BREXIT RECESSION?

SUMMARY

A slowdown is under way and there is some probability that a BREXIT recession is coming.

The UK economic engine spluttered in early 2018, faced with some cold east winds and persistent policy doubts. There should be some rebound from adverse weather effects, but other uncertainties will last a while longer.

It is always a matter of concern when the inflation rate is higher than the growth rate. It tends to mean a sluggish economy and constrained living standards. With inflation rates easing and some signs of earnings growth, we must hope that this imbalance (see chart below) does not last long.

Sadly, the consensus is that a modest outlook will persist. For example, the OBR’s March forecast has real GDP growth at or below 1.5% per annum over the next five years with investment at 2.5% p.a. or less.  Given normal forecasting errors, it doesn’t take much of a ‘shock’ to push 1.5% growth down to zero.

We are experiencing the ‘wrong’ kind of growth. Rather than productivity-led, long-term sustainable, ‘green’ growth fuelled by investment, innovation, skills, entrepreneurship and competitiveness, we have growth held back by 1) subdued consumption – high debts, low real wages, an ageing population, 2) an unsupportive policy mix – too loose money and high fiscal debt, and 3) an uncertain global outlook – Brexit unknowns and President Trump’s mercantilism.

Against this background, many businesses seem focused on the here and now and micro rather than macro prospects.  Some firms/sectors strive hard to fill near-term order books and manage skills shortages, whilst others fear unfavourable EU supply chain shifts from March 2019 (Brexit) onwards.  Unfortunately, messages from used car sales, garden centres, and other leisure and retail services suggest final (consumer) demand has softened in recent months. Household spending is not growing robustly, especially in real terms. This has affected retailers in the high street, tourism and other consumer services, and elements of discretionary construction. In contrast, high-end manufacturers and most business services remain relatively buoyant. Current trading and investment seem to be driven by capital replacement and capacity maintenance rather than building future growth potential.

The UK Economy

LATEST EVIDENCE

  Annual (2017) Quarterly Monthly
Real GDP (%ch, yoy) +1.9 +1.2 (Q1) n.a.
CPI inflation (%ch, yoy) +2.7 +2.7 (Q1) +2.5 (Mar)
LFS unemployment (%) 4.4 4.4 (Q4) 4.2 (Dec-Feb)
Current Account (£bn) -82.9 -18.4(Q4) n.a.
Base rate (%) 0.29 0.5 (Q1) 0.5 (Apr)

Source: ONS

The UK economy (see table above) slowed through 2017 and has started 2018 sluggishly – just 0.1% qoq growth in the first three months. There have been signals of weak consumption and investment growth, dampened by modest expectations about future earnings and profits. Surveys of consumer confidence have been softening.

The international environment has not helped, with a number of trade and diplomatic factors adding uncertainty – threatening a ‘cold war’ and a ‘trade war’. The US President is risking a return of mercantilism: the belief that it is the share of the cake, rather than the size of the cake, that matters. Such economic policies were abandoned a century and a half ago – their revival now would be a retrograde step.

Meanwhile, all this political controversy has been reflected in a stock market correction, commodity price swings and volatile exchange rates, adding market uncertainty to political and policy uncertainty. No wonder more people are back to a ‘wait and see’ mode of thinking, planning and commitment.

The essence of the problem, with or without Brexit, is that the UK economy has experienced the ‘wrong’ kind of growth for a number of years, almost to the point of establishing a ‘new normal’. The monetary and fiscal policy mix adopted to deal with the risks of debt and depression at the start of this decade seem intractable. At the same time, household and business prospects are constrained, and constraining, in an economy not built on productivity but on debt and cheap labour.

Crucially, the UK growth/inflation mix (discussed earlier and below) and the debt/deficits mix are unfavourable. The current account deficit remains large (3.6% of GDP in Q4 2017) and the public debt ratio huge at 86% (fiscal 2017/18). An ageing population, falling household living standards, weak investment incentives also contribute to the ‘wrong’ kind of growth, with low creative destruction and poor competitive aspiration.

