EY ITEM Club Spring Forecast UK economy hampered as Brexit fog continues to swirl April 2019 EY | 1 Contents EY is the sole sponsor of the ITEM Club, which is the only non-governmental economic forecasting group to use the HM Treasury model of the UK economy. Its forecasts are independent of any political, economic or business bias. Foreword 1 Highlights 3 Introduction 4 Forecast in detail 22 1. Fiscal policy 22 2. Monetary policy 23 3. Prices 25 4. Activity 26 5. Consumer demand 27 6. Housing market 29 7. Company sector 30 8. Labour market and wages 32 9. Trade and the balance of payments 33 Foreword Mark Gregory EY Chief Economist, UK @MarkGregoryEY Foreword As you were ... At the risk of sounding like a broken record, the outlook for the UK economy remains incredibly difficult to forecast. The UK did not leave the EU on 29 March as planned and the exact date of departure now is still unclear as politicians return from the Easter recess. As a result, we are trying to understand how much of the performance of the UK economy is being influenced by Brexit-related uncertainty. The disappointing level of business investment seems likely to be due to the lack of clarity on the future UK–EU relationship but, by contrast, some of the growth in UK GDP in the first three months of 2019 may be due to business and consumer stockpiling as a precaution against a nodeal Brexit. However, Brexit is not the only factor making forecasting the UK economy difficult. In the first quarter of 2018, we experienced ‘the Beast from the East’ and this together with Easter falling much later in 2019 than 2018 makes year-on-year comparisons difficult. ... with little sign of faster overall growth ... Drawing the data together and assuming the UK now leaves the EU on 31 October, the EY ITEM Club expects the UK economy to grow at 1.3 % in 2019, down from the forecast 1.5% growth in its Winter Forecast 2019. A later exit from the EU means a slower acceleration in activity as uncertainty persists for longer through 2019 and business investment remains subdued. This effect carries over into 2020 with growth of 1.5% forecast compared to the 1.7% in the Winter Forecast 2019. ... but with differences appearing beneath the surface ... The real challenge though is not the level of growth, disappointing as it is (the slowest since 2009), but in understanding the implications of significant levels of variations in activity across different sectors of the economy. Business investment fell in 2018 and continued on this disappointing path in the first quarter of 2019. The outlook for the global economy has also worsened and the UK’s trade performance has been hit. Yet, EY’s latest Global Capital Confidence Barometer, a survey of over 2,000 executives worldwide, identifies the UK as the leading destination for M&A over the next 12 months. And there are more positive signs. UK consumers have upped their spending in the first quarter of 2019 with strong retail sales growth as real earnings continue to rise and the labour market remains buoyant. Following on from the Budget in the autumn and then the Spring Statement, government spending is also providing a boost to economic activity. The more data we analyse, the more difficult it becomes to form a consistent view of the economy. As the EY ITEM Club points out, while business investment has been falling, companies have nevertheless indicated they are investing in automation and artificial intelligence, although this may be showing up in current not capital spend. This approach 1 Foreword seems likely to reduce employment and yet job growth continues and has recently been dominated by the creation of relatively more full-time positions, rather than the temporary hires we might expect given the uncertainty and the move to introduce labour-saving technology. ... creating the need for vigilance and flexibility. In this uncertain and difficult to analyse economy, businesses should: ► Continue to prepare for a no-deal Brexit as this remains a possible outcome with all the risk this could entail. ► Invest time and resources to tracking the market, with a particular focus on the regular updates on employment numbers, pay and inflation, as these provide the best warning signs of how businesses and consumers are faring. ► Develop options that support rapid responses, such as a quick increase in investment or production, if uncertainty is removed or consumers continue to prove more resilient than we currently expect. ► Continue to build and test strategies against longer-term scenarios based around Brexit outcomes, changes in global trade, technological change and demographic developments. ► Not ignore the threats and opportunities from M&A but consider these in the context of the full landscape of capital deployment. 2 Highlights Highlights ► The EY ITEM Club Spring Forecast 2019 cuts the GDP growth projections to 1.3% (from 1.5%) for 2019 and to 1.5% (from 1.7%) for 2020. The downward revision for 2019 primarily reflects Brexit uncertainties which are being prolonged by the delaying of the UK’s exit from the EU to a flexible 31 October deadline. A weakened global economic environment is also a factor. The delayed Brexit means the UK economy will likely end 2019 with less momentum than previously expected, which will have some dampening impact on growth in 2020. ► UK GDP growth is likely to have picked up to at least 0.4% quarter-on-quarter (q/q) in Q1 2019 from just 0.2% q/q in Q4 2018 and could even have reached 0.5% q/q, but this almost certainly overstates the economy’s underlying strength. There appears to have been an appreciable lift from stockpiling by manufacturers’ clients, and there may also have been some degree of stockpiling by consumers amid concerns that a disruptive ‘no-deal’ Brexit could have occurred in late March. ► We suspect GDP growth may well be limited to just 0.2% q/q in both Q2 and Q3 2019. With Brexit potentially being delayed until 31 October and the domestic political environment fraught, prolonged uncertainty is seen as weighing down on economic activity. Businesses’ willingness to invest and to commit to major new projects is expected to be particularly affected. Consumers are likely to be more resilient, but they may nevertheless be cautious about making major purchases — particularly if the labour market falters. There is also likely to be a hit to economic activity from some unwinding of the stockpiling that occurred in Q1. Meanwhile, lacklustre global growth is likely to hamper UK exports. On the positive side, there should be some help to growth from fiscal policy, particularly increased government spending on the NHS. ► On the assumption that the UK does ultimately leave the EU with a ‘deal’ on 31 October, we expect an easing of uncertainties to allow economic activity to gradually pick up. Consumer spending should benefit from significantly improved purchasing power since mid-2018, although we suspect that real earnings growth will level off and it could even edge back a little in the near term. Having contracted through 2018 and very possibly through much of 2019, business investment should see a clear pick-up. With Brexit uncertainties diluted, many companies are likely to commit to investment that has been delayed, especially if there is a perceived need to update or replace existing plant and machinery or invest in new processes. Capital spending is also likely to benefit from some firms looking to increasingly invest in automation to make up for labour shortages and to try to boost productivity. However, the upside for business investment is likely to be limited by ongoing concerns and uncertainties about the UK’s longer-term relationship with the EU. It is also possible that a Brexit deal will lead the Chancellor to lift government spending more than currently planned. ► Reflecting the weaker growth outlook and the extended uncertainty over Brexit, we now suspect that the Bank of England is more likely than not to sit tight on monetary policy and keep interest rates at 0.75% through 2019. However, we would not rule out one 25 basis point hike to 1.00% over the summer if the UK economy shows resilience and the labour market continues to firm. Assuming there is no interest rate hike in 2019, we expect the Bank of England to raise interest rates twice in 2020 as it looks to gradually normalise monetary policy and as the economy is likely to be firmer. ► Should the UK leave the EU with a deal markedly earlier than 31 October — such as by 30 June — it is possible that GDP growth could be slightly higher in 2019 due to the likely dilution of uncertainty. This could result in business investment picking up earlier than under our central forecast. However, much could depend on the domestic political environment. ► Despite Brexit being delayed to 31 October and Parliament passing motions against a ‘no-deal’ Brexit, it is still a very real possibility. Under this scenario, we believe major uncertainty would negatively impact business sentiment and investment, as well as affect consumers. Trade would clearly be substantially affected as nontariff barriers kicked in. The impact of changes in tariffs is harder to judge as the Government has indicated that, under a temporary scheme, 87% of imports by value would be eligible for zero-tariff access compared to 80% of imports currently being tariff free. Meanwhile, there could be serious disruption at ports, which would affect supply chains. A sharp drop in the pound is likely in the event of a ‘no-deal’ Brexit and this would provide help to UK exporters, but it would also push up businesses’ costs and consumer price inflation, thereby weighing down on households’ purchasing power. We expect policymakers would look to support the UK economy by easing both fiscal and monetary policy. On balance, we suspect that GDP growth is likely to come in at just 0.1% in 2020, after expansion of 1.2% in 2019 — with the economy likely suffering stagnation or even mild recession over the first half of 2020. Growth is seen picking up to 1.2% in 2021. 3 Introduction Introduction The economy seemingly had a better start to 2019 than we had expected in our Winter Forecast 20191, after slowing markedly in Q4 2018. The UK economy ended 2018 on the back foot as GDP growth slowed to just 0.2% quarter-on-quarter (q/q) in Q4 2018 from 0.7% q/q in Q3. This resulted in overall GDP growth of 1.4% in 2018, down from 1.8% in 2017 and the weakest expansion since 2012. While 2018’s 1.4% growth outturn was exactly as we had estimated in our Winter Forecast 2019, the Q4 performance was even softer than the 0.3% q/q we had pencilled in. Indeed, it is likely that GDP growth picked up to at least 0.4% q/q in Q1 2019 from just 0.2% q/q in Q4 2018 and it could even have reached 0.5% q/q. This is despite heightened Brexit uncertainties with it going right down to the wire as to whether the UK would leave the EU on 29 March with or without a withdrawal deal. Indeed, it became increasingly probable during the first quarter that Brexit would be delayed, which was ultimately the case. UK: Contributions to GDP growth 4 Forecast 3 2 1 % year In fact, we strongly suspect that GDP growth of at least 0.4% q/q in Q1 2019 and possibly 0.5% q/q overstates the economy’s underlying strength and that heightened Brexit uncertainties actually had some upward impact on growth by leading to appreciable stockpiling, reflecting concerns that a disruptive ‘no-deal’ UK exit from the EU could occur in late March. This was particularly evident in the boost to manufacturing output that occurred in Q1. Admittedly, consumer spending looks to have been robust in Q1 but even this may have received some boost from stockpiling of some goods by consumers wary of a disruptive Brexit in late March. There were some limited reports of this occurring. It is also possible that some consumers brought forward purchases amid concern that prices could rise if a disruptive Brexit in late March led to sterling weakening sharply. 