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The UK economy faces stiff headwinds in the form of weakening economic data and rising political uncertainty, says Stewart Robertson*
The next year or two is likely to be tough for the UK economy. A messy political picture combined with strained international relations and economic weakness is an unhappy and unwelcome cocktail.
The last three months have not been a good time for the UK. Prime Minister Theresa May’s attempt to take advantage of a massive lead in the polls backfired at the recent general election, resulting in a hung parliament that will do nothing to stabilize the government. The harsh reality of how difficult Brexit negotiations will be simply adds to the administration’s vulnerability.
Moreover, cracks are starting to appear regarding the economic prospects for the country: growth has slowed sharply, inflation has risen markedly and sentiment has slipped. Although optimists 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. It seems impossible to construct a coherent or plausible economic scenario where the UK is better off outside the EU.
The slump in gross domestic product (GDP) growth to 0.2% in the first three months of 20171 is unlikely to be a temporary blip for the economy. Reliable leading indicators suggest no improvement in Q2 2017, with some suggesting it may be even worse than that. UK GDP data has become volatile in recent years, especially in regards to the composition of growth which often gets revised extensively.
Consumers feel the pinch
Perhaps the most worrying aspect of the first quarter data was the slowdown in consumer spending to 0.3%2, the weakest growth for more than two years. Consumption is always the mainstay of economic growth; typically accounting for between 60-70% of total spending. This has been particularly true in the aftermath of the Global Financial Crisis. Since 2008, it has seen average annual growth of 2.5%; in the last two years, it has been closer to 3.0%. Furthermore, weaker household spending looks set to be with us for longer: we have seen weaker car registrations, further slowing in the housing market and some poor retail sales data since April. Anecdotally, a number of high-profile UK retailers have signaled weaker spending patterns too.
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. And as in previous recent episodes of inflation spikes, consumers have reacted to the hit rather than changed their behavior in advance.
Strong spending growth recently has been financed largely by a steep decline in the savings rate to an all-time low. 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 forever. Although the majority of households voted for Brexit, many might now be re-assessing their opinion regarding its consequences. If so, they will rein in spending and increase precautionary savings. These factors point to weak consumer spending increases this year and next.
Business investment: reasons to be cautious
The small increase in business investment in the first three months of 2017 was encouraging. However, although investment intentions are much better than in the immediate aftermath of June 2016’s referendum, it is far too early to sound the all clear. The additional uncertainty created by the general election, along with the dawning recognition that Brexit negotiations will be more complex and challenging than the government had hoped, provides plenty of reasons for companies to act cautiously. In any event, investment spending is susceptible to adverse changes in sentiment.
The large negative contribution from net exports in Q1 2017 was disappointing. It had been hoped that the steep drop in sterling exchange rates since the referendum would stimulate exports and import substitution, but this has not yet happened to any great degree. One possibility is that UK exporters have taken advantage of the pound’s decline to increase margins rather than to improve market share or 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 the downturn elsewhere.
Rate hike a long way off
The sharp rise in inflation over the last year, from 0.7% in May 2016 to 2.9% in May 20173, 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% later in the year. Thereafter, it should fall back steadily, especially if growth slows as much as expected. That said, the mounting evidence of a slowdown suggests that the Bank of England will look through higher inflation even more now, making it rather bewildering that three members of the Monetary Policy Committee (MPC) voted for a rate hike at the June 14th policy meeting4. We doubt the MPC will raise interest rates until any growth scare has clearly passed. With Brexit negotiations just beginning, that looks a long way off. The Bank of England has not helped matters by the conflicting messages from Bank of England Governor Mark Carney and his chief economist Andrew Haldane recently. In the delayed Mansion House speech, Carney stated explicitly that now is not the time to be raising UK interest rates. The very next day, Haldane unhelpfully suggested that UK rates should go up soon. We believe that Carney’s view will win out, especially if growth remains weak.
Finally, if growth does stay weak, pressure will grow on the government to pursue more expansionary fiscal policies. After significant government spending cuts in the years following the Global Financial Crisis, the UK deficit is only a little over 2% of GDP, down from a peak of 10% in 20095. This suggests that there is scope for fiscal support, should the need arise, without generating any threat to fiscal sustainability over the long term.
* Investment professionals are members of AIA/AIC's Participating Affiliate, Aviva Investors Global Services Limited ("AIGSL").
1, 2 https://www.ons.gov.uk/economy/grossdomesticproductgdp/bulletins/secondestimateofgdp/quarter1jantomar2017
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