Outlook 2014 - United Kingdom
There are signs that UK’s economic activity is gathering momentum. But the recovery is not on a solid footing yet and, therefore, needs to be nurtured.
Recovery at last!
It took a while, but we can finally declare with a degree of certainty that the UK’s recovery is on a solid footing. After broadly stagnating since mid-2010, UK’s GDP grew by 1.8% in the year to September. As opposed to the previous recovery (between 09Q2 and 10Q2) that fizzled out quickly, the recovery this time round is broad-based and well-entrenched. Figure 1 shows that all expenditure components, with the exception of stock formation, contributed positively to growth in the first half of 2013 (13Q3 data were not yet available at the time of writing). Even better, reliable leading indicators suggest that growth is not expected to slow down significantly in the coming months. The manufacturing and services PMI are both way above the neutral level of 50 and the CBI retail and industrial surveys are strengthening further. Consumer confidence has also surged spectacularly (figure 2). This explains why retail sales has picked up significantly. Retail sales volumes in 13Q3 were 1.5% higher than in 13Q2, the strongest quarterly performance since 08Q1.
Housing market revival supports growth
The reason for the robust recovery is that the UK is experiencing what is known as the Yhprum’s law – which is both figuratively and literally inverse to murphy’s law – meaning that everything that can go right for the economy, is going right. On the domestic front, the housing market revival on the back of the Funding for Lending and Help-to-Buy schemes is supporting consumer sentiment. Indeed, very low mortgage rates and looser credit conditions (figure 3) have released some pent-up housing demand. Although the housing market momentum is gathering steam, we do not see an imminent risk of a bubble at this moment. Foreign investors’ interest in properties located in London has led to a two-speed recovery. Increase in house prices nationwide do not send any warning signals (figure 4), especially when it is not credit-driven nor due to lower household savings (the saving ratio rose from 4.4% in 13Q1 to 5.9% in 13Q2). This is why the BoE’s Financial Policy Committee (FPC) recently decided to not utilise its macroprudential tools to cool down the market.
No end to labour market recovery yet
Households’ recent optimism is not only due to rising wealth and looser credit conditions, but also thanks to the improving labour market. On the face of it, some may question the strength of the job market given that the unemployment rate is not falling rapidly. But at closer inspection, we see that employment is rising very fast, for a part due to the improving real estate sector (figure 5), but this is largely offset by increasing workforce (figure 6). As such, it will take a while until the 7% threshold of the Bank of England (BoE) will be hit, which may lead to a policy rate hike. Meanwhile, consumers are also benefiting from falling CPI inflation amid favourable base-effects. This will alleviate the squeeze on households’ real incomes. All in all, consumers are finally experiencing some tailwinds amid a healthier job market, rising asset prices and receding uncertainty.
Pace of fiscal consolidation is slowing down
Against the favourable domestic economic backdrop and looser credit conditions, investment is expected to pick up as well. According to business surveys, investment intentions have been rising for both manufacturing and services firms. Increasing capacity utilisation rates (figure 7) and easing concerns about the eurozone may also make firms more willing to invest in extra capacity to meet future demand. The extra good news for the private sector is that the pace of fiscal consolidation is going to slow down further in the coming two years (figure 8). In other words, the upcoming fiscal squeeze will still be acting as a drag on the economy, but less so than in the previous years.
External demand may finally contribute positively
On the external front, things are starting to look up a bit as well. The contribution of net trade to growth has been nothing short of dismal in light of the sharp depreciation of the currency on a trade-weighted basis (figure 9). Last year, net trade even managed to subtract from GDP growth. The good news is that demand from the eurozone – which is still UK’s biggest export market – is expected to improve as the region slowly crawls out of recession. British exporters are also likely to benefit from the growth acceleration in the US – the second biggest export destination (figure 10).
Economic slack still substantial
The government is taking the positive economic signs as evidence that the enacted austerity plans have been a great success and that those in favour of slower pace of fiscal consolidation (known as ‘plan B’) – including us – have lost the argument. We are not sure how UK’s economic performance can be considered a success whilst the recovery is almost at par with the eurozone. UK’s output even rose faster during the Great Depression (figure 11). Moreover, as we mentioned above, the authorities fail to mention that the pace of austerity has slowed down in 2013 compared to the previous two years. Overall, no one in the plan B camp argued that the UK will never grow. The claim was that without austerity the recovery would have been stronger and, as a result, the output gap, which is admittedly difficult to be estimated precisely (figure 12), would have closed faster.
Downside risks to growth must not be ignored
Looking ahead, growth is expected to remain in positive territory and pick up speed in the coming years as the private sector balance sheet repair process slows down. Although we have become more bullish as regards growth prospects in 2014, we must also discuss the key downside risks to our forecast. The key challenge will be growing if the global macro environment worsens abruptly. If external demand conditions deteriorate (e.g. due to a renewed escalation of the euro crisis), the UK economy will struggle. The same goes for a sharp spike in commodity prices that pushes up inflation and hurts households’ purchasing power. Should the recent appreciation of the pound accelerate going forward, the export sector will take a hit. The domestic risks are if the housing market starts worrying policymakers and forces the BoE to take measures to prevent a bubble. Higher capital requirements by the BoE or even a pre-emptive hiking of the policy rate can throw sand in the wheels of the fragile recovery. Finally, there is a risk that the government accelerates the pace of fiscal consolidation amid stronger macro fundamentals. This will certainly weigh on growth given that monetary policy is running out of ammunition to single-handedly bolster growth. To conclude, growth is expected to shift to a higher gear next year but there are number of risks that can still derail the recovery.