0 -1 -2 -3 -4 -5 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Domestic demand Net exports GDP growth Source: EY ITEM Club The ultimate outturn of a flexible delay to Brexit until 31 October 2019 has mixed implications for the economy, with both positive and negative implications. On the positive side, a disruptive ‘no-deal’ Brexit in March was avoided; and, while it still remains an ultimate possibility, the chances of it occurring appear to have diminished. On the negative side, Brexit uncertainty is being prolonged (especially as the flexible extension of the Brexit deadline means it could occur any time before 31 October); this is likely to continue to weigh down on business behaviour in particular. Additionally, a further source of uncertainty will be political developments in the UK. A change of Prime Minister could significantly affect the tone of future negotiations with the EU, especially if a committed Brexiteer took charge, as well as potentially affecting other areas of UK policy. There is also the very real possibility of a general election at virtually any time. Meanwhile, another challenge facing the UK is a weaker global economy, with the eurozone in particular suffering significantly softer activity than had been anticipated. Despite the better-than-expected start to 2019, the delaying of Brexit, a likely fraught domestic UK economic backdrop and weakened global economic activity have led us to cut our forecast for GDP growth in 2019 to 1.3% from the 1.5% that we had anticipated in our Winter Forecast 2019. We have also cut forecast GDP growth in 2020 to 1.5% from 1.7%. Our forecast assumes that the UK will ultimately leave the EU on 31 October with some form of withdrawal agreement, not that different to that currently put forward by the Government. 1 EY ITEM Club Winter Forecast 2019: UK economy surrounded by Brexit fog. February 2019. See ey.com/Publication/vwLUAssets/EY_ITEM_Club_UK_Winter_forecast_2018-19/$FILE/ey-item-club-winter-forecast-2018-19.pdf 4 Introduction Reflecting the weaker growth outlook and the extended uncertainty over Brexit, we now suspect that the Bank of England is more likely than not to sit tight on monetary policy and keep interest rates at 0.75% through 2019. However, we would not rule out one 25 basis point hike to 1.00% over the summer if the UK economy shows resilience and the labour market continues to firm. An interest rate hike later this this year could also conceivably occur if the UK ended up leaving the EU well before 31 October and the economy showed signs of improvement. Assuming there is no interest rate hike in 2019, we expect the Bank of England to raise interest rates twice in 2020 as it looks to gradually normalise monetary policy and as the economy is likely to be firmer. Should the UK leave the EU at the end of October without any deal, we believe the growth outlook for the final months of the year and, more particularly, for 2020 would be markedly weaker as major uncertainty would negatively impact business sentiment and investment, as well as affect consumers. Trade would clearly be substantially affected as non-tariff barriers kicked in. The impact of changes in tariffs is harder to judge as the Government has indicated that, under a temporary scheme, 87% of imports by value would be eligible for zero-tariff access compared to 80% of imports currently being tariff free. Meanwhile, there could be serious disruption at ports, which would affect supply chains. A sharp drop in the pound is likely in the event of a ‘nodeal’ exit by the UK from the EU and this would provide help to UK exporters, but it would also push up businesses’ costs and consumer price inflation, thereby weighing down on households’ purchasing power. We suspect that the Bank of England would most likely respond by cutting interest rates, while there would also likely be some easing of fiscal policy. On balance, in the absence of a deal, we suspect GDP growth would likely come in at 1.2% in 2019 and just 0.1% in 2020 — with the economy likely suffering stagnation or even mild recession over the first half of 2020. Growth is seen picking up to 1.2% in 2021. Brexit can kicked down the road with flexible delay to 31 October The major development since our Winter Forecast 2019 is the delaying of Brexit. This obviously has implications for our forecast in that the heightened uncertainty that has been affecting the economy is being prolonged. The UK was scheduled to leave the EU on 29 March but the Government requested an extension after the Prime Minister’s withdrawal agreement negotiated with the EU was defeated three times in Parliament during March. While Parliament passed motions during March against a ‘no-deal’ exit, these were not binding, and there remained a very real possibility that the UK could leave in late March without a withdrawal agreement. March also saw Parliament repeatedly indicate what it did not want to happen with Brexit but it singularly failed to come up with a majority view on anything that it did want — apart from not having a ‘no-deal’ exit. Having asked the EU for an extension to its exit date, the UK was given until 12 April to inform the EU of its plans. If Parliament was unable to pass the withdrawal agreement by then or specify a way forward acceptable to the EU, the UK was due to leave the EU without a deal on that date. However, the UK’s exit from the EU could be delayed until 22 May (the day before European Parliamentary elections) if the withdrawal agreement was passed. 5 Introduction Early April saw the UK Parliament continue to fail to come up with a majority view on anything that it actually wanted regarding Brexit with the exception of not having a ‘no-deal’ exit. This finally led Prime Minister Theresa May to change tack on 2 April when she offered to negotiate with Labour leader Jeremy Corbyn to try and come up with a consensus view on leaving the EU. This was generally seen as increasing the chances of a ‘soft’ Brexit. With the UK Parliament still unable to agree on a way forward on Brexit, Theresa May wrote to the EU on 5 April requesting a further delay on Brexit to 30 June. However, the Prime Minister proposed that the UK would leave the EU before 22 May if a deal could be approved by then so as to avoid participating in the European Parliamentary elections. Meanwhile, European Council President Donald Tusk floated the idea of offering the UK a flexible 12-month extension to the Brexit date. Under this suggestion, if the UK Parliament ratified a deal before the end of the extension date, it could leave the EU earlier. The final outcome saw the EU extend the Brexit deadline until 31 October, but with flexibility in that the UK could leave before that date if it ratifies the withdrawal agreement. However, there is a danger that the Brexit extension reduces the recent heightened impetus for a solution. UK: Indicative votes by MPs (27 March) Option Abstentions EFTA & EEA 377 65 19 Standstill transition 422 139 76 No deal 400 160 77 Revoke Article 50 to avoid 'no deal' 293 184 160 Common Market 2.0 283 188 166 Labour's plan 307 237 93 Customs union 272 264 101 Confirmatory referendum 295 268 74 No Yes Source : Oxford Economics/UK Parliament Option UK: Indicative votes by MPs (1 April) Abstentions Parliamentary supremacy to revoke 'no-deal'* 292 Common Market 2.0 282 261 Customs union 276 273 Confirmatory referendum 292 280 Our forecast is based on the assumption that the UK will leave with a withdrawal agreement on 31 October. This is by no means certain, and while the likelihood of a ‘nodeal’ UK exit from the EU has seemingly diminished, it has not disappeared — especially if a hard-line Brexiteer replaces Theresa May as Prime Minister in the meantime. Should there still ultimately be a ‘no-deal’ UK exit, the economic outlook will be very different, as we discuss in an alternative forecast further below. 191 It is also possible that the UK could end up requesting another Brexit extension before 31 October. This could occur, for example, if a general election is called. No Yes However, it is by no means certain that any further Source : Oxford Economics/UK Parliament extension would be granted. Much as it wants to avoid a ‘no-deal’ Brexit, the EU is reluctant to repeatedly grant the UK Brexit extensions given the prolonged uncertainty this causes for EU economies as well as for the UK economy. 155 95 89 66 Global economic environment has weakened Another unhelpful development for UK growth prospects since our Winter Forecast 2019 has been a further softening in the global growth environment and the outlook after a clear loss of momentum in the latter months of 2018. This has been particularly evident in the widespread troubles affecting industrial activity. Slower global growth and trade obviously have ramifications for the UK economic outlook, most obviously by affecting export prospects and business confidence. 6 Introduction World: GDP & PMI 65 6 5 60 4 55 3 50 2 45 1 0 40 -1 35 30 2001 % y/y Index The March 2019 edition of Consensus Forecasts2 projected that global growth would ease back from an estimated 3.2% in 2018 (which would have been unchanged from the 2017 outturn) to 2.8% in 2019. Significantly, the 2019 forecast of 2.8% global growth has been revised down from 2.9% in the February 2019 edition and 3.0% in the December 2018 edition. Additionally, the International Monetary Fund (IMF) cut its forecast of global GDP growth in 2019 to 3.3% from 3.5% in its April report, down from expansion of 3.6% in 2018. (Note: there are different weightings and methodologies in the IMF and Consensus forecasts). Additionally, Oxford Economics forecasts that global trade growth will slow markedly to 2.5% in 2019 from 4.8% in 2018 and a peak of 6.5% in 2017, and currently sees a serious risk that the slowdown in global trade will be even more marked this year. -2 -3 2004 2007 2010 2013 2016 2019 Global composite PMI (Adv two months,… Global GDP (RHS) Source : Oxford Economics/Haver There has been particular recent concern about signs of slowing activity in China, while the eurozone appears to have seen further softness in Q1 2019 after suffering a marked loss of momentum in the second half of 2018. According to the March 2019 edition of Consensus Forecasts, eurozone GDP growth is seen as slowing appreciably to 1.2% in 2019 from 1.8% in 2018. Additionally, US growth is seen as moderating to 2.4% in 2019 from 2.9% in 2018, while Japanese GDP growth is projected to edge back to 0.7% in 2019 from 0.8% in 2018. Meanwhile, the IMF sees Chinese GDP growth slowing to 6.3% in 2019 from 6.6% in 2018 and 6.8% in 2017. However, there are genuine reasons to hope that global growth can stabilise over the coming months and possibly even see some modest improvement later on in the year. Consensus Forecasts puts global growth stable at 2.8% in 2020 while the IMF sees it improving to 3.6%. World: Manufacturing PMIs 70 60 65 56 60 55 52 Index Index There has recently been an easing in US–China trade hostilities, thereby reducing the likelihood that further tariffs will be imposed — even if it is unlikely that existing tariffs will be reversed any time soon. This is obviously helpful for China’s prospects of avoiding a sharp slowdown, while that risk has also been diluted by the Chinese authorities adopting a number of macro policy easing measures — especially on the fiscal side. Furthermore, it was revealed in mid-April that Chinese growth had been better than expected in Q1 2019 at 6.4% y/y; this was the same rate as in Q4 2018. 