The long awaited first stab at UK gross domestic product (GDP) over Q1 2008 was released on Friday. Much has been written regarding the continuing crisis in the credit markets and the plight of the US economy, however, recent survey data indicates that whatever the problems in store for the UK over the next twelve months, so far activity appears to be holding up fairly well.
The country’s leaders should, however, not be lulled into a false sense of security. The International Monetary Fund (IMF) delivered a particularly hard hitting assessment of prospects and given that the economic imbalances in this country are as severe as in the United States there is no room for complacency.
We currently look for the UK economy to grow by 1.8% over 2008, marginally ahead of consensus (1.7%) and down from 3.0% in 2007. Although this would represent a slide back to sub-trend growth the greater concern surrounds the outlook for 2009 at which point the unwinding of the current account and personal indebtedness imbalances, coupled with the stretched state of government finances indicates a very real concern that growth in the future could be even weaker.
UK economy: the ongoing credit crisis
The most immediate problem surrounds the ongoing credit crisis and its adverse impact on the country’s financial institutions. Whilst politicians and banks argue regarding who might be to blame for the problems now affecting the global financial institutions, little has so far been done outside the US at present to resolve matters (although at the time of writing the Bank of England is rumoured to be planning to swap mortgage backed securities for, so far undisclosed amounts of government bonds for as long as possibly 1-3 years, along similar lines to the Fed’s Term Securities lending Facility).
The longer this dysfunctional state of affairs goes on, the greater the chances that serious damage might be done to the real economy. Given the significance of the financial sector to the UK economy’s well being, a prolonged period of dislocation could knock as much as 1.0% point off growth over the next twelve months.
Of greater concern is the adverse impact of the credit crunch on households and their spending intentions. Given that consumption accounts for around two-thirds of total activity, any adverse shocks emanating from the financial institutions are likely to have an even more significant (and lasting) impact. Here recent news has been far from encouraging with difficulties showing up, in particular, in the mortgage market.
UK economy: the link between the mortgage market and consumption
Unsurprisingly, mortgage demand has fallen sharply over the past three months with potential buyers facing greater constraints than at any time since the last pronounced housing market downturn back in 1990-91. At present average house prices are expected to fall by between 5-10% over the next twelve months but with fairly pronounced regional variations. The figure could yet be exacerbated by the fact that the buyer holds the whip hand and distressed sellers may yet be forced to accept lower offers, particularly where no or only small chains exist.
Although the outlook for the housing market is bleak, the link between falling house prices and falling consumer spending is not obvious. Firstly, house prices have risen a long way in a relatively short space of time and many home owners will still be sitting on substantial equity built up over the past decade.
However, consumer confidence is undoubtedly impacted by falling house prices and concomitant negative media headlines regarding most people’s single biggest investment. In that confidence can be impacted by changes in, as well as the absolute level of, house prices any negative moves are likely to have an adverse effect on potential spending intentions.
UK economy: unemployment and savings
The other factor likely to impact on spending is households’ perception of employment prospects. Falling economic activity and falling corporate profitability can become self-reinforcing. Although the validity of labour market data has been called into question, it seems likely that when faced by sharply higher input costs, companies will attempt to maintain margins by cutting back their, generally, single biggest cost, labour.
We view rising unemployment as highly likely as the slowdown gathers pace and therefore, while consumer spending has held up pretty well so far, it cannot be guaranteed to continue as the slowdown begins to bite.
Furthermore, just as in the US, the UK’s household savings ratio recently plunged to all time low levels (see chart below). The combination of falling house prices and increased uncertainty regarding the outlook for the wider economy, coupled with fears over job prospects, are almost certain to encourage consumers to save more and consume less.
UK households’ savings ratio (%)
UK economy: the corporate sector is less clear-cut
Turning to the corporate sector we believe that the outlook is less clear-cut, but by no means upbeat. Responding to concerns regarding falling demand, companies are likely to cut back investing intentions with construction spending under particular pressure following falls in commercial property prices.
Until Q3 2007 UK-based companies were racking up ever higher profits and margins had reached record levels. Whilst profitability is now under clear downward pressure and analyst earnings forecasts are being revised lower as a matter of course, many companies still have the benefit of being able to draw on retained profits built up over the past decade to see them through the downturn.
From an activity perspective much hinges on the ability of the export sector to limit the extent of the downturn (it alone cannot reverse it). In this context much depends on sterling’s fortunes on the foreign exchange markets.
UK economy: sterling’s continued slide is inevitable
Sterling is indeed heading lower against a basket of currencies including, importantly given that two-thirds of the country’s exports are destined for Continental Europe, the euro.
Although sterling’s decline has brought fears regarding imported inflationary pressure back to the surface, the Bank of England has dropped its near-term concerns. It is beginning to set monetary policy based on concerns over future growth on the basis that as demand ebbs and capacity constraints ease, so inflationary pressure should ease over the forecast time horizon.
Whilst the Bank is adopting a gradualist approach to monetary policy, we believe the door to be open to further rate cuts as 2008 progresses and look for base rates to end the year at 4.5% (although the risks are to the downside if growth disappoints and inflationary pressures subside). Against this backdrop and given the weakness of the country’s current account and fiscal positions, coupled with rising concerns in the political arena, we view sterling’s continued slide as inevitable.
Admittedly, a slowdown elsewhere would be likely to limit demand for exports, although this should be offset by the UK’s dwindling attraction as an export destination.
UK economy: the problems in the public sector
The March Budget drew the problems in the public sector into sharp relief. The combination of weak growth and already high levels of government borrowing provides a significant cap on the extent to which the public sector can provide much, if any, support to flagging growth.
Although the Chancellor was able to announce a lower public borrowing forecast for the current fiscal year in the light of higher tax receipts, estimates for the next five years have been revised up by a cumulative £20bn. This was in response to a weaker forecast for tax receipts, which was fuelled by weaker consumer spending patterns and reduced activity in the housing market.
The announcement, on Tuesday 15th April, that Shire Pharmaceuticals was to move its tax base to Dublin will have been greeted with dismay as it may prove the precursor for similar moves by other large UK domiciled companies in response to what is widely regarded as an uncompetitive domestic corporation tax structure.
On the Chancellor’s own forecasts, the ratio of public sector debt to GDP is forecast to push right up against the 40% ceiling envisaged in the Sustainable Investment Rule over the next few years and that excludes both Northern Rock as a renationalised entity and the private finance initiatives currently accounted for off balance sheet.
Mr Darling’s assessments are based on an economy which is forecast to grow by just 1.75% this year, but to recover to post growth of 2.5% in 2009/10. This forecast is at odds with those of independent forecasters and the IMF in which another year of below trend growth, resulting in even greater borrowing, is forecast.
UK economy: a definite slowdown
While the forthcoming estimate of domestic activity over Q1 2008 is likely to be pretty benign, strong currents lurk not far beneath the surface. The longer the turmoil in the credit markets continues, the greater the threat to growth over the medium term. Whilst we forecast a slowdown in domestic activity this year, there are other independent forecasters who take a much less relaxed view.
Growth of c1.5% this year, falling to c1.0% or less in 2009 raises the distinct possibility of at least a period of technical recession here in the UK at some point over the next seven quarters. Fortunately for investors in the equity market, much of this has been factored into share prices already.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley