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.