50 48 45 40 44 35 30 40 2005 2007 2009 2011 2013 2015 2017 2019 Eurozone (LHS) China (Advanced two months, RHS) Source : Oxford Economics/Markit Policymakers are also likely to look to support growth elsewhere. Admittedly, fiscal stimulus is waning in the US after its peak contribution in 2018, but it will remain supportive in 2019. Additionally, the US Federal Reserve has become more dovish and it now looks likely to hold off from hiking interest rates further. Meanwhile, fiscal policy is becoming more expansive in the eurozone while the European Central Bank (ECB) took a dovish turn in early March when it announced a new series of targeted longer-term refinancing operations, starting in September 2019. This should ensure an adequate level of liquidity for banks and help bolster credit creation. The ECB also tweaked its forward guidance, indicating that that no interest rate hikes will take place “at least through 2019”. A further factor that will hopefully provide support to eurozone growth is decent fundamentals for consumers. Lower consumer price inflation and overall firmer wage growth should support consumer purchasing power while eurozone labour markets are still improving, with the unemployment rate currently at a decade low. 2 Consensus Forecasts, 11 March 2019. See consensuseconomics.com 7 Introduction Meanwhile, pressures on Emerging Markets (EM) have eased after they were pressurised markedly in 2018 by a number of factors included rising US interest rates, a stronger dollar and falling commodity prices. However, these pressures have waned so far in 2019 and EM financial markets have seen significant rebounds. UK: Exports and world trade 15 10 Forecast % year 5 There remains the risk that industrial sector weakness will increasingly drag on other areas of the economy in many countries. While some of the problems in industrial activity can be attributed to specific sector factors such as in the automotive industry (where manufacturers have been struggling with new emission regulations, a plunge in demand for diesel cars and generally softer demand), the weakness obviously runs deeper than that. Indeed, latest manufacturing hard data and surveys are still largely weak, especially for the eurozone and Germany in particular. 0 -5 -10 -15 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 World trade Exports Source: EY ITEM Club There is also the risk that financial market weakness as seen in the latter months of 2018 could resurface and weigh down on global growth. It is likely that the economy saw stronger growth in Q1 as stockpiling countered heightened Brexit uncertainties and weaker global growth The UK economy seemingly saw significantly improved growth in Q1 2019, after shifting down to a lower gear in the latter months of 2018. This is despite the economy facing heightened Brexit uncertainties and slower global economic activity. However, it looks likely that the Q1 2019 performance was lifted by ‘special factors’, primarily related to stock-building amid concerns that a disruptive ‘no-deal’ UK exit from the EU could occur in late March. Admittedly, consumers seem to have been very resilient in Q1 2019, but even their performance may well have been lifted by some degree of stockpiling, reflecting concerns over the impact that a potential disruptive Brexit in late March could have, while warm weather also seemingly boosted retail sales over Q1. Specifically, UK GDP growth slowed to just 0.2% q/q in Q4 2018 from 0.7% q/q in Q3. The Q4 2018 component breakdown of the expenditure side of the economy did not make very appetising reading. Disappointingly and worryingly, business investment fell 0.9% q/q in Q4, which was the fourth successive decline, resulting in it being down 2.5% year-on-year (y/y). This followed q/q declines of 0.6% in Q3, 0.4% in Q2 and 0.6% in Q1, marking the first time that business investment had fallen in four successive quarters since the steep downturn of 2008/9. The steeper decline in business investment in the fourth quarter strongly suggests that already cautious businesses were even more reluctant to commit to capital expenditure as doubts mounted as to whether the UK would leave the EU with a deal in late March, and companies looked for greater clarity over the UK’s likely long-term relationship with the EU. Overall investment contracted 0.6% q/q in Q4 and was down 1.1% y/y. Despite the sharp drop in business investment, the decline in overall investment was helped by a rise in government investment (up 0.5% q/q). Consumer spending growth was stable at 0.3% q/q in Q4. There was evidence of improved consumer spending power in Q4 as real household disposable income rose 1.0% q/q and 2.2% y/y. The household saving ratio also improved to 4.5% from 4.1%. However, the upside for consumer spending appeared to be limited by increased caution amid heightened Brexit and economic uncertainties as consumer confidence weakened in December to its lowest level since July 2013. Government spending rose 1.3% q/q and was up 1.0% y/y in Q4. This was a marked pick-up in government spending q/q following recent restraint. Meanwhile, there was a reported modest fall in stock-building excluding adjustments in Q4; this was at odds with reports that a number of companies had looked to protect their supplies of inputs and finished goods amid heightened concerns about a disruptive Brexit. Net trade made a modest negative contribution of 0.1 percentage points (ppts) to fourth-quarter GDP growth. Exports of goods and services rose 1.6% q/q in Q4. Imports climbed a greater 2.1% q/q. The underlying trade 8 Introduction performance was weaker than indicated by the headline figure as there were reported significant exports of non-monetary gold (which correspondingly affected gross capital formation in the opposite direction). On the output side of the economy, growth in services output slowed to 0.5% q/q in Q4 2018 from 0.6% q/q in Q3. There was relatively soft growth in the distribution, hotels and catering sector (up 0.3% q/q). There are indications that Brexit uncertainties and increased concerns over the domestic economy have recently weighed on demand for business services. Additionally, demand for consumer services has recently been subdued. Particularly disappointingly, industrial production contracted 0.8% q/q in Q4 after a rebound of 0.6% q/q in Q3. Within this, manufacturing output plunged 0.8% q/q in Q4. The recent weakness in manufacturing activity has been widespread and it has been hampered by problems in the automotive sector as manufacturers struggled with new emission regulations. Further bad news saw construction output relapse 0.5% q/q in Q4 after expansion of 1.8% q/q in Q3. We suspect that the economy achieved improved growth of at least 0.4% q/q in Q1 2019 and it could conceivably have reached 0.5% q/q. However, we believe this overstates the economy’s underlying health. UK: Monthly output estimates 5 4 3 3m-on-3m There was seemingly an appreciable lift to growth in Q1 2019 from stockpiling of inputs and finished products as companies looked to safeguard their supplies, reflecting fears of an imminent disruptive Brexit. This was particularly evident in markedly higher manufacturing output in January and February amid reports of clients looking to guarantee their supplies of products. Survey evidence from the Purchasing Managers’ Index suggests that manufacturing activity benefitted further in March from record stockpiling of inputs and finished products. 2 1 0 -1 -2 -3 GDP Production However, there is obviously the possibility that if a Construction Services significant number of the stocks being built up were Source : Haver Analytics imported (which seems logical) that may well have had an appreciable negative impact on net trade. Indeed, it is notable that the UK’s trade deficit widened markedly in January and February. Imports of goods excluding oil were up 6.2% on a three-month/three-month basis in February compared to a 0.1% drop in exports. It should also be borne in mind that some of the resources being spent on stockpiling have eaten into capital that might otherwise have been used for other purposes such as investment or advertising. There is also evidence of consumer resilience in Q1 2019 with retail sales volumes rising a robust 1.6% q/q in Q1 — although consumer spending on services was likely to have been less impressive. However, business investment seems highly likely to have fallen again and net trade was probably negative as it was hampered by weaker global growth as well as imports being lifted by stock-building. 9 Introduction Latest monthly GDP data show GDP rose 0.2% month-onmonth (m/m) in February. This was the consequence of manufacturing output spiking 0.9% m/m with overall industrial production up 0.6% m/m. Construction output rose 0.4% m/m in February while the dominant services sector eked out expansion of 0.1% m/m. Index 65 UK: CIPS/Markit composite PMI & GDP growth 60 55 % 2.0 1.5 1.0 0.5 February’s 0.2% m/m growth in GDP followed a 0.5% m/m 0.0 50 jump in January which was clearly largely a correction -0.5 after GDP had contracted 0.3% m/m in December 45 -1.0 (although there was significant help to GDP growth in -1.5 January from strong retail sales as consumers seemingly 40 looked to take advantage of the clearance sales). The -2.0 Office for National Statistics (ONS) has highlighted that 35 -2.5 the monthly GDP data can be volatile and there can be 2006 2008 2010 2012 2014 2016 2018 little doubt that January’s 0.5% m/m jump in GDP clearly GDP growth (RHS) Composite PMI (LHS) Source : Oxford Economics/Haver Analytics&CIPS/Markit overstated the strength of the economy just as December’s 0.3% m/m drop markedly overstated the weakness. The ONS has indicated that the three-month/three-month measure of GDP gives a more reliable reflection of the economy’s state; this stood at 0.3% in the three months to February; the same as in the three months to January and up from the low of 0.2% in the three months to December. Even if GDP was only flat m/m in March, this would have resulted in GDP growth of 0.4–0.5% q/q in Q1 2019 barring any revisions to the January/February data. It is very possible that the economy was only flat in March given the tortuous twists and turns on Brexit — although retail sales were robust and it is likely there was a further boost to activity from stockpiling. Notably, the Purchasing Managers’ Index reported that the service sector contracted in March for the first time since July 2016 and also found that construction activity contracted marginally. However, the Purchasing Managers’ Index reported that manufacturing activity spiked to a 13-month high in March as it got a substantial lift from producers and their clients stockpiling inputs and finished products at a record rate to guarantee their supplies in case of a disruptive Brexit. Meanwhile, retail sales jumped 1.1% m/m in March, helped by warm weather. Additionally, it is conceivable that retail sales were lifted in March by some stockpiling of goods by consumers wary of a disruptive Brexit in late March. There were some limited reports of this occurring. It is also possible that some consumers brought forward purchases amid concern that prices could rise if a disruptive Brexit in late March led to sterling weakening sharply. Conditions look to be in place for reasonable domestic demand if uncertainties ease, helped by improved consumer spending power A notable feature of the economy in 2018 was how much more resilient consumer spending was than other sectors of the economy as Brexit and economic uncertainties (notably including slowing global growth) mounted during the year. Consumer spending rose 1.8% over 2018, clearly above GDP growth of 1.4%. Robust retail sales over Q1 2019 coupled with a return to modest growth in private car sales points to consumer spending showing further resilience in Q1 2019. It is worth remembering that consumer spending also proved resilient in the aftermath of the UK’s vote to leave the EU in the June 2016 referendum. This largely reflected the fact that fundamentals at the time remained relatively positive for consumers for some time after the referendum vote with purchasing power decent and the labour market improving. 