UK: From bad to worse
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- More signs of slowing growth in the UK, led by weaker consumer spending
- Inflation still rising, hurting real incomes – should peak in Q3/Q4 2017
- Exports have not risen as much as hoped; investment hasn’t weakened as much as feared
Political shambles adds to economic woes
The last three months have not been a good time for the UK. Prime Minister May’s attempt to take advantage of a massive lead in the polls backfired disastrously, resulting in a hung parliament that will do nothing to stabilize the Government as had been intended. For this to happen when the harsh reality of just how difficult Brexit negotiations will be is becoming more apparent, simply adds to the vulnerability. And of course this is compounded by the UK’s weak bargaining position in those talks. Moreover, cracks are starting to appear regarding economic prospects for the country: growth has slowed sharply (Figure 1), inflation has risen markedly (Figure 2) and sentiment has slipped. Although many continue to insist that Brexit will be relatively painless and in the UK’s long-term interest, evidence is mounting that this will not be the case. In our view, it is impossible to construct a coherent or plausible economic scenario where the UK is better off outside of the EU.
Consumer slowdown now clearcut with more to come
The slump in GDP growth to just 0.2%in Q1 2017 is disturbing, but not unexpected. It is also extremely unlikely to be the end of bad news on the economy. Reliable leading indicators suggest no improvement in Q2 2017, with some pointing to even worse than that. UK GDP data has become quite volatile in recent years, especially in regards to the composition of growth which often gets revised extensively. Perhaps the most significant aspect of the Q1 2017 breakdown was the noticeable slowdown in consumer spending to 0.3%, the slowest for more than two years. Consumption is always the mainstay of economic growth (typically 60% to 70%t of total spending) and this has been particularly true in the aftermath of the Global Financial Crisis (GFC). Since 2008 it has grown, on average, at an annual rate of 2.5%; in the last two years it has been closer to 3.0%, so the slowdown at the start of 2017 is notable and concerning.
Furthermore, weaker household spending looks set to be with us for a while yet: in Q2 2017 so far we have seen weaker car registrations, further slowing in the housing market and some poor retail sales data. More anecdotally, a number of high-profile UK companies have signalled a noticeable turnaround in spending patterns over the last three months.
Higher inflation causing pronounced real income squeeze
The main explanation for the change in spending patterns is not hard to find: households are feeling the pinch from higher inflation which is hitting real incomes. In simple terms, a year ago wage growth was running at 2.7% and CPI inflation at just 0.3%. The implied real wage growth of 2.4% was ample to support ongoing robust increases in spending. Today wage growth has fallen to 1.7%, while inflation has jumped to 2.9%, implying a significant real wage squeeze (Figure 3). And as in previous recent episodes of inflation spikes, consumers have reacted to the hit rather than changing behaviour in advance. It is noteworthy that, in purely mathematical terms, strong spending growth recently has been financed largely by a steep decline in the savings ratio to an all-time low (Figure 4). As long as consumers are confident about the future, lower savings can be defended. But if the future is uncertain, such a course of action begins to look unwise. More importantly, it can only be done once – savings cannot fall for ever. Although the majority of households voted for Brexit, many might now be re-assessing their opinion regarding its consequences and if so, they will rein in spending and increase precautionary saving. Looking ahead, these factors point to continued weak of consumer spending increases this year and next.
Hoped-for export revival has been disappointing
The small increase in business investment in Q1 2017 was encouraging – there had been fears that Brexit-related worries would impact such spending meaningfully. But although investment intentions are much better than in the immediate aftermath of the referendum, it is still far too early to sound the all clear. The additional uncertainty after the General Election, along with the dawning recognition that Brexit negotiations may not go as well as our Government has stated, provides plenty of reasons for companies to act cautiously. In any event this category of spending is susceptible to any adverse changes in sentiment. The other disappointing aspect of the Q1 2017 GDP report was the large negative contribution from net exports. It had been hoped that the steep drop in sterling exchange rates would stimulate exports and import substitution, but this has not yet happened on a scale of any consequence (Figure 5). One possibility is that UK exporters have taken advantage of the pound’s decline to increase margins rather than to improve market share and export volumes. This may help explain why export surveys have remained comparatively upbeat even in the face of disappointing export growth. In one sense it doesn’t matter that much, as higher corporate profits will help insulate the UK economy from some of the chill winds of downturn elsewhere.
CPI inflation to peak above 3% in Q3/Q4 2017
The sharp rise in inflation over the last year is mainly a result of the depreciation of sterling and much of the impact has now fed through. Nevertheless, we expect it to move a little higher, peaking at a little above 3% in Q3/Q4 2017. Thereafter, it should fall back steadily, especially if growth does indeed slow as much as we believe. Three months ago, we highlighted that if the UK economy remained resilient as inflation climbed, then the Bank of England would face a dilemma on policy – cut rates to support growth, or raise them to choke off inflation. We said then that we believed the Bank would look through higher inflation (which should prove transient). Given the growing evidence of a slowdown, that seems even more likely now, making it rather bewildering that two more on the Monetary Policy Committee (MPC) voted for a hike at the most recent policy meeting. We continue to think that the UK will not raise interest rates until any growth scare has clearly passed. With Brexit negotiations having only just begun, that looks a long way off.
Difficult times ahead for the UK economy
Finally, if growth does stay weak, pressure will grow for the Government to pursue more expansionary fiscal policy. Whether “austerity” was an accurate description of the official stance in the years following the GFC, the UK’s public finances are in far better shape today. The deficit is now only a little over 2% of GDP (down from a peak of 10%), suggesting that there is scope for fiscal support, should the need arise, without generating any major threat to fiscal sustainability over the longer term. Overall, the next year or two is likely to be quite a tough time for the UK economy (Figure 6). Messy politics combined with strained international relations and economic weakness is an unhappy and unwelcome cocktail.
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