Broken: Budget, Brexit & OBR

The key economic message from (yesterday’s) UK 2017 Budget is that there was something of a loosening of macro fiscal policy with a number of measures aimed at encouraging investment and growth.  Analysis of the details is covered by many commentator elsewhere.  The main point of our interest here is the changed OBR view of the overall economy’s future.  It suggests fiscal policy is not going to do much for absolute or relative UK productivity and competitiveness in the next few years.

The most important OBR message is that growth stays below 2% per annum (averaging about 1.4%) because productivity only increases from just below to just above 1% per annum for the foreseeable future.  In consequence, unemployment rates start to rise (though still below 5%) and the inflation rate peaks shortly and falls back to target (2% per annum).  Real earnings start to rise modestly, but only from 2019.  The rise in business investment is anchored at about 2.4% per annum and household consumption increases at a similar rate to the economy as a whole (averaging 1.4%).  Net trade contributes nothing.  As a result, the government deficit ratio drops slowly from over 2% to about 1% over five years and the public sector net debt peaks at 86.5% of GDP in 2018/19 but is still as high as 79% by 2022/23.

The message is stark.  If the central forecast is for growth below 2% a year, the downside risks could be ominous.  If Brexit imposes new barriers to trade, as currently seems likely, the risk of recession becomes far from negligible.  The need to fix the ‘broken’ model of UK development is profound.  Whether it comes from a domestic resurgence fueled by policy on skills, innovation and investment, from an indigenous spark of entrepreneurship and competitiveness (cheap £), and/or from new trade deals with various parts of the growing world, the productivity deficiency has to be closed.  An Industrial Strategy white paper is expected shortly.  The economics and development community will need to interrogate this closely and deeply when it comes.  The fear is that it’s all too late to avoid a harsh economic period in the years ahead.  The broken economy needs mending.

Wrong Kind of Growth

UK inflation hit 3% in September (CPI) and it doesn’t look like reversing downwards soon.  Growth (real GDP) is running at no better than 2%.  Whenever inflation rate > growth rate, it makes one nervous.

Moreover, we have the “wrong kind of growth”: driven by employment growth that is not productivity-led.  Real wages are falling, interest rates and exchange rates are still too low.  The trouble is that cheap labour and cheap money tends to fuel mediocre growth, at best.  Incentives to invest in new capital, innovation and skills are depressed, made worse by current trading uncertainty (BREXIT plus Trump).  Creative destruction is stalled, supporting unproductive ‘zombie’ companies.  Weak sterling offers competitive advantages but can also lower the incentive to do so.

The consensus is that growth will remain subdued through 2018 and  beyond.  Suppressed trade/investment and stretched household/public finances reflect the fundamental productivity gap.  To delay the next recession, we need more investment in the digital revolution in services and, thus, the adjustments needed to skills and innovation that will drive entrepreneurship and competitiveness.  And, that means better inter and intra regional connectivity and higher business aspiration.

The upcoming UK budget/industrial strategy (and the BREXIT negotiations) should focus on these areas of regional development.

Summer of Uncertainty

After an indecisive General Election, and with the BREXIT negotiations now underway, the political runes remain hard to read. Meanwhile, the global economic context is unstable and the economic outlook uncertain.

The financial markets and UK and foreign-owned businesses have reacted warily to the process of regulatory and trading change that is now underway. In contrast, many households are over-borrowing whereas many businesses have robust cash reserves. This and other economic imbalances are profound, especially with respect to productivity, trade and the public finances- regardless of how BREXIT proceeds.

Against this background, the latest data show a mixture of below trend growth and above target inflation, with high employment, low unemployment and, still, low interest rates. Consumer and business surveys remain largely positive but there is a marked contrast between negative real wage growth (hurting average households) and, despite poor productivity figures, improving profitability (net rates of return for average businesses).

Meanwhile, the key business issues are ones of skills deficiencies and tight labour markets contrasting with some caution over investment and competitiveness. Generally, the economy is growing but losing some momentum.