10 Introduction Consumers have been helped by a clear pick-up in purchasing power since mid-2018. Specifically, ONS data show that annual total average weekly earnings growth rose to 3.5% in the three months to December, where it remained in the three months to February 2019; this was the best level since the three months to July 2008. It was up from 2.4% in the three months to June 2018. Meanwhile, annual regular earnings growth (which strips out sometimes-volatile bonus payments) also rose as high as 3.5% in the three months to January, which was also the best level for a decade. It was up from 2.7% in the three months to June 2018. However, it edged back to 3.4% in the three months to February. UK: Average earnings and inflation 7 6 5 Forecast 4 % year This improvement in earnings growth indicates that increasing labour market tightness was finally having a discernible upward impact on pay. Significantly, employment rose 222,000 in the three months to January, which was the largest gain since late 2015 and took the total up to a new record high of 32.714 million. The employment rate reached a new peak of 76.1% in the three months to January, while the unemployment rate dipped to 3.9% which was the lowest rate since the three months to January 1975. Employment growth slowed to 179,000 in the three months to February, but this still saw the level rise slightly higher to a new peak of 32.721 million; it also kept the employment rate up at 76.1% and the unemployment rate down at 3.9%. 3 2 1 0 -1 -2 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Average earnings* CPI inflation *National Accounts Source: EY ITEM Club Further helping consumer purchasing power is the fact that after rising back up from 2.4% through Q2 2018 to 2.7% in August, consumer price index (CPI) inflation fell back to 2.1% in December then dipped further to a 25-month low of 1.8% in January. With earnings growth firming and CPI inflation moderating, the ONS reported that annual real earnings growth improved from 0.1% in the three months to June to 1.6% in the three months to February, which was the best level since mid-2016, although still appreciably below long-term norms. (The ONS calculates real earnings growth using the consumer price index including owner occupiers’ housing costs — CPIH). It had earlier improved from -0.4% in September 2017 to 0.2% in February 2018 before getting stuck in the 0.1– 0.3% range between March and June of last year. Annual real earnings growth was stable at 1.5% in the three months to January. A key question for UK growth prospects is will consumer purchasing power see further improvement over the coming months? Our suspicion is that consumer purchasing power could well level off following its recent gains and could even see a slight easing back in the near term. This suspicion is reinforced by the fact that annual real earnings growth dipped to a five-month low of 3.2% in February from 3.9% in January, while regular earnings growth fell back to a five-month low of 3.1% from 3.7% in January. However, it has to be borne in mind that monthly earnings data can be volatile (and in the case of total earnings growth, influenced by bonus payments which can also be erratic). This is why most attention is focused on the three-month earnings rates. 11 Introduction UK: Contributions to consumer spending growth 6 5 4 3 2 % year True, there is a good case for arguing that the ingredients in terms of labour market tightness are in place in the labour market to push pay up further. As at the three months to February 2019, the Labour Force Survey (LFS) unemployment rate of 3.9% was the lowest since the three months to January 1975, while the employment rate was at 76.1% in the three months to February, which was the highest since records began in 1971. Meanwhile, pay growth for those towards the lower end of the income distribution will continue to receive support from statesanctioned increases in the National Minimum Wage (NMW) and National Living Wage (NLW). The NLW rose from £7.83 to £8.21 per hour in April 2019, an increase of 4.9%. The NMW, which applies to those aged under 25, rose by 3.6%–4.3% in April, depending on the age of the employee. The minimum wage for apprentices increased by 5.4% from £3.70 to £3.90 per hour. 1 0 -1 Forecast -2 -3 2010 2012 2014 2016 2018 2020 2022 Savings contribution Income contribution However, it would be prudent to exercise caution in Consumer spending growth predicting that pay growth will continue to pick up. Source: EY ITEM Club Employers will certainly be keen to keep their labour costs as low as possible given the current highly uncertain economic outlook and they will face rising costs from pensions auto-enrolment (having risen from 1% to 2% in April 2018, and due to rise again to 3% in April 2019). Additionally, employers with payrolls of more than £3 million a year have had to pay the Apprenticeship Levy since April 2017. Furthermore, latest productivity developments are hardly conducive to granting higher pay increases. ONS data show that output per hour was down 0.1% y/y in Q4 2018 as it only rose 0.3% q/q after a 0.2% q/q drop in Q3. This completed an underwhelming overall productivity performance for 2018, with erratic movements. Indeed, the ONS noted that labour productivity rose just 0.5% over 2018 as a whole, which was markedly below the annual average growth rate of 2.0% seen before the 2008/9 downturn. This can only fuel concern over the UK’s muted productivity performance over the past decade. It also meant that unit labour costs rose 3.1% in 2018, the largest increase since 2013. Meanwhile, several of the factors that seem to have limited pay growth’s response to a tightening labour market in recent years are still significant — notably a lack of worker power stemming from de-unionisation, globalisation and the threat of offshoring. Fragile consumer confidence amid major economic, political and Brexit uncertainties has also probably deterred many workers from pushing hard for markedly increased pay rises over the past couple of years. Moreover, the low official unemployment rate disguises a still significant pool of working-age people who are out of work or underemployed. As at the three months to February 2019, 4.12 million people were either officially unemployed (1.343 million), classed as inactive but saying they wished to work (1.830 million), or in part-time jobs but wanting a full-time role (0.950 million). A final factor likely to limit any further pick-up in earnings growth is that employment growth looks set to be clearly lower over the rest of 2019 amid relatively muted growth and, now, extended Brexit uncertainties. Admittedly, employment growth was still a robust looking 179,000 in the three months to February, but the actual employment level at 32.721 million was only up slightly from 32.714 million in the three months to January. Furthermore, employment is a lagging indicator and the economy had been strong over Q3 2018 when GDP expanded 0.7, % q/q. Certainly, there is current survey evidence to suggest that employers are currently increasingly adopting more of a ‘wait and see’ approach on employment given the economy’s marked loss of momentum since Q3 2018 and heightened Brexit uncertainties. The delaying of Brexit until 31 October and potential highly uncertain political developments over the coming months, along with a weakened global economic environment, are likely to fuel businesses’ caution over employment. Taking everything into consideration, while we expect earnings growth to largely retain its recent firmer tone, we suspect that it may level off and could even dip in the near term at least. Consistent with this view, survey evidence that has previously been pointing to labour market tightness pushing up starting salaries and, seemingly, also salaries for people switching jobs, is now showing the rates of increase coming off their recent highs. The monthly KPMG and REC/IHS Markit Report on Jobs for March observed “a combination of lower 12 Introduction candidate availability and strong demand for staff led to further increases in pay. That said, rates of pay growth softened since February. The latest increase in starting salaries, though sharp, was the slowest recorded for just under two years. Meanwhile, temp pay growth was the least marked since March 2017.” 3 Similarly, there is survey evidence that while employers have been recently giving modestly higher pay increases for their existing staff, the increases have been somewhat limited and may now be levelling off. The Bank of England’s regional agents reported in their Q1 2019 survey of business conditions (published in March) that “Pay settlements remained on average in the range 2.5% to 3.5%, and pay growth appeared to be flattening off after past rises. Nonetheless, contacts continued to give targeted pay awards to address skill shortages. And companies with a high proportion of low-paid staff concentrated pay increases on staff who were on or just above the National Living Wage. Some contacts said that the increase in employer autoenrolment pension contributions this year would add to total labour cost growth.”4 Overall, we expect annual earnings growth to average 3.2% over 2019, up from the 2018 outturn of 3.0% but down modestly from the end-of-2018 growth rate of 3.4%. This level would still clearly be below the pre-financial crisis norm of 4.5% to 5% annual growth. % of disposable income, 4QMA A March survey by XpertHR (which collates data on pay settlements at large employers) said firms it surveyed expected on average to award basic pay rises of 2.5% this year, the same as in 2018. In the immediate past before 2018, increases had been centred around 2%. An earlier survey released in mid-February by the Chartered Institute of Personnel and Development (CIPD) indicated that employers in the private sector plan to raise average basic pay by 2.5% over the coming year. This was up from 2% in the November survey and was the highest rate since the survey started in 2012. However, the CIPD also revealed that public sector employers expect pay increases to fall back to an average of 1.1% in 2019 after a temporary rise to 2%. It appears that companies have been facilitated in giving only modestly higher pay rises to existing UK: Savings ratio staff by a marked reluctance of many workers to 14 change their jobs amid heightened economic 12 uncertainties, with Brexit being a significant factor Forecast in this. 10 8 6 4 2 0 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Meanwhile, consumer price inflation edged up to Source : EY ITEM Club 1.9% in both February and March from the 25-month low of 1.8% seen in January 2019. It may well edge above 2% in the near term but we suspect it could then dip back under 2% for a while later on this year. We see it averaging 1.9% in 2019 and 2.0% in 2020. With average consumer price inflation seen dipping to 1.9% in 2019 from 2.5% in 2018, overall inflationadjusted pay is forecast to increase by an average 1.3% in 2019, appreciably up from 0.5% in 2018. However, it would be down modestly from the decade-high rate of 1.6% seen in the three months to February 2019. Additionally, employment growth is expected to slow in 2019 after the surprisingly strong start to the year, which will limit the improvement in real household disposable income growth. This is expected to increase 1.5% in 2019 compared to growth of 2.1% in 2018. It is also seen at 1.5% in 2020. There is, of course, the possibility that extended Brexit uncertainty following the delay until 31 October will increasingly wear down consumers and have an increased dampening impact on their behaviour, especially willingness to make big-ticket purchases. This would be all the more likely if it was evident that the economy was struggling and the labour market was faltering. According to GfK, consumer confidence in March was still only marginally above the January/December level, itself the lowest seen since July 2013. 