Although some improvement was experienced in the second half of 2017, the “productivity puzzle” persists, with output per hour still about 20% below trend and the ‘gap’ with our competitors not shrinking. In essence, we have too many low value jobs in a weak investment cycle and not enough robust supply chains based on ‘collaborative yet competitive’ business relationships.

OBR FORECASTS

The Spring release by the OBR in March barely changed its forecasts from November. The key messages were: the cyclical economy is weak: growth is not expected to exceed 1.5% per annum between now and 2022; the structural economy is weak: growth potential remains modest by historical standards because productivity is still poor and the fiscal economy is weak: the public finances remain precarious – the deficit is shrinking but the debt burden is not.

Essentially, the OBR is predicting more of the same over the forecast period: growth not fuelled enough by investment, productivity and real earnings.   The economy is operating near to potential and there is little spare capacity. In the near term, Brexit uncertainty may dampen domestic and foreign direct investment, whilst reducing net positive immigration, compared with what otherwise might have occurred.

The wider consensus is the same. The latest HM Treasury compilation has growth of 1.5% in 2018 and 1.4% in 2019. The UK economy is precariously balanced with low growth and higher inflation (2.3% and 2.1% respectively). Historically, if it persists, the latter being at a higher rate than the former has proved uncomfortable for growth and jobs.

ECONOMIC STABILITY

Interest rates remain very low and are only expected to increase slowly over the next few years. At some point, base rates probably need to get back to about 3.0-3.5% (roughly equivalent to underlying nominal GDP growth), if pre-Great Recession ‘normality’ is to be restored.

As long as this is done in small, slow steps, such an adjustment need not hurt overall economic growth. There may be some pain for over-extended household and corporate debtors who may not have planned properly for higher rates, but a gradual process of change to more ‘normal’ interest levels will improve resource allocation for and by most economic actors in time – a likely condition for getting the economy working sustainably towards the ‘right’ kind of growth.

The question, however, is whether pre-2010 ‘normality’ is a viable target or only of academic/historical interest. The west’s policy response to the debt crisis, including zero interest rates and ballooning central bank balance sheets (quantitative easing – QE), avoided a Great Depression. But, the resulting, persistent debt pile (worldwide over $230trn and over 300% of GDP), was merely shifted from private to public balance sheets. This implies a risk of a renewed funding default if creditors lose confidence in the ability of debtors to repay, particularly as the costs of borrowing (bond yields) edge higher.

As the central banks start to unwind the ‘2010-model’, it is not clear that a return to the ‘old normal’ is possible. The risk is that another crisis hits when the authorities have less room for manoeuvre: a drop of interest rates of the scale seen at the start of the decade to support activity levels is not now feasible. With growth at no more than 1.5% per annum, a fairly small negative ‘shock’ could push the UK towards recession and the Bank of England has less room to do anything about it. In this respect, current evidence of a softening of final demand is worrying. Moreover, it makes a shift towards more sustainable investment and productivity-led growth even more urgent.

 

 

 

More Wrong Kind of Growth

Summary

The UK economy experienced another year of modest economic performance in 2017. Despite the technological drive for change across a range of industries, political, public sector, business investment and consumer factors held back the pace of economic development.

The consensus is that there will be ‘more of the same’ in 2018, with the ‘wrong kind of growth’ persisting unless productivity accelerates. Inflation is expected to stay above target but ease back from its exchange rate highs. The risk of recession is higher than the risk of a boom but an improving world economic outlook suggests some upside to offset BREXIT uncertainties.

Even if the forecasters are correct, there should be considerable interest in major structural changes that will be negotiated or get underway this year, especially those related to future trade patterns and industrial strategy.

Against this background, local businesses are confident, operating at high capacity and continuing to face constraints from infrastructure and skills. The need for investment in competitive productivity has never been stronger.

The UK Economy

LATEST EVIDENCE

UK Annual Quarterly Monthly
Real GDP (%ch, yoy) +1.8 (’17) +1.5 (Q4) n.a.
CPI inflation (%ch, yoy) 2.7 (’17) 3.0 (Q4) 3.0 (Dec)
LFS unemployment (%) 4.9 (’16) 4.3 (Q3) 4.3 (Aug-Oct)
Trade deficit* (£bn) -40.7 (’16) -5.8 (Q3) -2.8 (Nov)
Base rate (%) 0.29 (’17) 0.41 (Q4 17) 0.5 (Jan 18)

Source: ONS   *goods and services

The UK economy (table above) ended 2017 with modest growth, high inflation and low unemployment. The trade deficit was probably shrinking a bit and interest rates were starting to edge higher, along the yield curve. There were signs of good activity in some manufacturing and export sectors but the overall mood in many industries was more sombre, with uncertainty about the future weighing on business decision making. At the same time, consumers were restrained by falling real incomes whilst net government and net trade’s contributions were unhelpful, at best.

For 2018, the questions are whether unemployment has troughed, inflation has peaked and growth can be maintained. Most forecasters suggest a slight move away from the ‘wrong kind of growth’ towards more productivity-led activity but the extent of the improvement is expected to be modest. In particular, the consensus of current forecasts is for 1.4% growth and 2.4% inflation, both slower than in 2017.

OBR FORECASTS

There were three key messages from the OBR in November:

  • The cyclical economy is weaker than previously thought: growth projections fell (not forecast to reach 2%p.a. over next 5 years).
  • The structural economy is weaker than previously thought: growth potential dropped to c1.4% per annum (because productivity worse).
  • The fiscal economy is weaker than previously thought: public finances in deficit until 2019/20. (Debt burden stays close to 80% of GDP.)

Essentially, the OBR is predicting more of the same over the forecast period. This can be summed up as “the wrong kind of growth” – growth not fuelled by enough investment, productivity and real earnings.   The economy is operating near to potential and there is little spare capacity. In the near term, BREXIT uncertainty dampens domestic and foreign direct investment, whilst reducing net immigration, compared with what otherwise might have occurred.

There are two broad risks to this OBR central outlook:

  • Fears about BREXIT disruption may be over-stated. New technological innovation, skills and investment may add value more quickly than anticipated. Also, a buoyant world economy could provide more of a local boost, as long as the pound remains competitive and UK trading patterns can be adjusted smoothly. Output and productivity growth may get back to 2% p.a. or more sooner than we think.
  • The forecasts are now so low, however, that the chance of a shock to confidence causing a further slowdown, even recession, cannot be ruled out. Investment and consumption may stagnate because of constrained living standards/high debt burdens, new trade barriers/corporate realignment of capacity and operations, and higher interest rates.

The future is always uncertain but the current UK outlook is particularly so.

ECONOMIC STABILITY

Interest rates remain very low and are only expected to increase slowly over the next few years. Base rates probably need to get back to about 3.5% at some point (roughly equivalent to underlying nominal GDP growth), if pre – Great Recession ‘normality’ is to be restored.

As long as this is done in small, slow steps, such an adjustment need not hurt overall economic growth. There may be some pain for over-extended households and corporate debtors who have not planned properly for higher rates, but a gradual process of change to more ‘normal’ interest levels will improve resource allocation in time – a necessary condition for getting the economy working well and sustainably.

The fiscal side of stabilisation policy remains constrained by historical and projected levels and ratios of debt. Political imperatives may allow some easing of the immediate fiscal stance, but the room for manoeuvre is limited in a low productivity, low growth economy that is losing clarity about access to important international markets.

Structural reform of the public finances is warranted but may be difficult in the current febrile environment of BREXIT and minority government.

The Dorset Economy

LATEST DATA & SURVEYS

The evidence is that the local economy lost a little momentum in the second half of 2017, reflecting the uncertainty about how BREXIT will evolve. It is unclear as to whether this is a real effect or a convenient scapegoat and some local firms are still quite sanguine. Whatever the truth, the impact is the same – more modest growth in 2018.

For example, the collapse of Carillion (15/1/18) suggests construction and public services may lose output in the near term whilst worrying statements from Airbus (FT 16/1/18) about the prospects for aerospace cast something of a cloud over local supply chains. Similarly, there have been a number of reports, notably from the CBI (FT 26/1/18), that contingency plans for “no deal” are being implemented by externally orientated businesses and this will involve a loss of UK jobs.