Latest evidence

  Annual (2016) Quarterly Monthly
Real GDP (%ch, yoy) +1.8 +1.7 (Q2 17) n.a.
CPI inflation (%ch, yoy) +0.7 +2.7 (Q2 17) +2.6 (Jun)
LFS unemployment (%) 4.9 4.6 (Q1 17) 4.5 (Mar-May)
Trade deficit* (£bn) -£37bn -£8.8bn (Q1 17) -£3.1bn (May)
Base rate (end %) 0.25 0.25 (Q2 17) 0.25 (July)

Source: ONS   *goods and services

Economic growth may be petering out, with household spending constrained by prospects for real incomes (earnings not compensating for higher inflation, despite high employment). Investment remains modest and net trade in massive deficit (overall, price effects outweighing substitution effects despite some headline successes). Longstanding UK economic weaknesses persist.

It is always regrettable when the inflation rate exceeds the growth rate (see table above). UK growth went from fastest to slowest amongst the G7 over the year to Q1 2017. For April-June, there was a tiny bounce but, it appears to be one of the ‘dead cat’ variety. In the first half of the year, UK real GDP growth was running at half the rate it did in the second half of 2016. Given the uncertainty surrounding BREXIT, most forecasters expect this underlying loss of pace to persist.

On the policy front, the ‘hung’ Parliament suggests some erosion of fiscal austerity might occur. It could also mean a stalling (before it has really begun) of the “Modern Industrial Strategy” – the white paper is now promised before end year. It is to be hoped that uncertainty about the BREXIT negotiations and the government’s lack of a strong electoral mandate do not stand in the way of positive action on public investment at home.

Meanwhile, with inflation above target and expected to remain so, albeit lower in June than May, the Bank of England remains extremely loose. Contrast its unchanged interest rate and QE stance with the actual and pronounced movement to a ‘less loose’ position by the US Federal Reserve, as the US recovery builds. It will be interesting to see if the European Central Bank, already talking about having removed the risk of deflation, abandons its negative interest rates and its QE measures later this year – now that the EU economy is grinding out some forward momentum (at least its better bits).

Financial Stability

The Bank of England’s latest Financial Stability Report (June 2017) describes the current domestic financial position as having risks at a “standard level”, which seems to mean ‘broadly normal, no immediate threats”). Nevertheless, the Financial Policy Committee (FPC) is highlighting four main “pockets of risk” that “warrant vigilance”.

  • Consumer credit is growing too fast (+10.3% in the year to April 2017), especially in unsecured loans for motor vehicles, credit cards and other personal loans. Because the maturity on these types of credit are relatively short, loan viability can deteriorate rapidly if the macro environment becomes adverse. The FPC is concerned about the commercial banks relaxing loan criteria and cutting margins. It is asking whether risk is being correctly priced by the banking sector. Some commentators worry that consumer finances look precarious, as they did in the pre-crisis days of 2007.
  • Mortgage debts are high (average debt/income ratio above 100%) and potentially vulnerable to higher interest rates. Although the latter are unlikely to rise sharply in the foreseeable future, debt levels are high enough relative to incomes to suggest even small changes could prove problematic. Periods of economic adjustment can be worsened by an unbalanced mortgage market because mortgage payments tend to be maintained by households as interest rates rise or incomes are lost, requiring other spending to be cut. This can transmit adverse mortgage effects quickly to the wider macro economy. Indeed, banks with bad loans in housing tend to react by reducing lending to the rest of the economy/unrelated sectors, reinforcing any macro downturn. The FPC is asking banks to stress test their home loan books for mortgage rates 3% above current standard variable rates, indicating where we might be heading on rates over the longer term.
  • Financial market assets may be overvalued. UK bond yields are very low (-c2% for 10-year gilts) and volatility is minimal. Commercial property values are high and some would argue that corporate share values are overstretched. Sudden corrections in these markets could have significant impacts on broad financial stability and detrimentally affect macro growth.
  • Although world growth has accelerated recently, the FPC identifies some global risks, particularly the high debt levels supporting growth in China and the high exposure of UK banks to any correction there. It is also concerned about the continuing high-level of non-performing loans in Italy and ‘peripheral’ Europe. The ‘holes’ in the books of the Italian banks could yet undermine the euro.

Beyond these four risks, the FPC also mentions concern for the banks if disorder from the BREXIT negotiations emerges and vulnerability to cyber-crime is exposed.

Overall, the banks have strengthened their capital positions markedly since the 2008/9 crisis but their profitability remains weak. Stress tests reveal that resilience is good but, given the risks highlighted above, continued vigilance is required. The FPC is right to be watching closely and recommending early action to prevent excesses in UK banking.

