2007 Green Budget
The Economic Outlook
31 January 2007
Professor David Miles +44 20 7425 1820 david.miles@morganstanley.com
Melanie Baker +44 20 7425 8607 melanie.baker@morganstanley.com
Vladimir Pillonca +44 20 7425 5839 vladimir.pillonca@morganstanley.com
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Summary
 Over the past decade growth and inflation have been stable. This may be
sowing the seeds of future volatility by encouraging people to borrow more.
 The Treasury has recently revised up its estimate of the UK economy’s
potential growth rate from 2.5% to 2.75%, but it uses a more ‘cautious’ rate
of 2.5%. But 2.5% looks to be a central forecast, rather than a cautious one.
 House prices have moved up very sharply in recent years causing
affordability problems and driving borrowing higher; disposable income net of spending on essential items - looks set to grow only modestly.
 We are more pessimistic than the Treasury about economic growth in the
next couple of years. We expect weaker consumer spending growth through
to 2009.
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Plan
 What is the sustainable rate of growth now?
 Where are we in the cycle?
 What is the short term economic outlook?
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The economic environment has been unusually stable
over the last decade
Figure 4.1. Economic growth and inflation less variable than in the past
12
30
10
Real GDP
Retail price index
25
8
20
Q1 2005
Q1 2001
Q1 1997
Q1 1993
Q1 1989
Q1 1985
Q1 1981
Q1 1977
Q1 2005
Q1 2001
Q1 1997
Q1 1993
Q1 1989
Q1 1985
Q1 1981
Q1 1977
Q1 1973
-5
Q1 1969
-6
Q1 1965
0
Q1 1961
-4
Q1 1973
5
Q1 1969
-2
10
Q1 1965
0
Q1 1961
2
15
Q1 1957
% change over year
4
Q1 1957
% change over year
6
Source: ONS, Morgan Stanley Research
4
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Labour participation has risen to historical highs
But do these favourable developments mean that UK’s sustainable GDP
growth is set to rise way into the future?
51
50
% of population
49
48
47
Labour participation
46
Q1 2004
Q1 2000
Q1 1996
Q1 1992
Q1 1988
Q1 1984
Q1 1980
Q1 1976
Q1 1972
45
Source: ONS, Morgan Stanley Research
Note: We define labour participation as employment plus unemployment (aged 16 years and above) divided by the overall population.
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GDP growth — contribution of Capital, Labour and TFP
Factors
(percentage point
contributions)
Capital
deepening
TFP
Growth
Extra
labour
supply
Overall potential Actual
GDP Growth
observed
from sum of
GDP Growth
filtered
contributions
1972 - 2005
1972 - 1985
1985 - 1995
1996 - 2005
2001 - 2005
0.5
0.6
0.3
0.8
0.6
1.6
1.6
1.7
1.4
1.4
0.2
-0.3
0.4
0.6
0.5
2.3
1.9
2.4
2.8
2.6
2.3
1.8
2.5
2.8
2.4
2003
2004
2005
2006 Q1- Q2
0.6
0.4
0.3
0.2
1.5
1.5
1.4
1.3
0.5
0.6
0.7
0.7
2.6
2.5
2.3
2.2
2.6
3.2
1.8
2.4
Forecasts
2007
2008
2009
2010
0.3
0.3
0.3
0.5
1.4
1.5
1.5
1.6
0.9
0.8
0.6
0.3
2.6
2.6
2.4
2.4
Note: The trend rate of the underlying components from the production functions is calculated using a HP Filter,
which aims to decompose output into a permanent (‘trend’) component and a cyclical factor.
Source: Morgan Stanley Research
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Conclusions: What is the trend rate of growth now?
 Using a production function approach, we conclude that sustained population
growth and a small pick-up in the rate of technical progress could push UK
potential output growth to 2.6% in 2007 and 2008,
 Potential growth eases back to around 2.4% after 2008. The temporary
acceleration reflects an assumption that population growth remains strong
and then slows, while the employment rate recovers and total factor
productivity growth picks up.
 Capital deepening is assumed to edge back up to its historical average.
 None of these underlying assumptions is implausible, but we can certainly
see some downside risks, especially in the near term.
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What is the trend rate of growth now? (Continued)
 Statistical filters suggest a potential growth rate of around 2.5% for 2006–10,
only marginally above the UK’s historical real GDP growth.
 But, conditional on our GDP forecasts, these filters tend to suggest a gradual
deceleration of potential output growth towards the end of the forecast
horizon (2009).
 Filtering the GDP data suggest that the Treasury’s estimate that the growth of
productive potential will remain at 2¾% beyond 2007 is slightly optimistic.
The 2½% assumption used to forecast the public finances looks central
rather than cautious as the Treasury claims
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Plan
 What is the sustainable rate of growth now?
 Where are we in the cycle?
 What is the short term economic outlook?
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Data revisions and changes in GDP forecasts will lead
to different estimates of where we are in the cycle….