The latest Federation of Small Businesses Survey (FT 5/1/18) found a high number (1 in 7) of respondents planning to downsize, close or sell the business in 2018. The overall confidence index was negative for only the second time in five years – the other time was just after the BREXIT referendum day 2016. Falling profits were highlighted, as costs increased and demand, especially consumer demand, weakened.

Similarly, the most recent Chamber of Commerce Survey casts a subdued shadow over the business atmosphere. It shows waning confidence in manufacturing and services at a national level. In Dorset, the mood was steadier about current activity and prospects. Locally, in the latest quarter, sales and orders remained positive and employment and exports grew. In the year ahead, more Dorset respondents expect turnover and profitability to rise than to decline. The prospects were steady compared with the previous quarter – an outlook a bit more confident than seen in the country as a whole.

The various Purchasing Managers’ surveys continue to send mixed signals but there was a softening of activity through 2017 in the SW region, including Dorset. The December report showed business confidence about the near future resilient yet the output and employment measures, whilst still positive, were lower. Compared with a year ago, last month’s output reading was down 11% (from 58.7 to 52.2).

Meanwhile, in the year to September 2017, Dorset enjoyed virtually full employment, with most local places’ ratios below national and many below SW regional averages (see next table – SW averages 78% and 3.5% respectively).

Local Labour Indicators (Oct 2016 – Sep 2017)

Emp % Unemp % Emp % Unemp %
Bournemouth 76.4 3.8 Dorset 78.5 2.7
Poole 75.3 3.2 Somerset 74.8 4.0
Christchurch 80.7 2.3 Devon 78.3 3.0
East Dorset 80.6 2.4 Wiltshire 81.0 3.1
North Dorset 83.7 2.5 Southampton 73.3 4.9
Purbeck 85.2 2.3 Portsmouth 74.0 4.3
West Dorset 79.4 2.7 Hampshire 81.1 3.0
Weymouth & Portland 62.8 4.0 Isle of Wight 71.8 4.3

Source: ONS: employment 16-64 age groups, APS. unemployment 16+ economically active

The local labour market is tight and living costs high, making it hard to find and attract new and replacement skills as long as companies are unwilling or unable to pay higher wages. Skills acquisition and retention is a key area in need of improvement if Dorset is to move towards more sustainable, productivity-led growth.

There is also an issue about a shrinking of the ‘middle’ market, with new entrants (16-25 years old) finding it hard to enter and progress along a desired career path (see Prince’s Trust Survey released 24/1/18 – said to reveal “a staggering deterioration of young people’s confidence in themselves and in their future”).

STRUCTURAL FEATURES

In December, the ONS released latest numbers on the GVA breakdown for 2016 for Dorset.  Total GVA was £16.1bn in 2016 (current prices), placing the county 32nd out of the 38 LEP areas – roughly as expected given its relative size. In terms of GVA per head, taking population into account, Dorset achieved £20,900. This broad measure of productive performance showed Dorset to be below regional and national averages, ranking 24th out of the 38 LEPs.

Dorset’s index of GVA per head was 79.3 (UK average = 100) – down on the previous year. For the first time, Dorset was more than 20 percentage points (pps) below the national average, continuing a long-term downward trend.

This slippage in comparable standing is disappointing. Although it reflects a widening gap across the country (Greater London versus the rest), it also indicates a poor relative local productivity record: Dorset GVA per head dropped from just 8.7pps below the UK average in 2000 to 20.7pps below average in 2016.

This fall in the relative GVA per head index is similar to the experience of other south coast areas. Amongst the 12 “southern” LEPs listed in the next table, Dorset ranked 10th on GVA per head. Only four of twelve have seen a positive change over the last two decades.