Macro Stability

Meanwhile, the Monetary Policy Committee (MPC) of the Bank of England is beginning to talk about raising interest rates and starting the process of ‘normalisation’ – by reducing the overhang of liquidity from quantitative easing (QE). In May, the MPC vote was 5-3 in favour of keeping the base rate at 0.25%. The ‘mood’ music is that the Bank wants to prepare the markets and other economic actors for a slow tightening of monetary policy from here.

Although inflation is now above target, the MPC does not expect this to last because, as yet, there is no momentum towards higher inflation from the labour market. The drop in the ‘headline’ inflation rate from May to June (back to 2.6%) was taken as evidence for this view. Accordingly, there will be no major increase in interest rates soon. Thereby, the ‘awkward’ incentives provided by prolonged low interest rates, which continue to hinder the savings/investment process, and to support unsustainable domestic debts and so-called ‘zombie’ firms, look likely to persist.

Since the General Election, there has been some debate about the future of the governments’ ‘austere’ approach to fiscal policy. Some loosening may be seen in the Autumn Budget but the internal Conservative Party conflict between ‘wets and dries’ and ‘brexiteers and remainers’, and about the future leadership makes any prediction on this front futile. Fiscal policy is just another uncertainty for business and households to deal with.

Macro stability also hangs on the ‘success’ of the UK’s trade negotiations with Europe and other major trading blocs. New impediments to free trade, real (tariffs, quotas, regulation or other trade barriers) and psychological (affecting aspiration and trade engagement by UK and foreign companies), would be a major blow to productive potential, trend and achieved growth, and future living standards. As recent discussion of the demands of the strong agricultural and health lobbies in America indicate, the UK willingness to do non-EU trade deals is confronted by the reality of BREXIT transition and the potential need for difficult compromises and unforeseen consequences.

The Economic & Development Outlook

At the time of the pre-election Budget (March 2017), the Office of Budget Responsibility (OBR) set out modest and largely flat economic prospects for the UK economy.  Since then, other forecasters, including the OECD and the IMF (down from 2% to 1.7% for 2017 real GDP growth and 1.4% for 2018), have been moderating their views and helping to create a more subdued consensus. For example, the latest (June) HM Treasury monthly survey of independent forecasters shows growth at 1.6% and inflation at 3% in 2017 and 1.4% and 2.5% respectively in 2018. The equivalent unemployment rates are 4.9% and 5.1%. The current account deficit and public-sector net borrowing improve a little but remain excessive.

Overall, the UK and local economies are forecast to slow down further over the year ahead, with a small increase in unemployment and still weak productivity. There is a strong real and policy need to break this pattern (see our Local Economy briefing 19 – Productivity Revisited – released with this report). The promised “Modern Industrial Strategy”, including significant real investment in productivity-growing capacities, is sorely needed.

Conclusion

During this summer of uncertainty, UK macro stability is being tested by a global and domestic environment that is undergoing profound structural and psychological change.

Feeling Fine?

God Save America.  2016 will go down as the year of Brexit and Trump.  REM sang, “It’s the end of the world as we know it … and I feel fine.”  At the moment, it feels like the end of the global economy as lead by the anglo-countries.  It’s hard to feel fine because markets and economies hate uncertainty and we now have uncertainty in profusion.

Why are economists worried?  Uncertainty usually puts the brakes on investment.  Simply, weaker investment means lower output, fewer jobs, weaker productivity and worse standards of living compared with what might otherwise have been.

Intervention to mitigate these negative effects might be possible … but it’s hard to do that in economies where the public debt is already too high and interest rates are far too low.  Without adverse implications, it’s difficult to add to the public debt, spend more and tax less when fiscal policy is over-borrowed.  It is very hard to encourage productivity-enhancing private investment when expected returns are so depressed.

President-elect Trump said in his victory statement that his administration would double US growth and hinted that this would be done by recourse to massive infrastructure renewal.  That may work but it would be a hard task in good times.  Starting from here, it looks impossible without a high risk of scary repercussions – higher taxes, higher inflation and much higher interest rates … eventually.

It feels like the end of the world economic order as we’ve known it over the last sixty years.  Maybe, we can look back in ten years time with relief about how well it all went but, right now, it don’t feel fine.  God save us all.