3
% of potential output
2
1
0
-1
-2
-3
-4
HM Treasury - Budget 2006
MS - Green Budget 2006 (HP 1600)
HMT PBR 2006
MS - Green Budget 2007 (HP 1600)
1990Q1 1992Q3 1995Q1 1997Q3 2000Q1 2002Q3 2005Q1 2007Q3 2010Q1
Source: HM Treasury, Morgan Stanley Research
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Dating the cycle under different approaches compared to
the Treasury’s
Table 4.3. Dates of UK economic cycles
HM Treasury
HP 1,600
1972Q4 – 1978Q1
(22Qs)
1978Q1 – 1986Q2
(34Qs)
1986Q2 –1997Q2
(45Qs)
1997Q2 – F2007H1
(41Qs)
1972Q4 – 1977Q3
(20Qs)
1977Q4 – 1987Q2
(39Qs)
1987Q3 – 1994Q1
(27Qs)
1994Q2 – 2003Q3
(38Qs)
2003Q4 – F2009Q2
(23Qs)
Statistical filters
CF
1972Q3 – 1977Q4
(22Qs)
1978Q1 – 1982Q4
(20Qs)
1983Q1 – 1987Q3
(19Qs)
1987Q4 – 1993Q4
(25Qs)
1994Q1 – 1999Q4
(24Qs)
2000Q1 – F2009Q1
(37Qs)
BK
1972Q3 – 1977Q3
(21Qs)
1977Q4 – 1987Q1
(38Qs)
1987Q2 – 1994Q1
(28Qs)
1994Q2 – 1999Q2
(21Qs)
1999Q3 – 2003Q3
(17Qs)
2003Q4 – n/a
Sources: Morgan Stanley Research; HM Treasury.
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Plan
 What is the sustainable rate of growth now?
 Where are we in the cycle?
 What is the short term economic outlook?
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The short term outlook, some specific risks
Figure 4.8. UK goods, services and current account balances
3
2
% change over year
1
0
-1
-2
-3
Goods balance
-4
Services balance
-5
Current account balance
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
-6
Source: ONS
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Corporate profits are healthy…
18
Profitability of non-financial private companies, gross of depreciation
16
% ratio of profits to capital
Profitability of non-financial private companies, net of depreciation
14
12
10
Q1-06
Q1-05
Q1-04
Q1-03
Q1-02
Q1-01
Q1-00
Q1-99
Q1-98
Q1-97
Q1-96
Q1-95
Q1-94
Q1-93
Q1-92
Q1-91
Q1-90
Q1-89
8
Source: ONS
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Investment rewards: big gap between return to and
cost of capital
16
14
12
%
10
8
WACC (using a 4% equity risk premium; gross of tax)
6
Rate of return on capital (PNFC's) after depreciation
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
4
Source: ONS, Morgan Stanley Research; Note: WACC (weighted average cost of capital) is for UK private non-financial corporations (PNFCs).
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Here’s what consumers’ balance sheet looks like
Household financial balance sheet
GBP billions
Q4 2004
Q4 2005
Q3 2006
Total financial assets
3,152
3,591
3,745
Currency & deposits
855
921
976
Share & other equity
506
586
574
Insurance technical reserves
1,641
1,933
2,034
Other
143
144
154
Total financial liabilities
1,172
1,249
1,338
Loans
1,083
1,158
1,246
876
938
1,017
1,980
2,342
2,407
Secured on dwellings
Total net financial assets
Source: ONS
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Gross financial liabilities have risen to comparatively high levels
160
% disposable income
1995
2004
120
80
40
Spain
Italy
France
Germany
US
UK
0
Source: Eurostat, Federal Reserve, BEA, Morgan Stanley Research
17
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The saving rate is low, especially after adjusting for
contributions to corporate pensions
12
Overall savings rate
10
Savings rate (excluding change in net equity of
households in pension schemes)
%
8
6
4
2
Q1-06
Q1-05
Q1-04
Q1-03
Q1-02
Q1-01
Q1-00
Q1-99
Q1-98
Q1-97
Q1-96
Q1-95
0
Source: ONS, Morgan Stanley Research; Note: Net equity of households in pension schemes is the balance of contributions to and pensions paid by private funded
pension schemes..
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Debt servicing levels and costs are both relatively high
now
18
14
Debt servicing as % disposable
income
MIRAS adjusted
12
Bank of England base rate
16
%
10
8
6
4
Debt servicing is interest payments by households
and regular payment of mortgage principal
2
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
0
Source: ONS, Inland Revenue and Morgan Stanley Research; Note: MIRAS is mortgage interest tax relief (phased out during the 1990s).
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Ten years of house price rises in context
200.0
% changes since November
1996/Q3 1996 (depending on the
frequency of the data)
180.0
160.0
140.0
120.0
100.0
80.0
60.0
40.0
20.0
0.0
Nominal
house prices
Household
mortgage
debt
outstanding
Real house
prices
Real
consumer
spending
Real GDP
Real
household
disposable
income
Source: Haver, HBoS, ONS, BoE, Morgan Stanley Research
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Explaining the change in house prices since 1996
Percentage point contribution to change in real house prices
Model I
Model II
Rise in income per capita
28
44
Increase in number of persons
9
15
Change in real interest rate
14
33
Change in expected capital gains
62
39
Change in housing supply
-
-16
Total change explained by model
113
114
Source: Morgan Stanley Research
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Link from housing market to consumption not entirely
clear….but risks seem skewed to the downside for real
consumer spending growth, relative to Treasury view
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Figure 4.17. Real consumer spending growth close to average
7
Real household consumer spending
% change over year
6
Average since 1996
5
4
3
2
1
Q1-06
Q1-05
Q1-04
Q1-03
Q1-02
Q1-01
Q1-00
Q1-99
Q1-98
Q1-97
Q1-96
0
Source: ONS, Morgan Stanley Research
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GDP growth forecasts compared under alternative
scenarios
2.5
2.0
1.5
Morgan Stanley pessimistic case GDP projection
Morgan Stanley central case real GDP projection
2011-12
2010-11
2009-10
2008-09
2007-08
2004-05
2006-07
HM Treasury (Real GDP growth assumption used in fiscal projections)
1.0
2005-06
% change year-on-year
3.0
Source: HM Treasury, Morgan Stanley Research
23