GVA per head by LEP area, UK = 100 2016 & pps change since 1998

index change   index change
Cornwall & IoS 64.8 -0.5 Solent 91.7 -8.9
Heart of the SW 75.2 -4.7 Oxfordshire 126.6 +6.9
Dorset 79.3 -9.4 Coast to Capital 95.6 -10.5
Gloucestershire 99.1 +3.0 Bucks Thames Valley 114.3 -12.7
Swindon & Wilts 96.9 -12.2 Enterprise M3 122.3 +2.1
West of England 111.5 +4.5 Thames Valley Berks 158.4 -6.1

Source ONS.

Recent growth in Dorset GVA has been in services, with most growth in business and financial services and least in manufacturing and resources. Production has gone from 23.5% of the economy in 1998 to 18.5% in 2016. This 5% loss has shifted largely to private services (not including real estate).  Within Dorset, about two-thirds of the GVA was generated in the east Dorset conurbation – Bournemouth, Poole, Christchurch and East Dorset (next table shows details).

GVA & GVA per head within Dorset: All industries

£mn £/head GVA % share
Bournemouth 4,145 20,971 25.7
Poole 3,964 26,167 24.6
Christchurch 1,019 20,596 6.3
East Dorset 1,693 18,999 10.5
North Dorset 1,233 17,354 7.6
Purbeck 879 18,962 5.5
West Dorset 2,322 22,905 14.4
Weymouth & Portland 875 13,386 5.4

Source: ONS

The Government’s recently announced Industrial Strategy (below) aims to correct some of the imbalances and inadequacies displayed by the latest GVA statistics.

The annual GVA regional performance publication will always be one of the areas where future analysts will observe whether the Industrial Strategy is having the desired effect.

The Development Outlook

BREXIT & TRADE

More open trade deals between customs unions/countries are intended to increase economic welfare for all partners to the agreement by reducing barriers to exchange in the markets and sectors covered by the agreement, i.e. by increasing economic efficiency, productivity and wealth.

Economic analysis shows decisively, in theory and in practice, that movement towards open (freer and fairer) trade is a net ‘good’ for all concerned. It is one of the things on which virtually all economists agree: more open trade increases competition, raises productivity and boosts living standards for trading partners as resources are re-allocated to reflect absolute and comparative advantage. Although there may be internal distribution issues, all macro parties are better off.

Historically, most trade deal activity has been based on trade in products rather than services but, increasingly, more agreements are likely to be made about the latter. It is important, however, to remember that trade deals are political as well as economic animals. Sadly, the spirit of mercantilism – the view that trade is a zero-sum game with winners (surplus generators) and losers (deficit generators) – is far from dead. In a world of “America First” and “Deutsche vorherrshaft”), Ricardian views of trade – that efficient and mutual specialisation means it is not a zero-sum game) – need to be defended.

This is what is worrying about BREXIT. For example, one of the UK’s comparative advantages is in financial services. Shifting capacity from London to Paris, because of reduced EU access freedoms/passports for the former, merely diminishes both countries’ ability to create total wealth most effectively: a potentially negative reallocation of resources.

The problem is that BREXIT does the opposite to ‘normal’ trade negotiations. For any likely eventual UK-EU terms, it leads to a constraint on trade rather than a liberalisation. Even if, in the long run, ‘freer’ trade deals are agreed with other trading blocs, it will be many years for the near-term losses to be compensated for. There are costs of losing ‘single access’ for both sides.

Also, under BREXIT, failure to set a trade deal with the EU does not mean, as it usually does, a return to the status quo. It results in a less open move to WTO rules. Countries that have a ‘better than WTO’ trade deal with the EU – e.g. Norway, Switzerland, Canada, South Korea – and those further along in the trade negotiations – over 50 in total – would have better access to EU markets than the United Kingdom after a ‘hard’ BREXIT.

Both the EU and the UK lose trade opportunities from a failure to agree favourable terms. Currently, the EU takes c40% of UK exports. The UK takes c10% of EU exports. At the margin, it is not easy for either to substitute these patterns with new markets quickly.

Finally, there are the psychological effects on supply chains – club members tend to deal more with themselves than outsiders – even at an economic cost. There are already reports that UK companies are finding it hard to get onto the list of potential suppliers in the EU after March 2019 and attracting EU ‘talent’ is getting tougher.