The Economy – After BREXIT

SUMMARY

On 23rd June, the UK electorate voted to ‘leave’ the EU (BREXIT). The immediate economic consequence was a collapse in Sterling, making exports cheaper and imports dearer. Over time, this might help growth and add to inflation. However, the referendum result increased uncertainty about the economic outlook and may reduce net new investment, output and jobs in the months ahead and beyond.

More firms and investors now seem less confident about the outlook for growth. The survey evidence and the forecast consensus has shifted downwards, acknowledging that there is some risk of negative real GDP growth, higher inflation and lower employment.

In addition, upheaval within the leading UK political parties, the lack of terms/a plan to smooth the UK approach to BREXIT, and concerns over the forthcoming presidential election in the United States all encourage a ‘wait and see’ attitude amongst key businesses.

With forward indicators weakening, the economy is still constrained by fundamental weaknesses: low productivity growth and competitiveness (as shown by persistently large trade deficits). For the foreseeable future, uncertainty over BREXIT will not improve these factors.

Latest evidence

  Annual Quarterly Monthly
Real GDP (%ch, yoy) +2.2 (2015) +2.2 (Q2) n.a.
CPI inflation (%ch, yoy) 0.0 (2015) +0.4 (Q2) +0.5 (Jun)
LFS unemployment (%) 5.4 (2015) 5.1 (Q1) 4.9 (Mar-May)
Trade deficit* (£bn) -36.6 (2015) -12.4 (Q1) -2.3 (May)
Base rate (%) 0.5  (2015) 0.5  (Q2) 0.5  (Jul)

Source: ONS   * goods and services

Growth in the UK economy was fairly modest and flat through the first half of 2016. Despite global/national political and economic uncertainty, as the table above indicates, real growth was maintained close to trend (just over 2% year-on-year), inflation remained well below the 2% per annum policy target (though it edged a little higher) and the drop in unemployment may have started to flatten out (at about 5%). The net trade deficit was still enormous and the loose money and austere fiscal policy stance was largely unchanged. Productivity growth remains too low for sustained and sustainable UK growth.

If real GDP growth now slips below 2% per annum, employment growth will ease or reverse and little or no improvement in productivity can be envisaged. Meanwhile, the recent (roughly 9%) drop in Sterling will boost future inflation. The economic outlook, especially in the face of having to unwind or replace trade, regulation and other business-facing agreements within the EU and other partners, has deteriorated.

Local Economy & Development

The latest purchasing managers’ index (PMI) for SW England shows SW output fairly good but employment slipping back in June. These figures were recorded “pre-BREXIT”. Moreover, the SW regional economy tended to soften through the first half of 2016.

For the PMI series, apart from momentum over time, the crucial benchmark is whether the indices are above or below 50. The former indicates growth and the latter stagnation. It will be interesting to see, in response to BREXIT, whether the next reading for SW PMI output, (to be issued mid-August), will edge below the 50-benchmark, as the UK average did in July and the SW employment index already had done in June. Thereafter, the question is whether negative “BREXIT effects” persist.

Other surveys have shown similar recent trends. For example, the British Chamber of Commerce Survey for the latest quarter pointed to “sub-par UK economic growth even prior to the EU-referendum”. With regard to the future outlook, the mood has been generally more cautious than it was, with many sectors from manufacturing, through retailing and car sales, to property and other services declaring a sudden loss of business momentum after the referendum. What little evidence we have suggests there was an immediate drop in household spending, affecting retailing, tourism and leisure locally; a decline in property movements – affecting commercial and housing sales; and a continuation of caution with respect to business investment.  We do not know whether these were temporary or persistent effects.

In response to these developments, and the aggravated risks and eventual opportunities that lie ahead, the development question is how businesses and the various public agents mitigate any negative impacts. The significant drop in sterling will help some (exporters) but not all (importers and exporters dependent on imports of components and materials). In time, the likely increase in a range of input, factory and final prices will affect some supply chains and household budgets. Moreover, there is a fear that the continuing banking malaise (with share values down sharply from already low levels) may dampen the flow of credit – a key ingredient for maintaining growth.

The Bank of England stands ready to support the financial system (e.g. by relaxing banking capital requirements, lowering base rates, and issuing more quantitative easing). It believes the banking and insurance sectors are much more resilient to shocks than they were in 2008. Also, the new “May-Hammond” Treasury has indicated that it may be more willing to borrow and spend than its predecessor. Its ‘new’ industrial/EU-funding policies, however, are far from clear, (especially as the Business Department is being reformed).

