UK growth slows

UK growth slows due to 2016 Brexit uncertainty | In short

UK financial markets kicked off 2016 with the worst start to a year since 2008. Uncertainty around the UKs fate in the EU, and market turmoils look set to continue through the second quarter, as the economy and markets continue to seek stability.

 

Q1 2016

UK GDP qoq %, Q1 2016

Actual 0.4%
Previous 0.6%
Consensus 0.4%
Delta 0.4%

Trade and the EU dampened growth momentum at the start of the year, whilst domestic demand provided the majority of growth in the quarter.

A slow down of quarterly growth from 0.6% in Q4 to 0.4% in Q1 was in line with expectations.

Private consumption accelerated to 0.7% qoq from 0.6% in Q4. Government consumption expanded by 0.4% qoq following growth on 0.3% in Q4. Gross fixed capital formation grew by 0.5% after an oil -related contraction of 1.1% in Q4 2015.

However, business investment continued to decline. In its latest Inflation Report, the Bank of England noted that while the financing conditions on the supply side had

continued to improve in Q1, there had been a slowdown in demand for loans for large companies. This probably relates to the broader hesitancy by businesses ahead of the EU referendum that has been noted in other surveys. Despite a sharp

fall in trade weighted sterling in the first quarter, the trade deficit widened to

£18.0b in Q1 from £16.4b in Q4. Changes in exchange rates often take time to affect demand for imports and exports. It is therefore too early to expect a material boost in demand for UK goods from the weaker sterling. Indeed, if companies do not expect the weakness in sterling to be sustained if the UK votes to stay in

the EU, which seems likely, the temporary weakness in sterling might not show up in the trade balance at all. UK exporters may decide instead to bank the higher margins rather than cut prices as a form of precautionary saving in case of a Brexit.

 

Q2 2016

At press date, a general poll of polls, pointed to a 35% risk of the UK leaving the EU on June 23.

Our forecasts show a further slowdown in Q2 is likely ahead of EU referendum; after which we see growth accelerating in H2. Short of a Brexit, the pace of UK growth should recover in the second half of the year.

However, political uncertainty, orders and investment, and measures of confidence, all point to Brexit risk weighing on the appetites of households and businesses alike ahead of the vote.

We forecast a modest slowdown to a quarterly rate of 0.3% in Q2, driven by softer consumption and investment. Followed recovery in growth to 0.6% in Q3 if the UK votes to stay in the EU. Domestic fundamentals remain healthy.

Over the medium-term the risks to the downside for growth are limited: as private consumption (2/3rds of UK GDP), remains robust:

  • Household balance sheets are in good shape compared to pre-crisis.
  • Household debt as a %GDP has fallen to 90% from its peak of 107% in 2009.
  • Household debt to disposable income has fallen from 165% of GDP in 2008 to 136% of GDP in 2015 – back to 2003 levels.
  • The households’ ability to manage the debt has improved significantly.

Combine the above with: record employment, cheap oil, modest but accelerating wage gains, and a relatively business friendly Bank of England we expect this recovery to continue and with it, annual GDP growth to accelerate to 2.1% in 2017 from 1.9% this year.

Round Up 2015

Looking back to look forward | In short

 

Round-Up 2015

The dramatic declines in oil prices and commodities over 2015, created enough noise in many markets to obfuscate the modest growth achieved globally.

Whilst China decelerated and many emerging market economies contracted; developed economics recorded growth a mixed levels, but nothing was simple.

The Eurozone returned to moderate growth and the UK expanded slightly faster. Whilst the US grew comfortably its growth rate disappointed; and Japan experienced lackluster growth – again.

In financial markets:

  • Global sovereign bond yields receded further
  • The US dollar strengthened persistently, particularly vs emerging market commodity exporters

Stock market performances varied:

  • The UK FTSE posted a moderate decline (however the make up of the FTSE is somewhat over-weighted by global commodity companies relative to the actual economy)
  • The US S&P500, closed the year flat.
  • Whilst there was a moderate gain in Europe (STOXX up 4% in local currency, down 7% in US dollar terms)
  • And healthy performance in Japan’s NIKKEI

 

For 2016, we project global growth will pick up slightly.

Again the growth should be led by developed economies.

Overall we expect growth in Eurozone and UK to remain close to its growth trend – although disturbed mid-term by the uncertainty of Brexit. 

Expectations are for the US will likely expand solidly, and strengthen over 2016.

The outlook in Japan is modestly positive while Canada will remain weak. 

China’s growth will continue to decelerate gradually, while many emerging Economies will struggle with lower oil and commodity prices. 

On the other hand India and Mexico are posed to outperform.

 

Eurozone

As Eurozone domestic demand stays firm, supported by healthy gains in Germany, Spain and Ireland, alongside some improvement in Italy, its leaders must deal with the challenges caused by the influx of refugees and the rise of populist protest parties.

These anti-European movements pose a more serious risk to the cohesion of the EU and the euro than the euro crisis of 2011-12 ever did. We expect these risks to remain contained as Europe tries to defuse the migrant crisis and unemployment continues to fall.

Whilst no major EU country has scheduled a national election for 2016, we see a 35% risk that the UK may vote to leave the EU. Brexit could be very disruptive for the UK and cause tremors across the EU. At the least, it will generate a slow down in trade with the UK in H1 2016 whilst the outcome is mooted.

 

United States

We project US growth to exceed the forecasts of the Federal Reserve (Fed). Tight labour markets will finally push up wages and increases in core inflation will quickly follow. 

As a result, we expect to see several rate rises by the Fed in 2016, more than is currently priced into markets, still leaving monetary policy accommodative.

