UK growth analysis
0UK growth slowed rapidly in 2011 as last year’s fiscal and monetary tightenings flowed through and the over-indebted private sector was unable to offset the impact. We have had essentially zero growth over the last six to nine months, and the country’s output gap is one of the largest in the developed world and continues to increase.
The new QE programme from the BoE is the most significant easing step of any major developed country in recent months, and UK asset prices have modestly outperformed relative to other major countries as the BoE is easing more aggressively than any other developed world central bank.
However, we continue to expect that this round of quantitative easing will be much less effective than the Bank of England’s (BoE’s) asset purchases in 2009 because of the international context: larger countries are not meaningfully easing this time around. Thus, the UK government continues to undertake significant fiscal austerity, global financial conditions remain tight, and UK external demand is weak.
So, while we’re watching the economy and asset prices closely to see if there is a response to the current round of QE, it looks likely that the UK will require further easing. We can expect that overall economic conditions will remain weak, and that the recent drop in inflation will make the BoE more comfortable about continuing to provide stimulation through asset purchases.
For those that want only the headlines this is our summary. For those that want more detail, we sift through the issues below.
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In terms of the international context, and looking at UK, US and Euroland growth and output levels, after beginning fiscal and monetary tightening before other major economies, the UK economy slowed sooner than other major economies early in 2011 and has remained depressed for longer, so there is more excess capacity than in the US or Euroland. UK growth has modestly improved in recent months but remains around zero, so it is now about as weak as Euroland and much weaker than the US.
A modest positive for the UK economy has been the latest round of QE purchases, which is more aggressive than the easings underway in the US and Euroland. Central bank asset purchases push more money in to the economy, and this money can be used to purchase financial assets or goods. Since the latest round of purchases began, UK asset prices have modestly outperformed those of other developed countries. The pound has actually risen against its trading partners due to the recent fall in the euro.
Private UK domestic demand has been much weaker than in the rest of the developed world, contracting at a 3% annualized pace through the third quarter and so far not showing any pickup in response to the recent stimulation. Timely stats like consumer confidence and retail sales remain weak. We expect nominal spending to be limited by income growth as households remain over-indebted and are likely to continue to de-leverage their balance sheets. Wage growth remains weak due to the depressed level of output, and the sustained weakness in wages will probably translate into continued weak nominal spending. That said, the contraction in real PCE will probably ease a bit as price pressures on consumers have stopped (headline inflation has fallen from 5% earlier in the year to 1.5-2% going forward) and asset prices have recovered some of the August drop.
Weak jobs growth and high unemployment rates are producing weak nominal income growth. Wednesday’s employment report showed that picture mostly not changing, with unemployment claims not improving from their high level and nominal wage growth ticking up slightly to 2%. While employment growth gets a lot of focus, what really matters for spending is total income growth (the combination of payroll and wage growth). As in other developed countries, the recent period of sustained high unemployment rates in the UK has contributed to a sustained downward pressure on wages, which, of late, have been a substantial driver of incomes. And, as credit creation remains stuck at zero, slow wage growth is limiting nominal spending growth. The good news for UK consumers is that the drop in wage growth (from 2.5% to 2%) over the last six months is much less than the drop in inflation over the same period (from over 5% to 1.5-2%), which should be some support to real spending.
Looking back, stock prices fell significantly in the summer, which likely contributed to the weakness in consumer confidence and flowed through to spending. The recent stabilization in stock prices is a modest positive. Additionally, the BoE has been especially aggressive in managing its financial system’s exposure to the European debt crisis, proactively opening the Extended Collateral Term Repo Facility last week and reportedly driving the lowering of US dollar swap line pricing via the Fed in late November. These measures should help stabilize asset prices as well, by ensuring that banks don’t need to sell assets in order to meet liquidity needs.
A big factor in the UK economy is that the UK government is sticking to its announced austerity programme, which has reduced the deficit by about a quarter over the last year and a half. The cuts so far have been in line with the government’s announced plan in 2010. Going forward, we can expect cuts to drag around 80bps off growth in the next six months, which is a bit less than the recent drag. The Treasury’s Autumn Statement, released at the end of November, made some marginal tweaks but did not significantly change the path of the austerity, although the government did announce (as broadly expected) a £21bln loan guarantee scheme to encourage lending to small and medium-size businesses that cannot currently get credit. We may expect that this will not have a significant impact on growth.
As for export hopes, foreign demand for UK goods has weakened through 2011 as trading partner growth has slowed. Strong export growth supported production, financial and business services, and hiring in late 2010 and early 2011, giving a meaningful support to the broader economy, but that support has now faded as tightening credit has slowed growth in Europe, which is the UK’s largest trading partner. Given the size of the trade linkage, we can estimate that a 3% drop in Euroland growth (which is about what has happened over the last six months) subtracts around 0.8% from UK growth. We can note that October’s trade report showed a strong pickup in exports, which looks anomalous given the weakness in global conditions and exporter surveys. We will watch to see if the strength is sustained next month.
Meanwhile, inflation has been tracking around the 2% target during the second half of 2011, and the risks are moderately skewed to the downside as wage growth continues to fall and the output gap continues to widen. The BoE views a continued drop in inflation as likely (its projection is 1.5% for mid-2012) due to the slack in the economy and the risks to growth from the ties to the European debt crisis. Whatever actually happens from here, the factors that led to the high inflation recorded in late 2010 and early 2011 are behind us. Inflation should not be an impediment to additional easing, although a pickup in growth or a drop in the currency might flow through to higher prices in due course.
Looking at the specific drivers of inflation, service inflation is below average and has been trending downward recently as wage growth remains extremely weak. Goods inflation remains around 0%, which is high relative to history.
Most signs point to continued weakness in the UK economy as the global slowdown (and in particular the slowdown in Europe as it works through the debt crisis) will likely continue to drag on the economy. Private sector demand growth is already extremely weak, although softer inflation may provide a limited boost to real wages. The government presses on with its deficit reduction plans, which remain a drag (though a slightly smaller one going forward). The balance of these risks is probably pointing to continued weakness in growth, but even with a modest pickup, more easing would be appropriate given how depressed levels of activity remain.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