Economic Outlook

According to the latest consensus compiled by HM Treasury (see table below), growth will be very sluggish in the next 18 months. The average forecast is for growth rates well below trend in 2016 and 2017 whilst CPI inflation is now expected to exceed the target (2% per annum) during 2017 and unemployment to rise back above 5.5%.

According to these ‘experts’, the outlook has changed dramatically. Indeed, average forecasts for growth in 2017 slumped from 2.1% (June survey) to only 0.8% (July survey) after the BREXIT vote. Moreover, the current account and public debt positions are worse for 2016 and only expected to improve marginally in 2017. The Bank of England perspective (in its forthcoming August Inflation Report) is expected to show a similar warning about a deterioration in economic prospects.

BREXIT has induced a change in mood, with the consensus about economic prospects shifting markedly downwards in recent weeks. Indeed, the drop in forecasters’ expectations has gained real expression with the downgrading of UK debt by the major credit rating agencies, the drop in the value of UK banking and other stocks, and the Bank of England’s FPC recent highlighting of risks to the financial system.

UK Consensus Forecasts: July 2016

  2016 2017
Growth +1.6 +0.8
Inflation +1.3 +2.4
Unemployment 5.3 5.6
  2016/17 2017/18
Current Account (£bn) -103.1 -82.1
PSNB (£bn) 67.4 58.3

Source: HM Treasury

Some of the new negative sentiment may fade after the initial shock but the danger is that the process of extracting the UK from the EU will generate a series of economic and political ‘aftershocks’ to the markets and the real economy and this could deplete confidence at a fundamental level.

As we have written before (see previous posts), the economics of BREXIT are straightforward. In summary, the creation of economic barriers, borders or boundaries, whether real or psychological, always leads to an increase in costs. That increase in costs, exacerbated by broader uncertainty, stalls investment, reduces output and cuts employment compared with what otherwise might have occurred. Thereby, the outlook for productivity and trade deteriorates.

The resulting fall in business profits and household incomes means less revenue for the government, which requires further fiscal austerity unless the government is willing to borrow more and grow the public deficit. In turn, these factors reduce realised and potential economic activity and confidence. At the same time, as higher costs are pushed through the supply chain, more inflation is generated, which, if accompanied by higher state borrowing, means, at some point, higher interest rates – a further dampener on future domestic demand.

It is important to note that in all these economic linkages and trends, we refer to outcomes in net, macro terms. There will be companies and workers in particular sectors that will benefit from the countervailing forces that always occur within any process of economic adjustment. There will be individual ‘winners’ and ‘losers’. The key observation, however, is that the net effect, for the economy as a whole and for the foreseeable future, is one of worsening growth prospects.

BREXIT will affect many Southern businesses and households. Some of these effects will be immediate and obvious; some will be postponed and insidious and some will not have noticeable impacts for several years. But, on average, in due course, less investment means less growth and lower living standards. We must not be distracted by one-off (good or bad) data releases or items of business news over the weeks and months ahead. The important thing is the change to performance potential, and its realisation, over the long run.

In the long run (after 2020), the economy may start to recover (assuming no major global ‘shocks’) from BREXIT.   In the very long term (perhaps, eight years plus), it may be back, or even beyond, where it might have been without BREXIT. The economy is a dynamic creature made up of millions of individual and group actors with diverse characteristics and behaviours. Uncertainty creates opportunity as well as fear. Human beings are inventive, innovative and entrepreneurial, especially as new generations emerge without the baggage of history. It is reasonable, therefore, to remain a long-term optimist about the economy.

For the near future, however, the prognosis is for a period/process of negative adjustment.

  • In the short run, this is likely to harm sectors dependent on current household and business spending first, though these effects may be temporary if incomes and employment hold up over the rest of 2016.
  • In the medium term, it will be the new trading adjustments that matter: 1) sterling depreciation helping exporters unless they are vulnerable to supply chain shifts caused by political uncertainty and higher import prices and 2) trade agreements and new tariff regimes for UK businesses active across the world. Both positive and negative effects are likely to ensue here.
  • In the long run, changes to corporate investment strategies will drive the impact. It is unlikely that global companies will see UK locations and facilities as favoured areas for investment to gain access to the wider European market. Importantly, it is changes at the margin that matter, specifically the potential for erosion of commitment to existing UK operations over time. Behavioural changes will gradually impact replacement and new investment demand. In a decade, the fear is that the next family of aerospace, motors and other engineering and electronics products and services go, at least partially, elsewhere, as trading costs and regulatory frameworks adjust to a new political reality

Analysis of current economic prospects makes regional development activity to boost the drivers of productivity even more vital. The development policy and delivery question is whether the negatives can be mitigated in terms of repairing or building local competitiveness over time. Even as the BREXIT storm rolls over us, we must prepare for better days.

