UK Update: No Immediate Storm Likely but Let’s Keep an Eye on Global Climate
What should we make of the UK’s economic performance and outlook? Just as Brexit seems to dominate so much of the political discourse it also exerts its influence over many aspects of the economic debate, with indicators all too often interpreted in terms of what they imply for the Brexit debate.
The debate is also complicated by a recent focus on counterfactuals; for example, sterling it is said would have fallen anyway, regardless of the referendum, or if it is also stated, the economy might have grown more strongly had we voted to remain. Of course, we don’t know what may or may not have happened. Who knows, in all likelihood it is likely both of these would have been true. Sterling would likely have fallen anyway, while investment plans would likely have been higher without all the political uncertainty.
Yet, despite all this, in the six quarters since the referendum the economy has grown at a similar pace to the year and a half before it.
But we are where we are, so let's focus on what the data is telling us before we look ahead.
Data reveals a mixed picture
The economic picture is mixed. On the positive side, recent headlines have focused on the likelihood of the independent Office for Budget Responsibility (OBR) having to revise up its view of UK growth in time for the Chancellor’s spring statement in mid-March. Only last autumn the OBR cut its growth forecasts. The margin of error on forecasts can sometimes be high, particularly the further ahead one looks.
While the OBR may have been too cautious last autumn, there is no denying the UK has a challenge with trend growth. As the Governor of the Bank of England outlined at his quarterly press conference last August, the Bank has been cutting its view of trend growth since the financial crisis a decade ago.
That crisis also exposed how imbalanced the economy is, highlighted in macroeconomic terms by the sizeable current account deficit and by the Government’s large but falling budget deficit. There is also the tendency, as we have seen over the last year, for households to run up their debt. Of course, the household sector has huge assets, too, so the picture varies greatly among households.
There is also considerable variation in the UK’s productivity performance. We have written extensively on this subject so we won’t dwell on it here. Suffice to say, overall UK productivity is low but varies significantly across and within sectors and regions. Productivity can be measured as output per person or per hour worked; the improvement that was announced in January saw productivity rise by 0.9% in the three months to September largely because less hours were worked, as well as output picking up. This, if anything, justifies some of the caution we have highlighted about how to interpret productivity numbers. Nonetheless, the recent rise is good.
If productivity is higher, trend growth may be revised up. It would mean less of the budget deficit is then deemed to be “structural” and explained by long-term factors and more of it cyclical. This is significant. The larger the structural budget deficit the more it has to be addressed by tax hikes or spending cuts. If the OBR revises its forecasts up then the Chancellor has, in theory, more room for fiscal manoeuvre.
Given the uncertainty associated with Brexit and its immediate economic impact, the Chancellor could make a valid case to either spend his extra leeway or use it to run down the budget deficit sooner. He will probably do a mixture.
Could the budget deficit fall quicker than expected?
One of the surprises this year may be a point we have alluded to before: the possibility of the budget deficit falling far quicker than appreciated.
Latest data shows the public sector net borrowing (excluding public sector banks) in surplus by £10.0 billion in January. This is the second best January figure since current records began in April 1993. As a result, the budget deficit in the first 10 months of the current fiscal year is £37.7 billion. This is £7.2 billion lower and hence better than a year ago. The likelihood is the deficit will now be lower than the OBR’s projection of £49.9 billion for the current fiscal year. This is good. It may even be lower than last year’s £45.8 billion. Of course, a budget deficit still adds to the national debt – this was £1,736.8 billion at the end of January 2018, equivalent to 84.1% of gross domestic product.
The UK is still able to easily finance its deficit, reflected in low bond yields. If nominal economic growth (inflation plus growth) continues to outstrip the level of bond yields, this helps the Government’s debt dynamics considerably.
What happens to inflation and rates has a big bearing on yields. Inflation was sticky at 3% last month, largely as the market expected. But we still expect it to decelerate through the year, as the impact of sterling’s depreciation wears off. Much will depend on domestic costs and the ability of firms to pass on higher prices. Wage growth could edge up, and we think it will. The labour market is still tight and there appears little spare capacity in the economy.
This will reinforce the Bank of England’s bias to tighten. There has recently been some hawkish comments from a couple of voting members of the MPC. While the Governor’s recent comments appear more balanced.
Indeed there are still some figures that should make the Bank think twice. Retail sales recently were soft. Investment intentions are restrained – although this is perhaps not a surprise given the ongoing political uncertainty over Brexit. For some firms it is a case of waiting for greater clarify over any deal, including the transition. For others, there may be fears of political turmoil. No one should be surprised. It is not easy to leave something we have been in for over four decades, hence I argued the case (successfully) last summer for a transition deal.
Stronger world economy should maintain spirits, but observe closely
Of course, the UK cannot be judged in isolation from the rest of the world. Global sentiment has picked up but we need to keep close eyes on many variables such as whether oil prices could firm, inflation rise or even monetary growth slow. We will focus on these global indicators in a forthcoming piece.
For now, our UK economic view remains that we will see inflation decelerating and wage growth creeping up, helping consumption. The stronger world economy will boost global trade, helping exports. This should lead to steady growth around 2%. In this environment we expect the Bank of England to hike interest rates twice this year, most likely in May and November.
But investment remains restrained. Indeed the risks and challenges cannot be ignored. The outlook for any economy depends upon the interaction between the fundamentals, policy and confidence. For the UK, there is still considerable uncertainty over domestic politics and over Brexit policy and this may weigh on business confidence. Whether it weighs on UK assets remains to be seen. For now, UK equities have rebounded after the market dislocation, long-term yields are low and sterling is more stable.