3 KPMG and REC, Report on Jobs, March 2019. See markiteconomics.com/Survey/PressRelease.mvc/4d902c62b57a4ca882080efac4dd417c 4 Agents’ summary of business conditions — 2019 Q1, Bank of England, 21 March 2019. See bankofengland.co.uk/agentssummary/2019/2019-q1 13 Introduction Meanwhile, with the household saving ratio being very low, consumers may at the very least be keen to avoid further dissaving. Additionally, lenders have cut back on the availability of unsecured consumer credit. Business investment is likely to remain pressurised until Brexit uncertainties ease decisively Business investment was clearly the economy’s weakest link in 2018 as it contracted q/q in every quarter, culminating in a 0.9% q/q and 2.5% y/y drop in Q4. Overall, business investment contracted 0.4% in 2018. There can be little doubt that uncertainties over Brexit have been a major factor behind the extended weakness in business investment, and this belief is seemingly reinforced by the fact that the contraction in capital expenditure deepened in Q4 2018 as the original 29 March Brexit date drew ever nearer, and uncertainties mounted as to whether the UK would leave the EU with a deal. The Bank of England observed in its February 2019 quarterly Inflation Report that “Surveys of companies generally confirm the negative impact of Brexit uncertainties on investment. The Agents’ recent survey of investment intentions cited Brexit as the largest headwind to capital spending, and the Bank’s Decision Maker Panel Survey suggests that Brexit’s importance as a source of uncertainty has risen further in recent months.” The Inflation Report also observed that “UK business investment growth dropped below growth in other advanced economies in the year to 2018 Q3, consistent with a UK-specific factor depressing investment.” 5 Business investment weakness through 2018 occurred despite some positive factors. These included decent rates of return on capital for companies, relatively cheap financing conditions and decent access to capital. UK: CBI ITS - investment intentions* * next 12 months 20 10 % balance The strong suspicion is that business investment 0 contracted again in Q1 2019 as Brexit uncertainties -10 intensified. Consistent with this view, the Bank of -20 England’s regional agents reported in their Q1 2019 quarterly survey of business conditions (published in -30 March) that investment intentions in the -40 manufacturing sector for the next 12 months were at a nine-year low, with contacts mainly citing Brexit -50 Dotted lines denote 10-year averages uncertainties as the main factor. Additionally, -60 investment intentions ‘edged down’ in the services 2006 2008 2010 2012 2014 2016 2018 sector, although they were positive. The agents Plant and machinery Buildings notably observed that “many professional and Source : Haver Analytics financial services firms continued to invest in artificial intelligence and automation, often in response to tight labour market conditions.”6 Additionally, the CBI’s Industrial Trends Survey for Q1 2019 showed very weak investment intentions for the next 12 months. With Brexit now delayed until 31 October 2019, the domestic UK political situation fraught and the global economy currently struggling, it is hard to imagine anything else but further weakness in business investment until late 2019 at least. On the assumption that the UK does leave the EU with a deal on 31 October 2019, then there should be some lift to business investment as uncertainties are diluted. Supporting this view, the Bank of England’s regional agents observed that while manufacturers’ investment intentions for the next year were currently at a nineyear low, “many contacts believed there could be a rebound in investment if a Brexit deal was agreed.” Meanwhile, Chancellor Philip Hammond has frequently expressed his hope that a ‘smooth’ Brexit would see a marked pick-up in business investment. 5 “Inflation Report — February 2019“, Bank of England, 7 February 2019. See bankofengland.co.uk/-/media/boe/files/inflationreport/2019/february/inflation-report-february-2019.pdf?la=en&hash=8487F69ED26692F4697D363A4E47111D1B0503D3 6 Agents’ summary of business conditions — Q1 2019, Bank of England, 21 March 2019. See bankofengland.co.uk/agentssummary/2019/2019-q1 14 Introduction However, we suspect that while an easing of immediate uncertainties in the event of the UK leaving the EU with a deal would have some positive impact on business investment, the upside would likely remain constrained by companies’ uncertainties over the future long-term relationship between the UK and the EU. It may also be that many UK companies would be cautious about significantly stepping up their investment in the immediate aftermath of the UK leaving the EU — even with a deal — as they may want to see how the UK economy performs for a while after Brexit before committing themselves, especially to costly investments. On the positive side, business investment should gain some support from firms looking to increasingly invest in automation to make up for labour shortages and to try to boost productivity. There is also likely to be an increasing need for some companies to replace dated equipment or invest in new processes after recently holding off from doing so due to the heightened uncertainties. Still relatively cheap and available credit, as well as recent decent returns on capital, should also be supportive to investment. Looser fiscal policy will help growth in 2019 and there is the prospect of a further increase in government spending to come in 2020 Some help to UK growth in 2019 is coming from the changes to fiscal policy that were announced in the Budget for 2019/20 on 29 October 2018. Further out, the Chancellor’s Spring Statement on 13 March held out the prospect of additional increases in government spending in the 2020/21 Budget to be held in Q4 2019 should the UK ultimately leave the EU with a deal. If the UK does manage to leave the EU with a deal by 31 October, these increases could yet materialise, although it looks likely that the three-year Spending Review that was due to be held this summer will have to be delayed, as the Chancellor stated in mid-April after Brexit was delayed until 31 October that “until a deal is done, we cannot make decisions about the Spending Review”.7 In the October Budget, the Chancellor had indicated that the 2019 Spending Review would see annual average spending growth of 1.2% in real terms. The Chancellor announced looser fiscal policy for 2019/20 than had previously been planned in the October 2018 Budget after the Office for Budget Responsibility (OBR) concluded that — following recent consistently lower budget deficits (Public Sector Net Borrowing excluding banks — PSNBex) than it had been projecting — it had systematically been underestimating income tax and corporation tax receipts. This led the OBR to substantially revise down its forecasts for underlying government borrowing over the medium term. UK: OBR estimates of fiscal tightening Looser policy 0.4 0.2 0.0 -0.2 % of GDP Rather than letting the budget deficit come down quicker than previously forecast, the Chancellor chose to spend the majority of his windfall, with most of the stimulative measures helping the economy in 2019. Pressure on the Chancellor to adopt such an approach had come from the Prime Minister’s pledge at the Conservative Party conference at the start of October to end austerity. This led the OBR to observe that the October Budget largely “spent the fiscal windfall rather than saving it”. The OBR specifically commented that the “overall effect of the Budget measures is to increase the deficit by £1.1 billion this year and £10.9 billion next year, rising to £23.2 billion in 2023–24. This is the largest discretionary fiscal loosening at any fiscal event since the creation of the OBR.”8 -0.4 Tighter policy -0.6 -0.8 -1.0 Forecast -1.2 -1.4 -1.6 2015-16 2017-18 2019-20 2021-22 2023-24 Oct-18 Mar-19 Source : Oxford Economics calculations using OBR forecasts In particular, spending on the NHS was increased following Government pledges that had been made earlier in the year. Another significant measure announced by the Chancellor was an increase in income tax thresholds from April 2019. Specifically, the personal allowance threshold, the rate at which people start paying income 7 “Hammond: Brexit deadlock leaves little room for key issues”, BBC, 12 April 2019. See bbc.co.uk/news/business-47909151 Overview of the October 2018 Economic and Fiscal Outlook, Office for Budget Responsibility, 29 October 2018, page 83. See obr.uk/overview-october-2018-economic-fiscal-outlook/ 8 15 Introduction tax at 20%, is to be increased from £11,850 to £12,500 in April, which was a year earlier than had been planned. Additionally, the higher rate income tax threshold, the point at which people start paying tax at 40%, is to rise from £46,350 to £50,000 in April. The OBR made further downward revisions to expected PSNBex, announced in the Spring Statement on 13 March. Specifically, the OBR reduced its forecast of government borrowing over 2018/19 to 2023/24 by a cumulative £29.9 billion to £118.5 billion from £148.4 billion. This was based on the assumption that the UK would leave the EU in an orderly way in the near term. By the OBR cutting its expectations of the cyclical deficits over the period 2018/19 to 2023/24, the Chancellor now has £26.6 billion fiscal headroom against his fiscal mandate (which requires the structural budget deficit to lie below 2% of GDP in 2020–21) rather than the £15.4 billion set out in last October’s Budget. Bank of England now seen sitting tight on interest rates through 2019 The economy is unlikely to be hampered by markedly tighter monetary policy in 2019. Indeed, it now looks more likely than not that the Bank of England will sit tight on interest rates through this year, having hiked them just once in 2018 — from 0.50% to 0.75% in August. This was the second hike in the current cycle of a tightening monetary policy as the Bank had earlier lifted interest rates by 25 basis points to 0.50% in November 2017, taking them up from the emergency rate of 0.25% that had been introduced in August 2016 to bolster the UK economy in the aftermath of the vote to leave the EU in the June 2016 referendum. UK: Probability of Bank Rate after December 2019 MPC meeting 80% 70% 68% * Implied by market pricing on 16th April Probability 60% 50% 40% 30% 27% 20% 4% 10% 0% 0% 0.75 Source : Bloomberg 1 1.25 1.5 The Bank of England is seen as remaining in ‘wait and see’ mode on monetary policy until the Brexit situation becomes clearer and it can judge how the economy is responding to developments. On the assumption that the UK eventually leaves the EU smoothly with a deal, the Monetary Policy Committee (MPC) concluded at their meeting ending on 20 March that the Bank of England maintained the view that “were the economy to develop broadly in line with its February Inflation Report projections, an ongoing tightening of monetary policy over the forecast period, at a gradual pace and to a limited extent, would be appropriate to return inflation sustainably to the 2% target at a conventional horizon.” 