BREXIT 3 – the decision

A small majority of UK voters have chosen to ‘leave’ the EU.  Now we will reap the economic deluge in terms of financial market shocks, lower investment and fewer jobs.  It will take a few years for the negotiations to assert some certainty back on the future path of trade and exchange.  It will take longer for the negative effects on inward investment to work themselves out.  The UK economy will be weaker than it otherwise would have been for up to a decade.  The SW economy will be poorer as key factories and facilities across the region are sidelined or lost, many household incomes are reduced and fiscal transfer resources are diminished.

The question, then, is how we respond to and mitigate these choices and negative effects.  The next Prime Minister, as well as negotiating with all our partners, has to instigate policies that will increase investment, raise productivity and drive development whilst dealing with the probable break up of the United Kingdom.  Hopefully, by 2025-30, we can look back and say “well, it was a painful adjustment but we did it and now the future looks bright again for England” (alone?).  Today, it’s hard to look ahead with confidence but the hard work starts now.

New Year Blues – Waves of Uncertainty

In early 2016, the world economy appears to be floundering. The imbalances of financial, trade and other flows that were exposed by the “Great Recession” have never been properly resolved. Waves of new uncertainties are taking their toll, breeding fear into business and investor confidence at a time when stabilisation policy options are stretched and seemingly ineffective.

The first uncertainty concerns the Chinese Economy.  China is still growing faster than many others and there is no particular reason why the slowing of Chinese real GDP growth to what are still relatively fast rates (over 5% per annum) should affect the mood right now as opposed to in any other period – past or future.  A correction, however, is underway, as a) the Chinese currency falls, b) Chinese political risk rises – pushing its claims over various offshore islands, c) accusations are made about Chinese product dumping in US and EU markets, and d) financiers worry about China’s ability (and will) to continue propping up subsidised industries and banks carrying bad debts.

The second uncertainty reflects events across the Middle East and North Africa to do with Syrian and other civil and religious wars and terrorism, population disruption and exodus, and relations between Iran and Saudi Arabia.  Russia and the West are also at loggerheads and relations between the EU and its near neighbours are strained to east and south.  Some of these issues look irredeemable at the moment. The failure to constrain the effects of the conflict to a small geographical area could be serious.

The third (and partly related) uncertainty is the oil and other commodity markets. The drop in prices undermines fiscal stability, growth and earnings in a number of countries, led by Russia, Brazil and even Australia.  Oil prices have fallen below US$30 a barrel. It is not unusual for oil prices to have periods of high volatility and wide swings as the demand and supply balance adjusts. Although there are significant lags in the process of adjustment, what goes down will come up. Already, there is talk of the supply chain drowning in oil. This will lead to stoppages, closures and mothballing at the wellhead. Supply will fall again and, since world demand continues to grow, oil prices will get back to US$100 a barrel – not now, but eventually.   Meanwhile, low oil prices are good for most of the business economy, at least in the short term. Why are investors panicking about something that should be boosting non-oil profits now? Methinks, it is another case of too much contagion for the markets’ own good.

The fourth uncertainty is about equities themselves. Was the run up in share prices over the previous three years or more a ‘sugar high’ related to the enormous liquidity pumped into the system through various bouts of Quantitative Easing and related monetary largesse by the West’s central banks? Is there real value in the corporate world or is it all built on sand? Today, the markets seem to believe the latter. But, they may be wrong. First, a lot of the excess liquidity was never made active. Second, technological progress and innovation is gathering rather than losing pace. Despite some demographic ageing, the medium to long-term prospects for growth and development do not seem diminished. Yes, we need to get western productivity rates up to support living standards but that calls for more investment and net inward migration, not less. There is a positive story to tell about the underlying economy that should outweigh the short-term ‘bears’, eventually.