There are always winners and losers when trading structures change but BREXIT, by meaning less open trade, means the average UK citizen will be poorer than would otherwise have been the case – unless there is speedy substitution elsewhere. Future politics will be judged on whether this price is material or not and on whether it turns out to be a price worth paying. It is hoped we do not have a populist, more closed economy by the early 2020s.

INDUSTRIAL STRATEGY

Turning to the Industrial Strategy released in November One of the government’s key ‘antidotes’ to BREXIT trade affects, the key point is that it presents a worthy intention to tackle the UK’s long-established and widening productivity ‘gap’ (with its closest competitors) by rebuilding the underlying capacity and export competitiveness of UK sectors, places and workers. The issue is whether it yet amounts to more than throwing everything into the kitchen sink and seeing if anything floats!

The Industrial Strategy is a long-term plan to boost productivity and earnings, based on five foundations – re-packaging the drivers of productivity as follows:

  • Ideas (innovation): raise R&D as a percentage of GDP, turn more inventions into markets, and preserve and extend collaboration between economic actors.
  • People (skills): advance technical education, STEM and retraining – raising quality, filling gaps, and spreading spatial capacity and opportunity.
  • Infrastructure (investment): expand transport, housing and digital infrastructure and use public procurement to build resource efficiency.
  • Business Environment (entrepreneurship and competitiveness):
    generate government-industry sector deals, make UK the place to start and grow businesses, and develop a fiscal system that supports scale-ups and exports.
  • Places (local capacity and competitiveness): produce local industrial and transforming cities strategies that narrow regional productivity differentials and other disparities through local leadership and co-operation between places.

The Strategy announces sector deals for the life sciences, construction, artificial intelligence, and automotive industries and proposes ones for creative industries, industrial digitalisation, and nuclear. It also intends to form a team that will support future (emerging and disruptive) sectors.

The Strategy presents four Grand Challenges for the industries of the future – aspiring to a fourth industrial revolution of technological fusion. The four are: artificial Intelligence & big data, future mobility, clean growth, and ageing society. If engaged, Dorset can feature positively in each of these areas.

The Strategy also promises a review of LEP roles. The Industrial Strategy requires Dorset to produce its own Local Industrial Strategy under the LEP’s guidance, although when, what and how this will be done is not yet clear.

The Strategy talks about the composition of the UK economy, with its world class heights but much mediocrity, as being a major cause of relatively low productivity. Any new policies to address this need to emphasize how sustained growth is generated: globally competitive productivity growth on the supply side and greater trading engagement on the demand side.

The Industrial Strategy discusses many of the ‘right’ issues and proposes to act on many of the ‘right’ levers. The timescales, resourcing and processes are unresolved, but it is a reasonable framework for future development, based, as it is, on improving national and local productivity performance.

As with all UK government’ approaches to sub-national development, however, the uncertainties are about long term political commitment and consistency, especially in an era of changing international economic relationships, and about private sector and local buy-in across industry and place.

For Dorset and its neighbours, the important thing is to improve existing economic linkages – markets, supply chains and wider connectivity – and to develop new ones. We need more connective agglomeration, higher aspirations and a positive attitude towards personal, business and community development.

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.

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.

More on productivity

ONS has published analysis of its microdata on the productivity of UK firms since the downturn.  On the ONS website, see Microdata perspectives on the UK productivity conundrum, An Update, released on 4th October.

Overall, they show working hours back above and output below pre-downturn levels.  Hence, productivity is still falling on average.  But, the variation by firm and by sector is wide.  ONS confirms that exporters, foreign-owned and larger companies perform better, in relative terms, as do high broadband users – although, the downturn has had more negative effects on some of these ‘better’ categories in absolute terms.

The ONS’ central finding is that the lack of recovery in productivity is worse for services (excluding the financial and communications sectors) than manufacturing, and that labour productivity performance in 2010 was weaker among smaller firms than larger firms across all sectors.

This research confirms that historical relationships about productivity in UK firms persist but shows that the downturn has narrowed some of the relative gaps and has been worse, generally, for smaller, low-tech services than for most.