9 Of course, the last MPC meeting took place before Brexit was delayed from 29 March, but it seems reasonable to assume that the Committee’s stance would be broadly similar should the UK leave the EU with a deal during Q2. With the Brexit uncertainty being prolonged and this being likely to hamper the economy, we believe the odds currently favour the Bank of England keeping interest rates at 0.75% through 2019. The currently weakened global economy and uncertain outlook could reinforce MPC caution on raising interest rates. However, we would not rule out one 25 basis point hike over the summer. If the UK economy proves resilient over the coming months despite the extended Brexit uncertainties, it is possible that the MPC could decide that an interest hike from 0.75% to 1.00% is warranted — especially if the labour market continues to tighten and earnings growth moves higher. It is also possible that the Bank of England could raise interest rates later this year if the UK ends up leaving the EU well before 31 October and the economy then shows signs of picking up. Even then though, the MPC may prefer to err on the side of caution and wait for extended evidence of improved economic activity. Assuming that there is no interest rate hike in 2019, we expect the Bank of England to raise interest rates twice in 2020 (each time by 25 basis points) taking them up to 1.25% by the end of next year as it looks to 9 Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 20 March 2019, Bank of England. See bankofengland.co.uk/-/media/boe/files/monetary-policy-summary-and-minutes/2019/march2019.pdf?la=en&hash=31B9FECDB314DB48096F96474F2820C78D78B5D5 16 Introduction gradually normalise monetary policy and as the economy is likely to be firmer if the UK has left the EU with a deal. The current interest rate of 0.75% is some way below where the Bank of England judges rates will ultimately settle. In its August 2018 quarterly Inflation Report, the Bank gave its estimate of the so-called ‘equilibrium interest rate’. This is defined as “the interest rate that, if the economy starts from a position with no output gap and inflation at the target, would sustain output at potential and inflation at the target”.10 The Bank estimated that in real terms, the long-term equilibrium interest rate is 0%–1%. Adding the targeted inflation rate of 2%, this translates into a long-term equilibrium interest rate of 2%–3%. The Bank sees the equilibrium interest rate as lower in the near term due to still significant headwinds facing the economy, such as consumers’ further need to repair balance sheets, fiscal drag and heightened uncertainty (particularly from Brexit). Modest pick-up in growth expected if a ‘no-deal’ Brexit avoided Our forecast is based on the critical assumption that the UK will ultimately leave the EU on 31 October with a deal. Once this happens, nothing much is expected to change immediately as a transition arrangement essentially preserves the status quo until at least the end of 2020. Furthermore, the strong suspicion has to be that the transition arrangement will ultimately have to be extended, not only due to the UK’s later than originally expected exit from the EU but also due to the likelihood that negotiations over the UK’s longer-term relationship with the EU will prove to be difficult. The forecast sees GDP growth slowing to 1.3% in 2019 from 1.4% in 2018 — this would be the weakest expansion since 2009. Economic activity is expected to be held back over much of 2019 by extended Brexit uncertainties, while a fraught domestic political environment will also likely fuel business caution. Meanwhile, weakened global growth is expected to hamper UK exports as well as reinforce business caution. UK: Contributions to GDP growth 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 1997–2007 2007-2017 %pts While the economy is likely to have expanded at least 0.4% q/q in Q1 2019, this was seemingly significantly helped by stockpiling amid concerns of a disruptive Brexit in late March and the underlying performance was likely softer. We suspect that the economy will struggle to eke out much growth at all in Q2 as some of that stockpiling is unwound due to the delayed Brexit. However, despite the delaying of the UK’s exit from the EU, Brexit uncertainties seem certain to continue to impact on the economy through Q2 and Q3, particularly through limiting businesses’ willingness to commit to investment and engage in major new projects. There is also the probability that businesses will adopt a more cautious approach to employment, which in turn is likely to affect consumers. 2017 2018 2019 2020 2021 2022 Consumer spending Investment Govt. consumption Other (inc. inventories) Net trade Source: EY ITEM Club Nevertheless, consumers have undeniably been resilient so far in 2019, and they are unlikely to completely rein in their spending, while fiscal policy will provide some support to the economy over 2019. We are also hopeful that global economic activity can at least stabilise over the coming months. If the UK does manage to leave the EU with a deal on 31 October, we believe the conditions are in place for a gradual pick-up in activity thereafter, with domestic demand improving. As outlined above, there are good reasons to believe both consumer spending and business investment should benefit from reduced uncertainty, while there could be a further lift to activity from increased government spending. Consequently, GDP growth is seen improving to 1.5% in 2020 as the economy sees expansion of around 0.4% q/q in Q1 and Q2, edging up to 0.5% q/q in Q3 and Q4. Consumer spending growth is seen picking up modestly from 1.4% in 2019 to 1.7% in 2020 amid reasonably solid real income growth, modest employment growth and firmer confidence. Meanwhile, business investment is seen as expanding around 2% in 2020 after 10 Bank of England quarterly Inflation Report August 2018, page 39. See bankofengland.co.uk/-/media/boe/files/inflationreport/2018/august/inflation-report-august-2018.pdf 17 Introduction contraction of a similar amount in 2019 amid reduced uncertainties and a need/desire to save labour and lift productivity. To reiterate the point made above, given the extended uncertainty that has occurred, businesses may be initially cautious about committing to investment and new projects, preferring to see whether the economy really is gaining any benefit from a Brexit deal. Net trade is seen as essentially in balance over 2020. Global economic activity may well see some improvement in 2020, but UK exporters may face a stronger pound as we expect it to firm if the UK does leave the EU with a deal. The EY ITEM Club forecast for the UK economy, spring 2019 % changes on previous year except borrowing, current account, and interest and exchange rates GDP Domestic demand Consumer spending Fixed investment Exports Imports 2017 1.8 1.4 2.1 3.5 5.6 3.5 2018 1.4 1.6 1.7 0.2 0.1 0.7 2019 1.3 1.6 1.4 -1.0 2.7 3.9 2020 1.5 1.5 1.7 1.7 2.9 2.8 2021 1.8 1.9 1.9 2.8 3.5 3.4 2022 1.9 1.9 2.0 2.6 3.8 3.8 2023 2.0 2.0 2.1 2.8 3.8 3.7 Net government borrowing* Current account (% of GDP) Average earnings CPI Bank rate Effective exchange rate 2017 2.2 -3.3 2.6 2.7 0.3 77.4 2018 1.1 -3.9 3.0 2.5 0.6 78.5 2019 1.4 -3.9 3.2 1.9 0.8 80.1 2020 1.3 -3.6 3.2 2.0 1.1 83.9 2021 1.1 -3.6 3.4 1.9 1.6 81.9 2022 0.9 -3.2 3.5 2.0 2.0 82.6 2023 0.8 -3.1 3.5 1.9 2.3 82.5 *Fiscal years, as % of GDP Source: EY ITEM Club It is possible that GDP growth could be adversely affected later on in 2020 by increasing uncertainty as the transition arrangement under the UK’s withdrawal agreement with the EU is scheduled to come to an end. However, we strongly suspect that this will need to be extended (and there is scope to do so) as it seems highly unlikely that the UK and EU will have been able to sort out their future trading relationship by then. Certainly, the negotiations that have taken place so far do not inspire confidence that there will be any quick resolution of what will undoubtedly be complex dealings. Should the UK leave the EU with a deal markedly earlier than 31 October — such as by 30 June — it is possible that GDP growth could be slightly higher in 2019 due to the likely dilution of uncertainty. This could result in business investment picking up earlier than under our central forecast. However, much could depend on the domestic political environment. Still a genuine risk of a ‘no-deal’ Brexit Despite Brexit being delayed from 29 March to 31 October and Parliament passing motions in March against a ‘no-deal’ Brexit, this remains a very real possibility. One scenario under which this could occur is if Theresa May was replaced as Prime Minister by a hard-line Brexiteer and a general election was held resulting in a majority Conservative government. 18 Introduction Our underlying analysis of the likely performance of the UK economy in the event of a ‘no-deal’ Brexit is little changed from in our Winter Forecast 2019. The main difference, of course, is that a UK ‘no-deal’ exit would occur seven months later (assuming no further delaying of Brexit), which means that whereas we previously forecast that GDP growth would be 0.7% in 2019 and 0.6% in 2020, there would now be little hit to growth in 2019 while 2020 would take much more of a hit. Economic activity in 2021 would also suffer more. Specifically, if the UK leaves the EU without a deal on 31 October, we suspect that GDP growth would slow to a minimal 0.1% in 2020 — with the economy likely to suffer mild recession over the first half of the year — from 1.2% in 2019. Growth is seen improving to a modest 1.2% in 2021. Leaving the EU without a deal at the end of October and switching to World Trade Organization (WTO) trading rules would obviously have major ramifications for the UK’s economic outlook. However, in putting together any forecast for this eventuality, it needs to be borne in mind that economic projections made in the immediate aftermath of the vote in June 2016 for the UK to leave the EU proved overwhelmingly pessimistic. The critical point this time around is that the circumstances facing the UK after 31 October would immediately be different, whereas nothing really changed in the immediate aftermath of the vote for Brexit in June 2016. In particular, consumers kept on spending post-referendum as it took time for sterling’s sharp drop following the vote for Brexit to feed through to lift inflation and squeeze purchasing power. Consumer confidence weakened sharply immediately following the June 2016 vote but it then recovered pretty quickly as consumers’ circumstances were little changed in the immediate aftermath of the referendum vote. Meanwhile, nothing changed regarding trading conditions or supply chains. If a ‘no-deal’ Brexit occurs at the end of October, there will be an immediate change of trading circumstances and some developments will be harder to assess than others. In particular, there is no knowing at this stage just how much disruption will occur at ports and how badly supply chains will be affected. And if there are scenes of chaos, how much will this affect business and, also, consumer confidence and behaviour? On the positive side, while the delaying of Brexit from 29 March to 31 October has extended the uncertainties facing the economy, it gives businesses and the Government more time to prepare for a ‘no-deal’ UK exit from the EU. Nevertheless, there is a limit to how much preparation can be done. Consistent with this view, a survey of almost 300 companies by the Bank of England’s regional agents in their Q1 2019 survey of business conditions (published in March) found that around 80% considered themselves ready for a ‘no-deal’ Brexit compared to 50% in a January survey, nevertheless “many companies reported that there were limits to the degree of readiness that was feasible in the face of the range of possible outcomes in that scenario. These included issues relating to tariffs, border frictions, exchange rate movements and recognition of certifications — which many companies felt were outside their control. Indeed, the March survey also showed that respondents — even those that felt ‘ready’ — still expected output, employment and investment over the next 12 months to be significantly weaker under a ‘no-deal, no-transition’ Brexit than under a deal scenario.”11 Sterling is likely to fall markedly following a ‘no-deal’ Brexit from the EU — as it did after the referendum vote in June 2016 — and this is likely to feed through to lift inflation, squeeze consumers’ purchasing power and push up companies’ input costs. The Government has indicated that it would look to mitigate the overall impact on inflation by making overall reductions to import tariffs compared to the current situation, but the suspicion is that this will be insufficient to prevent inflation from rising materially. However, the weaker pound should give some support to UK exports. Trade will be affected as both the UK and the EU levy tariffs and non-tariff barriers (NTBs) are introduced across a range of sectors. However, the Government has indicated that it would make overall reductions to tariffs in the event of a ‘no-deal’ Brexit. Specifically, under a temporary scheme 87% of imports by value would be eligible for zero-tariff access compared to 80% of imports currently being tariff free. With both export and import growth suffering, the effect on GDP growth from this source would be ambiguous. We believe that heightened business uncertainty after a ‘no-deal’ Brexit would weigh down markedly on business investment, although it should be borne in mind that it would already have been weak for a prolonged period, with latest available ONS data showing that it contracted for the fourth successive quarter 11 Agents survey on preparations for EU withdrawal, Bank of England, 21 March 2019. See bankofengland.co.uk/agentssummary/2019/2019-q1/agents-survey-on-preparations-for-eu-withdrawal 19 Introduction in Q4 2019 when it was down 0.9% q/q and 2.5% y/y. This was the first time that business investment had fallen for four successive quarters since the depths of the 2008/9 financial crisis. Heightened uncertainty would also be likely to have some dampening impact on consumer spending, although this could well again prove surprisingly resilient. Indeed, it is notable that consumer spending seemingly proved resilient in Q1 2019 despite mounting Brexit uncertainties. We suspect that policymakers would look to provide both fiscal and monetary policy support to the economy in the event of a ‘no-deal’ Brexit. The Bank of England has repeatedly stated that interest rates could either go up or down should there be a ‘no-deal’ UK exit from the EU, depending on the balance of how the UK’s supply capacity and demand side of the economy are perceived to be affected. Exchange rate movements will also be a factor. However, we strongly lean towards the view that interest rates would be far more likely to be cut than increased if there is a ‘no-deal’ Brexit. With Bank Rate currently only at 0.75%, there is of course limited scope for taking interest rates lower, although the Bank of England could also reactivate quantitative easing. Meanwhile, the Chancellor has indicated that emergency fiscal measures could be introduced in the event of a ‘no-deal’ Brexit and we suspect that he would announce some loosening of fiscal policy. However, how much fiscal stimulus the Chancellor would be able to provide would likely be limited by the fact that the public finances are still far from healthy despite the recent marked improvement. There is also the concern that a sharp loosening of fiscal policy could further undermine investor confidence in the UK, at a time when it would already have likely been pressurised markedly by a ‘no-deal’ exit from the EU. Risks to forecast look balanced 70 60 Number of quarters We see the risks to our UK forecast of GDP growth of 1.3% in 2019 and 1.5% in 2020 largely balanced. On the downside, the main risk obviously is that there is still the very real risk of a ‘no-deal’ Brexit. Meanwhile, global growth could continue to deteriorate and be significantly weaker than we expect over 2019 and 2020. UK: Period between recessions 50 40 Average = 31.5 30 20 Even if a Brexit deal occurs by 31 October 2019, the domestic political situation is highly uncertain, and this 10 could significantly weigh down on economic activity. The 0 Prime Minister has indicated that she will step down once Q4 Q1 Q2 Q4 Q2 Q4 Q3 1956-Q2 1962-Q2 1974-Q1 1975-Q4 1981-Q2 1991-Q1 2009-? the exit from the EU has been secured. This, and the 1961 1973 1975 1979 1990 2008 change of Conservative leadership, could cause Source : Oxford Economics/Haver Analytics uncertainties that affect economic activity — particularly if the new leader is a hard-line Brexiteer who wants weaker ties with the EU over the long term. A general election looks possible at any time, and a change in government would have severe implications, for example, for fiscal policy, microeconomic policy and interest rates. It is also somewhat of a leap of faith to forecast consistent UK GDP growth out to 2023 given the length of the current expansionary cycle. Indeed, 2018 marked a ninth year of growth since UK GDP last contracted (by 4.2% in 2009). In its forecasts provided for the October 2018 Budget, the OBR observed that “in the 63 years for which the Office for National Statistics (ONS) has published consistent quarterly real GDP data, there have been several recessions — suggesting that the chance of a recession in any five-year period is about one in two. So the probability of a cyclical downturn occurring some time over our forecast horizon is fairly high”.12 There is also the concern that in the event of a recession, the Bank of England would not have much ammunition to fight it, given that interest rates are so low. However, there are good reasons to think that the current UK economic upturn could continue for some time to come. The overall strength of the UK expansion since 2009 has been relatively limited, and it followed a particularly deep contraction over 2008/9. There is currently little sign of inflation about to take off, with wage growth still relatively muted despite some recent pick-up and the unemployment rate currently being at its lowest level since early 1975. It may well be that there is more slack in the labour market than the official 12 Overview of the October 2018 Economic and Fiscal Outlook, Office for Budget Responsibility, 29 October 2018, page 83. See obr.uk/overview-october-2018-economic-fiscal-outlook/ 20 Introduction figures indicate. Consequently, it looks highly unlikely that the Bank of England will need to sharply raise interest rates, which would rein in growth. However, there really does need to be a clear pick-up in productivity growth over the medium term for UK expansion to have the best chance of continuing. As mentioned above, a potential upside risk to the growth outlook for 2019 is that Brexit occurs by the end of Q2 2019, thereby diluting the uncertainty that is particularly weighing on business behaviour. A second growth upside potential is that earnings growth could continue to pick up appreciably following the improvement seen in the second half of 2018 in reaction to increased recruitment difficulties in a number of sectors, thereby leading to higher than expected consumer purchasing power and spending. However, this would likely lead to a modestly faster hiking of interest rates than we currently forecast. Even if earnings growth does not continue to pick up, there is the possibility that consumer spending could be stronger than we expect over the coming months. On a longer-term basis, another risk to the growth outlook is that Brexit does not take place and the UK ultimately stays in the EU. We believe that this would most likely lift growth prospects for the economy in 2020 and over the medium term. 21 Forecast in detail Forecast in detail 1. Fiscal policy The public finances saw substantial y/y improvement over the fiscal year 2018/19. This continued the recent consistent pattern of the budget deficit (measured in terms of Public Sector Net Borrowing excluding banks — PSNBex) coming in below the projections made by the Office for Budget Responsibility (OBR). This led the OBR to conclude in October when preparing the forecasts for the 2018 Budget that it had systematically been underestimating income tax and corporation tax receipts. Consequently, the OBR substantially revised down its forecasts for underlying government borrowing over the medium term. The OBR then made further downward adjustments in the March 2019 Spring Statement. PSNBex amounted to £23.1 billion over the first 11 months of fiscal year 2018/19 (April 2018–February 2019). This was the lowest deficit for the period for 17 years and was down an impressive 43.8% from £41.0 billion in April 2017–February 2018. UK: Public sector net borrowing * £bn, cumulative 50 45 40 35 * excluding public sector banks OBR forecast for 201819= £22.8bn In October’s Budget for 2019/20, the OBR slashed its 30 forecast for PSNBex in 2018/19 to £25.5 billion (1.2% of 25 GDP) from the £37.1 billion (1.8% of GDP) that it had 20 projected in the March 2018 Spring Statement. There 15 2017-18 were further reductions — albeit more limited — over a 10 2018-19 five-year horizon with the 2019/20 PSNBex cut to an 5 expected £31.8 billion (1.4% of GDP) from £33.9 billion 0 (1.6% of GDP) right through to the 2022/23 shortfall Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb reduced to £20.8 billion (0.9% of GDP) from £21.4 billion Source : Oxford Economics/Haver Analytics & OBR (0.9% of GDP). The budget deficit was then seen dipping further to £19.8 billion (0.8% of GDP) in 2023/24, which would be a 20-year low. In total the OBR cut the projected budget deficits over the five years 2018/19 to 2022/23 by a cumulative £18.5 billion. Mar The main reason why the expected PSNBex was slashed for 2018/19 but only trimmed for future years was that the Chancellor chose to take advantage of the OBR’s cutting of the underlying budget deficits by introducing fiscal stimulus measures, most