The fifth uncertainty surrounds politics in America and Europe. The possibility of a Clinton-Trump contest for the US presidency in next November’s election is alarming many. One is reminded of Churchill’s famous statement along the lines of “America will always do the right thing … after it has flirted with all the other options”.   There may be scope, therefore, for a political bounce in economic prospects, as we approach the election and a rational outcome seems more likely. Meanwhile, there is the matter of UK-EU negotiations for ‘real’ reform and the UK’s in-out referendum. The current betting is on some sort of ‘offer’ kicking off the full referendum debate in late February and being resolved by a vote in the summer. The polls are close and the reform proposed is unlikely to satisfy the sceptics. The question is whether the majority of middle-ground Brits will “do the right thing” in the end? No one knows. But, I worry about the investment delaying and diverting effects of the debate and the vote itself. In the short term, why would companies invest in UK industries until a resolution of ‘BREXIT’ emerges? In the long term, why would you expand UK operations if access to the single EU market is no longer guaranteed on competitive terms? To a regional development economist, borders and boundaries are always a constraint on economic potential and performance.

So, there are five reasons to be unsure about the external environment for UK economic prospects. How do domestic factors play into this mix?

First, 2015 was a year of slowdown. Real GDP growth was barely on trend (c 2.3%) and was weaker at the end of the year than at the start. There was no inflation overall, although this hid wide swings between segments, such as houses (+7.7% year to November) and energy (-7.3% year to December). Meanwhile, unemployment fell to 5.1% overall (September-November). The employment-led recovery is intact but, inherently, it is unable to spark a strong upturn without support from higher productivity, which remains in the doldrums – at a level only just above its previous peak. The demand chain is propped up by the effects of modest real earnings growth on private consumption but, unless and until it is supported by other demand factors (business investment and net trade), this is not going to last – especially if, as expected by the forecasters, the labour market is now leveling off.

Second, the economy is not rebalancing. The trade deficit remains huge and volatile, and the current account is being worsened by a collapse in returns from UK FDI abroad. At about 5% of GDP, the current account deficit remains unsustainable for the long term. Also, manufacturing continues to struggle against global headwinds, as typified by the headline loss of capacity in the steel industry. Manufacturing output is still some 6% below its previous peak (Q1 2008). Since the recession, there seems to have been a permanent loss of productive capacity and a worrying erosion of viable supply chains.

Third, the policy environment is tortured. The public deficit is responding very slowly to fiscal austerity. As yet, ‘crowding in’ of private activity as the public sector retreats is a myth. The monetary environment remains incredibly loose, with low interest rates continuing to dampen investment’ (saver and investor) spirits and, thereby, prospects for underpinning sustained growth. Lost in an austere liquidity trap, the stabilisation policy mix is not supporting growth.

Against this background, the forecast consensus is for a weaker economy in 2016. The January collection of independent forecasts issued by HM Treasury sees growth averaging 2.2% this year after 2.3% last. This represents a downward adjustment by the forecasters from late last year, but still seems modest. Given what’s happening in the financial markets, it would be astonishing if these forecasts were not revised below 2% for 2016 over the next few months. My own current estimate is 1.75% for growth in UK real GDP this year. Importantly, as highlighted above, the downside risks are significant and potentially bigger than the upside.

Other current consensus forecasts include:

  • Inflation is expected to rebound a bit: +1.3% for this year after zero in 2015, largely because of previous ‘bigger’ falls dropping out of the index.
  • Unemployment is predicted to average 5.1% – a rate it has already reached, suggesting no further progress in 2016.
  • The current account deficit is expected to improve barely at all – from £81.5bn in 2015 to £77.6bn in 2016. This is also a “no change” view.

The UK economy is losing momentum and, in several ways, 2016 already looks like a ‘lost year’. Given the waves of uncertainty crashing on the economic beach at the moment, the fear is that the outlook deteriorates from something fairly benign into something worse.

There are some more hopeful signs. It is entrepreneurs, workforce skills, innovation and competitiveness that drives the growth process, not the financiers and panicky markets. There is no evidence that these factors are diminished. Indeed, they are what have been keeping the recovery going despite the headwinds of poor policy and politics. Some of the new technologies will be disruptive for jobs – aspects of artificial intelligence and new consumer interfaces (clouds, hand-held information and communication outlets and driver-less cars). Nevertheless, let us pray that the value-creating songs of the inventors and the risk-takers are not drowned out by the New Year Blues now so prominent in our ears

The UK/EU hurdle for sustained recovery

Business Surveys point to a small loss of economic momentum in the early months of 2015, as reflected in the slowdown in first quarter real GDP.  After May’s General Election, some uncertainty has lifted and the anecdotal evidence points to a more positive mood amongst UK business in recent weeks.  The question now is whether the recovery can turn into a sustained upturn.  The short answer would be “yes”.  Positive consumer confidence and business intentions are supported by a small increase in real incomes that should maintain growth at perhaps 2.4% per annum through 2015.

