Sunday, June 14, 2009

UK Outlook: Too Soon to Be Sure of Recovery?

The release of the Bank England's Inflation Report in May showed that it expected the economic downturn to be steeper and to last longer than it projected in the February report. This view was echoed in the latest consensus forecasts for the UK, also released in May. The expectation in that report was for the UK economy to contract by 3.8% this year and to expand by just 0.3% in 2010, see table 1. But recent monthly economic dataflow, from PMI surveys to housing statistics, are showing that the economic outlook for the UK is improving and may not be as grim as expected. We comment on some of the evidence in this Weekly.

Are expectations for the contraction in the UK economy too pessimistic?

Chart a shows that the Bank of England central view is that quarterly annual gdp contracts by close to 5% this year at its worse point (it was down 4.1% in Q1) before gradually becoming less negative and returning to positive growth in 2010. The Bank's inflation forecast, based on this economic profile, shows that the consumer price index (CPI) remains below the 2% target throughout the next two years, falling close to zero this year before gradually rising back to above 1% in the second half of 2010, see chart b. This is also consistent with consensus forecasts made in May, with CPI expected to average 1.6% this year and 1.7% in 2010. The expectation is that this weak inflation environment will allow interest rates to stay low, with the three month interbank rate in the table at 1.3% at end-August this year and only a modest rise from this level to 1.5% at end May 2010. Not surprisingly, with that interest rate profile, the UK exchange rate versus the US dollar also stays weak.

What gdp components lead to the weak growth outcome?

The Bank of England does not provide details of the components that make up its gdp forecasts but the details of the consensus gdp projection can be seen in table 1. This shows that, from the perspective of expenditure, it is a fall in consumer spending of 2.7% this year and a further 0.4% contraction next year that drive down economic growth. As a result of weak consumer expenditure, which accounts for some 67% of the economy, business investment spending falls, by 10.2% this year and by an additional 3.6% in 2010. Associated with the latter is a drop in manufacturing output of 10% this year with only a modest rise of 0.7% expected in 2010.

There are signs that the economic outlook is improving...

The consensus forecast of a 3.8% contraction in gdp this year suggests that there is a further fall of 1.9% expected, given the 1.9% fall in Q1. But will the economy contract by as much as this, given the signs that the intensity of the economic downturn is already lessening? Chart c shows that the service sector PMI is now above 50, at 51.7%, the highest it has been since March 2008. But the chart also shows that the PMIs for construction and manufacturing, although recovering sharply from their lows, are still well in negative territory. Taking a composite of all these indices shows that overall output in the economy was flat in May at 50.4.

It is therefore very possible, that if the rise in the services PMI is sustained, and the improvement in manufacturing and construction continues, overall UK economic growth could turn positive by the end of the year, most likely in Q4. But we are still a long way from that point. Chart d shows that although the rate of contraction of mortgage approvals is much smaller, and that the RICS survey shows that buyer interest has increased rapidly, the level of approvals is still extremely low, and inconsistent with a strong recovery in either housing activity or house prices. Although consumer and business confidence is improving, they still remain at very low levels compared to their highs and are not supportive of economic recovery at this time.

...but it is too soon to be sure as rising unemployment could hit consumer and business spending

One of the key factors that could help determine whether the so called 'green shoots' of economic recovery become entrenched is the path of unemployment, which is still rising rapidly, see chart f. With unemployment already at 2.2m, the highest since 1996, the risk is that consumer confidence gets undermined by the reality of rising unemployment and this then hits business confidence. Such an outcome could result in business investment remaining weak and stall any recovery in production, even though company stock levels are also low. It is still too soon to be sure - it is possible that economic recovery could occur earlier than many expect, even the consensus - but it is also equally (or more than equally) possible that the UK economic downturn will persist into 2010. The jury is out.

Lloyds TSB Bank

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