We expect the Bank of Japan (BoJ) to maintain their quantitative easing and zero interest rate policies. Additionally we expected The People’s Bank of China (PBoC) to ease further, as well as the Reserve Bank of India.

 

The UK’s economic challenges

Why it’s still “the economy stupid” | In short:

 

The UK government faces three significant challenges to the economy, alongside wider uncertainties regarding productivity and long term growth. These are:

  1. The prospect for export-led growth given the strengthening Sterling
  2. The UK’s trading relationship with Europe, in light of a promised referendum on EU membership, and
  3. The issue of Scotland following the SNP’s landslide victory.

The UK General Election 2015 is over. The economy won the day: despite the disappointing UK growth figures half way through the campaign, the perceived threat of handing over the economic reigns to Labour, with or without the Scottish Nationalist Party in a coalition, was a strong force underpinning the Conservative’s victory. There may well be a post-election feel-good factor; the immediate aftermath of the election saw Sterling and the FTSE 100 rise and while the FTSE has fallen back, this is because of broader issues in Bond markets. Sterling has continued to rise against the US Dollar. Quite apart from the well-documented tightening of the UK purse post-election, the dangers of ever-rising house prices and the equally well-documented productivity shortfall, the UK government faces three distinct problems as it starts its next five years in office.

The first problem is the prospect for export-led growth which dominated the “real growth” debate in the previous administration. As the value of Sterling strengthens, this objective becomes more difficult. On one level, a strong pound helps the British consumer: imports and holidays are cheaper and it fuels demand-led economic growth. However, although the correlation is not strong, at just 50% against the Euro and 27% against the US dollar, a stronger value of Sterling will have a negative impact on UK exporters in highly price-sensitive markets (Figure 1).

 

2015-05-13_theUKsEconomicChallenges_fig01_v01

 

Figure 1  |  Value of UK exports vs EUR-GBP spot price, last price monthly, June 2001 – December 2015 (forecast)
Source  |  DeltaMetrics 2015, Bloomberg

 

The second problem is the UK’s trading relationship with Europe, given the promised referendum on European membership scheduled for 2017. Trade with Europe accounts for 43% of the UK’s goods trade; while this grew relatively strongly before and after the financial crisis, it has fallen back considerably since 2012 (Figure 2). Some of this is due to weak demand in Europe and a reorientation towards growth markets in Asia, particularly China. However, after 2019 we forecast some slowdown in the UK’s trade with Europe which, although potentially picking up in the next decade, is unlikely to regain the momentum of the pre-crisis era.

 

2015-05-13_theUKsEconomicChallenges_fig02_v01

 

Figure 2 |  Change in UK trade with Europe, %, (2002-2030 – forecast)
Source  |  DeltaMetrics 2015

 

Third, there is the issue of Scotland following the SNP’s landslide victory. The route towards the break-up of the United Kingdom may have become inevitable given the overwhelming scale of the swing towards the nationalist agenda in Scotland. This will have economic as well as political consequences. For example, and at first sight, the exit of Scotland from the United Kingdom would harm the rest of the UK far more than it would Scotland. Taking oil exports from the UK’s trade balance would add to a burgeoning energy trade deficit by around £1.6bn by the end of 2016. The trade deficit (net X) is already a drag on the UK’s GDP growth and adding to it would cramp what is still a fragile recovery.

However the largest consequence could be the breakdown of what is an effective currency and customs union. According to UK government calculations, some 80% of Scotland’s GDP is dependent on free trade with the rest of the UK. This includes oil, of course, but equally significant are financial services and whisky – two of Scotland’s other leading export sectors. In other words, a large proportion of Scotland’s economic performance relies on the performance of England, Wales and Northern Ireland as well. The UK is arguably the world’s oldest and most successful currency union and Free Trade Area. The Bank of England is, already, the lender of last resort ready to support Scottish banks and the Scottish deficit with UK taxpayers’ money, while Scotland currently has substantial fiscal and political autonomy. Negotiating the infamous Barnett Formula may be a breeze compared to the likely challenges of restructuring Scottish debt from outside of a full UK customs union.

Moreover, if there were a second referendum with a vote to leave the UK, then on Friday 19th September, policy makers in Scotland and the rest of the UK would have to work out the terms under which Scotland could join a currency union as an independent nation. Effectively, the Union suddenly faces the same challenges as the Eurozone: how to integrate a deficit nation into a structure where a transfer union (i.e. cross-border tax transfers) would be necessary to correct the internal imbalances between members of the union. UK taxpayers would legitimately frown upon a transfer union if Scotland had its own tax-raising powers. But it would ensure that the lender of last resort (i.e. the Bank of England) does not have to loosen fiscal policy through greater Quantitative Easing (QE) in order to underwrite the Scottish deficit which currently stands at £12bn and which will grow if, under Scottish independence, the new administration undertakes to deliver on its expansionary promises.

All of this uncertainty will have consequences for markets. The weakness of the correlation between trade and the value of Sterling highlights this: Sterling is used as a speculative currency rather than a trade currency, but there are consequences for exporters nevertheless. Further, there are already multiple uncertainties brewing around the possibility of a Brexit from Europe; the challenges of productivity and long term growth remain as persistent now as they have ever been; the strong value of Sterling does not currently seem to be impeding trade due to the weak correlation between trade and the value of Sterling, so export-led growth is more likely to be driven by longer term competitiveness and productivity growth; the risk of a breakup of the UK before last September’s referendum has now become a reality for the next Parliament, whose responsibility will be to transition towards full fiscal autonomy for Scotland without risking the currency union that has held for so long. In conclusion, the economic honeymoon may well be very short if these considerations gather momentum.