Nonetheless, there are some potential hurdles to sustained recovery.  The first will be the July Budget when the Chancellor is likely to set out the direction of economic policy for the five-year parliament ahead.  It may be shorter on detail than most commentators would like, largely because the Comprehensive Spending Review is only just underway and will not report its decisions before a possible “autumn statement”.  Nevertheless, some key issues, ranging from fiscal and political devolution through development spending intentions to welfare benefit cuts are likely to be flagged next month. These matters will deserve careful interpretation.

A bigger hurdle is the whole process of renegotiation ahead of the EU referendum promised before the end of 2017.  Whatever you think about the EU as a political force, the economics is simple: boundaries tend to increase costs, restrict markets and probably means economic growth will be less than it might otherwise be.  The ‘single market’ project, therefore, tends to have support from economists and businesses alike because it offers the prospect of larger and fairer markets: the infamous ‘level playing field’.

This does not mean the EU trading zone, as currently constituted, is perfect or that it could not be improved – hopefully, the Prime Minister’s negotiations will move us in a positive way on these matters.  It does mean, however, that, in the near term at least, leaving the EU will probably cause some disruption and uncertainty for UK business.  In the long run, the economy will adjust to the new reality, whatever it is, but the concern is for the pace of the current recovery over the next few years.

In particular, if you are a large and/or multinational company selling across Europe from a UK base (especially US, continental or Asian companies), you are likely to be cautious about local investment until the outcome of the referendum is known. You may not decide to close your UK operations outright or to curtail current production/service supply functions but you may starve them of new investment for a while as you direct future capital investment and focus new product sourcing decisions elsewhere.

Similarly, if you are in a supply chain that sells domestically but to firms that are engaged in EU trade, you may find a degree of uncertainty dampening your prospects over the period 2015-17.  Access to the wider continental pool of talent and skills might be affected adversely, as might access to finance, technology, products and services.  These things happen at the margin but they can be sufficient to restrict the improvement in productivity that the UK economy needs.

More positively, with the UK economy stronger than the rest of the EU at the moment, local businesses that focus on local markets may not see much immediate impact.  Others may start looking towards developing alternative markets outside the EU – some of which might be stronger growers (real and potential) than those in the European zone.  Again, in the long run, shifting incentives may well mean short-term disruptions are self-correcting.

In summary, the non-political essence is that we can be

  1. a) Optimistic about the long term, whatever the outcome of the referendum, because markets respond to new incentives and adapt accordingly, yet
  2. b) Pessimistic about the short-term effects of the EU negotiation process, because of the uncertainty that it will generate.

The worry is that the immediate effects of the whole EU debate are to subdue demand and supply, restrict investment and innovation, and dampen productivity growth and real living standards.  Herein, lies the immediate problem: economic growth is likely to be more sluggish than it might have been because productivity growth will continue to be restrained.

This means that most current economic forecasts are rather subdued.  Without a sharp recovery of productivity growth, it will be hard to sustain an upturn above a modest rate. Without knowing any detail of the in/out alternatives we will face, the policy hurdles ahead will tend to suppress the outlook from what it might otherwise have been.

Strategic Economics Report – April 2015

At the top of the column alongside, you will find our latest summary analysis of the state of the UK economy, its prospects and the outlook for SW and SE England businesses.  As usual, we provide this to readers and clients free of charge to aid local debate and understanding.

  • We describe an economy that has established a sound, if unspectacular recovery, despite a background of policy and global uncertainty.
  • We focus on three main restraints for growth going forward into the medium term:  the lack of productivity growth, the huge external deficits and the risks of deflation.

For southern businesses, the current uncertainties are still enough to constrain investment plans, especially if there is to be an EU exit referendum within two years.  Business emphasis is likely to be on micro planning and adaptation rather than macro ebullience.

As always, Strategic Economics Ltd stands ready to assist you with all things ‘economics’ in the uncertain times ahead.