The debate is also complicated by a recent focus on counterfactuals; for example, sterling it is said would have fallen anyway, regardless of the referendum, or if it is also stated, the economy might have grown more strongly had we voted to remain. Of course, we don’t know what may or may not have happened. Who knows, in all likelihood it is likely both of these would have been true. Sterling would likely have fallen anyway, while investment plans would likely have been higher without all the political uncertainty.
Yet, despite all this, in the six quarters since the referendum the economy has grown at a similar pace to the year and a half before it.
But we are where we are, so let's focus on what the data is telling us before we look ahead.
Data reveals a mixed picture
The economic picture is mixed. On the positive side, recent headlines have focused on the likelihood of the independent Office for Budget Responsibility (OBR) having to revise up its view of UK growth in time for the Chancellor’s spring statement in mid-March. Only last autumn the OBR cut its growth forecasts. The margin of error on forecasts can sometimes be high, particularly the further ahead one looks.
While the OBR may have been too cautious last autumn, there is no denying the UK has a challenge with trend growth. As the Governor of the Bank of England outlined at his quarterly press conference last August, the Bank has been cutting its view of trend growth since the financial crisis a decade ago.
That crisis also exposed how imbalanced the economy is, highlighted in macroeconomic terms by the sizeable current account deficit and by the Government’s large but falling budget deficit. There is also the tendency, as we have seen over the last year, for households to run up their debt. Of course, the household sector has huge assets, too, so the picture varies greatly among households.
There is also considerable variation in the UK’s productivity performance. We have written extensively on this subject so we won’t dwell on it here. Suffice to say, overall UK productivity is low but varies significantly across and within sectors and regions. Productivity can be measured as output per person or per hour worked; the improvement that was announced in January saw productivity rise by 0.9% in the three months to September largely because less hours were worked, as well as output picking up. This, if anything, justifies some of the caution we have highlighted about how to interpret productivity numbers. Nonetheless, the recent rise is good.
If productivity is higher, trend growth may be revised up. It would mean less of the budget deficit is then deemed to be “structural” and explained by long-term factors and more of it cyclical. This is significant. The larger the structural budget deficit the more it has to be addressed by tax hikes or spending cuts. If the OBR revises its forecasts up then the Chancellor has, in theory, more room for fiscal manoeuvre.
Given the uncertainty associated with Brexit and its immediate economic impact, the Chancellor could make a valid case to either spend his extra leeway or use it to run down the budget deficit sooner. He will probably do a mixture.
Could the budget deficit fall quicker than expected?
One of the surprises this year may be a point we have alluded to before: the possibility of the budget deficit falling far quicker than appreciated.
Latest data shows the public sector net borrowing (excluding public sector banks) in surplus by £10.0 billion in January. This is the second best January figure since current records began in April 1993. As a result, the budget deficit in the first 10 months of the current fiscal year is £37.7 billion. This is £7.2 billion lower and hence better than a year ago. The likelihood is the deficit will now be lower than the OBR’s projection of £49.9 billion for the current fiscal year. This is good. It may even be lower than last year’s £45.8 billion. Of course, a budget deficit still adds to the national debt – this was £1,736.8 billion at the end of January 2018, equivalent to 84.1% of gross domestic product.
The UK is still able to easily finance its deficit, reflected in low bond yields. If nominal economic growth (inflation plus growth) continues to outstrip the level of bond yields, this helps the Government’s debt dynamics considerably.
What happens to inflation and rates has a big bearing on yields. Inflation was sticky at 3% last month, largely as the market expected. But we still expect it to decelerate through the year, as the impact of sterling’s depreciation wears off. Much will depend on domestic costs and the ability of firms to pass on higher prices. Wage growth could edge up, and we think it will. The labour market is still tight and there appears little spare capacity in the economy.
This will reinforce the Bank of England’s bias to tighten. There has recently been some hawkish comments from a couple of voting members of the MPC. While the Governor’s recent comments appear more balanced.
Indeed there are still some figures that should make the Bank think twice. Retail sales recently were soft. Investment intentions are restrained – although this is perhaps not a surprise given the ongoing political uncertainty over Brexit. For some firms it is a case of waiting for greater clarify over any deal, including the transition. For others, there may be fears of political turmoil. No one should be surprised. It is not easy to leave something we have been in for over four decades, hence I argued the case (successfully) last summer for a transition deal.
Stronger world economy should maintain spirits, but observe closely
Of course, the UK cannot be judged in isolation from the rest of the world. Global sentiment has picked up but we need to keep close eyes on many variables such as whether oil prices could firm, inflation rise or even monetary growth slow. We will focus on these global indicators in a forthcoming piece.
For now, our UK economic view remains that we will see inflation decelerating and wage growth creeping up, helping consumption. The stronger world economy will boost global trade, helping exports. This should lead to steady growth around 2%. In this environment we expect the Bank of England to hike interest rates twice this year, most likely in May and November.
But investment remains restrained. Indeed the risks and challenges cannot be ignored. The outlook for any economy depends upon the interaction between the fundamentals, policy and confidence. For the UK, there is still considerable uncertainty over domestic politics and over Brexit policy and this may weigh on business confidence. Whether it weighs on UK assets remains to be seen. For now, UK equities have rebounded after the market dislocation, long-term yields are low and sterling is more stable.
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