spending power during the remainder of the year.

Business indicators are mixed

The measures from business are mixed. The Purchasing Managers’ Index (PMI) provides a broad guide to economic activity and in the services sector stood at 52.8 in April. This is way above the 47.4 low seen in July 2016, immediately after the referendum, but below the average of 53.9 since the start of last year. It rebounded from March’s weather impacted 51.7. Meanwhile, May data showed the manufacturing PMI rise to 54.4 with it being reported that, “Growth of incoming new business remained solid”. This was up from 53.9 in April and while above the post referendum low of 48.5 it was below the two peaks achieved last year of 57.8 in April and 58.3 in November. As figures above 50 reflect a growing sector, the message is that while there may have been a deceleration, both services and manufacturing are still growing steadily.

In fact, manufacturing output was up 2.9% in the year to March, recovering from only 0.9% in December. The survey from the Confederation of British Industry, meanwhile, shows that order books have been very volatile, ranging from -25 in April 2013 to 17 in November last year. They have fallen in recent months and now stand at -3.

There are similarly mixed signals on investment plans, and we will have to wait until there is clarity on the Brexit trade deal before we see a rebound here.

Inflation should continue to trend lower

Meanwhile, inflation looks set to decelerate. The path of inflation in the post Referendum period has been heavily influenced by the depreciation of the pound, and has mirrored developments in the wake of the 2008 global financial crisis, when sterling weakened, too. The fall in the pound boosted import prices and fed into input prices. For instance, in July 2011, in the wake of sterling’s previous depreciation, input prices peaked at 17.6%. Last year, meanwhile, the peak was 16.8%.

Some of this increase in costs was absorbed by firms in their profit margins and also led them to squeeze labour costs as much as possible to keep overall costs down. The rise in imported inflation also led to a temporary rise in consumer price inflation, squeezing living standards. But as domestic inflation pressures remained constrained, this feed-through from imported inflation has not been sustained and is now being reversed, just as happened in the aftermath of the financial crisis.

Thus headline inflation is decelerating, reaching 2.4% in April, versus the recent peak of 3.1% last November. In coming months, there may be conflicting pressures. Much higher oil prices, alongside a stronger dollar against the pound, is leading to higher petrol prices. Despite this near-term impact, our view, is for inflation to trend lower over the remainder of this year.

Forecasts reflect trends, but deficit could surprise

The latest Treasury summary shows that recent independent forecasts expect economic growth in 2018 of 1.4% with inflation reaching 2.2% and an unemployment rate of 4.3% by the fourth quarter of this year. The public sector net borrowing, or budget deficit, for this coming fiscal year is seen at £41.2 billion. Such forecasts reflect a continuation of current trends, and help explain recent financial market behaviour, although they are also influenced by developments elsewhere.

The market’s projection for the budget deficit is likely to prove too high. In fact, the budget deficit for 2017-18 was £40.5 billion, significantly lower than expected at the time of the recent Spring Statement, and lower than the £46.2 billion of last year. It reflects offsetting factors, with both taxes and spending rising. Total taxes were up 17.1% on the year, to £528 billion and national insurance contributions were up, too, by 6.8%, to £133 billion. This is consistent with steady economic growth. Meanwhile, current government spending was up 6.6%. It will not be until later this year – with the November Budget and Comprehensive Spending Review – that we will see how much room for manoeuvre the Chancellor has. But based on recent months, the deficit could trend lower.

Meanwhile, in terms of monetary policy, as we have stressed previously, there is the need to focus on the scale, sequencing and sensitivity of policy. Although interest rates were left on hold in May, other areas of policy are being tightened. The term funding scheme, which helped lending by smaller banks, ended earlier this year, and the counter cyclical capital buffer is being raised this summer, as previously announced last autumn by the Bank of England’s Financial Policy Committee.

While it may be difficult to quantify fully the tightening associated with these measures, alongside recent mixed economic data it suggests policy makers need to move gradually.

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