As we have said before, we believe that these trends have to improve before the recovery can be considered secure and sustainable.

Monetary Physics

The universe is made of matter and energy, but the boundaries between the two can seem to blur.  For example, physicists say light is made up of particles (matter) that behave like a wave (energy).  The quantum boundary between the two remains somewhat of a mystery – at least to me.

Money is similar but not exactly the same.  It appears to have economic mass and generate gravity: like matter, money attracts money and appears capable of destruction (through inflation) or expansion (through real growth).  It also appears to have economic energy, fuelling a range of supply and demand chains that suggest “what goes around comes around”.  Money can be sucked into a black hole (the event horizon of a debt-deflation induced liquidity trap) or it can be ejected out to grow new business stars with planets where new species (living standards) can evolve.  Creative destruction is a force of physics and economics.

Does monetary economics have the equivalent of the physics laws of thermodynamics concerning the conservation of energy and the process of entropy?  Yes, in the sense that the monetary system is always in balance – for every credit there is a debit, for every export there is an import,  – and yet it does seem to degrade over time (discounting the future).  Work and order are finite in the economy as well as the physical universe.  In both, some chemistry of creation and destruction seems all too natural

Bankers, whether central, investment or high street, have found ways to innovate with money over the years to influence the development of these laws of “flationarydynamics”.   Sometimes they goes too far – causing imbalances in stocks and flows that upset normal market functions and cause eruptions – supernovae that eliminate existing structures and trends.  Yet, in the death of one monetary star, the seeds of creation are soon.  New, more complex elements emerge to enrich the next cycle of growth.  Sometimes financial innovation, including in response to crises, can add real value, reallocating resources in a way that makes markets more efficient through new businesses, products, processes and markets.  New stars with complex elements that fuel recovery and development.

Right now the question is has the destructive phase of the 2008 financial supernova run its course or has it further to go before some new money-stars are born.  An optimist looks to new technologies, inventions and organisations, as well as the skills and creativity of the young, for our salvation.  The pessimist sees only the debt hangover, fiscal austerity, the low velocity of money and structural logjams.

The cycle turns but, in this period of “monetary physics”, we know not when.  As yet, it’s still long run opportunity and short term threat.  Just perhaps, however, we are getting nearer to the turn in confidence we need.

Don’t get me wrong

In writing about current economic policy in the year-to-date, I have been emphasising this is not the time for inaction.  The economic patient is very ill and intervention is necessary to keep it alive. That intervention should involve investment in the future capacity of the economy to grow – in infrastructure, skills and innovation, and in export markets.  Until the private sector is emboldened to make these investments, and that will only come when uncertainty about future demand is lowered, it has to come from the state.  Leadership in action is required just now.

What I have been questioning is whether the current stabilisation mix of loose monetary policy and tight fiscal policy will bring the growth and recovery that the patient needs.  I think not … mainly because it is not working.  Right now, we need pragmatic activity to boost confidence by creating real capacity for growth rather than a theoretical debate about rebalancing.

But, please don’t take this to mean I favour ‘big government”.  One of the key problems that caused, and makes it hard to get out of, the downturn is that the total scale of government in the economy (including ‘too big to fail’ banks) is out of kilter with the scale of the real private economy that supports it.  The economic patient will be a lot healthier, when it is back on its feet, if it can lose the excess weight of the unproductive parts of the state.

It is right to want to reduce the scale of the public sector to more manageable levels – not just because of the sustainability that brings to the public accounts but also because, in the long run, smaller government will mean more innovation and efficiency in the private sector and that will raise growth rates and living standards more and better over time.  The Euro-zone teaches us how “big government” can go wrong.  Rebalancing is desirable.  The irony, however, is that, right now, we need “big government” (a net spending stimulus in appropriate areas through lower taxes and directed expenditure) to make sure we recover and won’t need “big government” in the future.

So, don’t get me wrong.  Wanting policy action to stimulate growth on the edge of a depression is not the same as wanting the state to dominate the economy forever.