notably through increased spending on the NHS, as well as an earlier than previously planned raising of income tax thresholds. The March 2019 Spring Statement was not a major fiscal event, primarily comprising an update of the OBR’s outlook for the economy and public finances. This saw the OBR make further appreciable downgrades to expected PSNBex over the medium term. Specifically, PSNBex was forecast to be £22.8 billion (1.1% of GDP) in 2018/19 rising to £29.3 billion (1.3% of GDP) in 2019/20 but then coming down progressively to £21.2 billion (0.9% of GDP) in 2020/21 and £13.5bn (0.5% of GDP) in 2023/24. In total the OBR reduced its forecast of government borrowing over 2018/19 to 2023/24 by a cumulative £29.9 billion to £118.5 billion from £148.4 billion. The OBR’s new fiscal forecasts were based on the assumption of a smooth Brexit in the near term and they gave the Chancellor scope to offer a larger fiscal carrot should this occur. By the OBR cutting its expectations of the cyclical deficits over the period 2018/19 to 2023/24, the Chancellor now has £26.6 billion fiscal headroom against his fiscal mandate (which requires the structural budget deficit to lie below 2% of GDP in 2020/21) rather than the £15.4 billion set out in last October’s Budget. The Chancellor has indicated that the forthcoming three-year Spending Review — that was originally due to be held this summer but will now likely be delayed due to the extended Brexit uncertainties — could contain larger spending increases. In the October Budget, the Chancellor had indicated that the 2019 Spending Review would see annual average spending growth of 1.2% in real terms. However, one looming problem for the Chancellor that was not addressed in the Spring Statement is the change in the way that student loans will be accounted for. The OBR estimated that treating loans partly as grants could increase the structural budget deficit by around £12 billion (0.5% of GDP in 2020/21). This would absorb almost half the Government’s current headroom against the fiscal mandate, as well as making a balanced budget harder to achieve. 22 Forecast in detail 1. Monetary policy The Bank of England’s Monetary Policy Committee (MPC) raised interest rates once in 2018, with a 25 basis points hike from 0.50% to 0.75% in August. Since then the central bank has been very much in ‘wait and see’ mode as Brexit uncertainties have mounted. The March MPC meeting saw the Committee once again hold interest rates at 0.75% following a unanimous 9– 0 vote. The MPC maintained the view that if the economy pans out as per the growth and inflation forecasts in its February quarterly Inflation Report “an ongoing tightening of monetary policy over the forecast period, at a gradual pace and to a limited extent, would be appropriate to return inflation sustainably to the 2% target at a conventional horizon.” The MPC further observed at their March meeting that “Since the Committee’s previous meeting, the news in economic data has been mixed, but the MPC’s February Inflation Report projections appear on track.” The forecasts contained in the February quarterly Inflation Report were based on prevailing market expectations that it would be touch and go whether there will be one 25 basis point interest rate hike in 2019, while one–two 25 basis point hikes in total were seen by the first quarter of 2022. However, Governor Mark Carney has since highlighted that based on these marked expectations, the inflation forecast is marginally above the Bank of England’s 2.0% target on a medium-term horizon, which implies modestly more monetary policy tightening may be needed than the markets are pricing in. 6 UK: Bank Rate and 20-year bond yield 5 4 20-year government bond yield Forecast % 3 2 1 Bank Rate 0 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Source: EY ITEM Club We believe the underlying state of the economy largely justifies the Bank of England adopting a ‘wait and see’ approach on interest rates, regardless of the current heightened uncertainties. While GDP growth is likely to have picked up to at least 0.4% q/q in Q1 2019 from just 0.2% q/q in Q4 2018, this was seemingly lifted appreciably by stockpiling and exaggerated the economy’s true strength. The Bank of England itself in its March MPC minutes saw Q1 GDP growth at 0.3% q/q. It considered that consumer spending growth had seemingly recovered a little from recent weakness but also observed that “Brexit uncertainties had continued to weigh on confidence and short-term economic activity, notably business investment.” The MPC also noted a further weakening in survey indicators of output since the start of the year, which by themselves suggested somewhat weaker activity. A currently robust labour market and recent firmer earnings growth is supportive to the case for the Bank of England eventually hiking interest rates, but again it remains to be seen if this continues over the coming months given the economy’s loss of momentum in late 2018 and the suspicion that the underlying performance so far in 2019 is less impressive than the headline GDP growth figure for Q1 may suggest. Indeed, earnings growth slipped back in February when there were hints that the labour market’s impressive resilience could just be starting to fray. Nevertheless, the MPC will note that as a result of poor productivity growth and rising earnings, unit labour costs rose 3.1% in 2018, which was the sharpest increase since 2013. Facilitating the Bank of England adopting a ‘wait and see’ approach on monetary policy, consumer price inflation was stable at 1.9% in March, which marked the third month running that it had been slightly below the Bank of England’s 2.0% target rate. While inflation could edge above 2.0% in the near term, it looks likely to remain close to 2.0% for much of this year and, very possibly, 2020. However, the MPC noted at its March meeting that inflation could be a little higher than had previously been expected in the near term due to the recent rise in oil prices and Ofgem’s announcement in February of an increase in the caps for standard variable and pre-payment tariffs, from April, which had been somewhat larger than expected. While observing that unit wage growth had picked up, the MPC considered that “underlying inflationary pressures appeared to be broadly on track with the projections underlying the February Inflation Report.” 23 Forecast in detail With the Brexit uncertainty being prolonged and with this likely to hamper the economy, we believe the odds currently favour the Bank of England keeping interest rates at 0.75% through 2019. The currently weakened global economy and uncertain outlook could reinforce MPC caution on raising interest rates. However, we would not rule out one 25 basis point hike over the summer. If the UK economy proves resilient over the coming months despite the extended Brexit uncertainties, it is possible that the MPC could decide that an interest hike from 0.75% to 1.00% is warranted — especially if the labour market continues to tighten and earnings growth moves higher. It is also possible that the Bank of England could raise interest rates later this year if the UK ends up leaving the EU well before 31 October and the economy then shows signs of picking up. Even then though, the MPC may prefer to err on the side of caution and wait for extended evidence of improved economic activity. Assuming that there is no interest rate hike in 2019, we expect the Bank of England to raise interest rates twice in 2020 (each time by 25 basis points) taking them up to 1.25% by the end of next year as it looks to gradually normalise monetary policy and as the economy is likely to be firmer if the UK has left the EU with a deal. If the UK ultimately leaves the EU without a deal, the Bank of England has repeatedly held to the view that interest rates could move in either direction. The Bank of England repeated this view at their March meeting, with the minutes observing that “The economic outlook will continue to depend significantly on the nature and timing of EU withdrawal, in particular: the new trading arrangements between the European Union and the United Kingdom; whether the transition to them is abrupt or smooth; and how households, businesses and financial markets respond. The appropriate path of monetary policy will depend on the balance of these effects on demand, supply and the exchange rate. The monetary policy response to Brexit, whatever form it takes, will not be automatic and could be in either direction. The MPC judges at this month’s meeting that the current stance of monetary policy is appropriate. The Committee will always act to achieve the 2.0% inflation target.” However, recent comments by Governor Mark Carney have suggested that he thinks that it is most likely that the economy would need stimulus if there is a ‘no-deal’ Brexit, thereby indicating that an interest rate cut would be more likely than a hike. Recent comments by MPC members Silvana Tenreyro and Gertjan Vlieghe have suggested that they believe that interest rates would be more likely to fall than rise in the event of a ‘nodeal’ Brexit. However, another MPC member Michael Saunders is seemingly retaining a balanced view. We strongly lean towards the view that interest rates would be far more likely to be cut than increased if there is eventually a ‘no-deal’ Brexit. What is likely to be a limited and gradual rise in Bank Rate will exert upward pressure on long-term interest rates. But a falling fiscal deficit and the fact that more than half of the UK’s gilt stock is owned by the Bank (via its quantitative easing programme) and ‘captive’ buyers in the form of insurance companies and pension funds, will constrain the extent to which gilt yields increase. Sterling’s movements over 2019 so far have been largely driven by Brexit developments. The start of the year saw the pound under pressure from heightened concerns that the UK could leave the EU at the end of March without a Brexit deal. Evidence that the UK economy lost momentum in the latter months of 2018 also weighed on the pound. Sterling briefly traded at a 20-month low of $1.2409 on 3 January and also hit a 16month low of £0.9102/euro in early January (although its weakness was magnified by a ‘flash crash’ in Asia). The pound has since benefitted from reduced expectations of a disruptive Brexit, at least in the near term. After UK MPs voted against a ‘no-deal’ Brexit on 14 March, the pound neared $1.34 against the dollar, its best level since June 2018. The pound also traded as high as €1.1772, its strongest rate against the euro since June 2017. Following the decision for a flexible delay to Brexit until 31 October, sterling was trading around $1.31 and £0.865/euro. While sterling will likely be helped over the coming months by reduced expectations of a ‘no-deal’ Brexit, we suspect that its upside will be limited by domestic UK political uncertainties, lacklustre economic activity and the Bank of England likely holding off from hiking interest rates. On the assumption that the UK eventually leaves the EU at the end of October with a deal, we expect sterling to trend gradually upwards. Firmer UK economic activity and an expected couple of 25 basis point interest rate hikes by the Bank of England are seen 24 Forecast in detail as supporting the pound in 2020. Consequently, we see sterling trading around $1.37 at the end of 2019 and $1.46 at the end of 2020. 2. Prices Consumer price inflation averaged 2.5% over 2018, which was slightly down from a five-year high of 2.7% in 2017. With the exception of a spike up to 2.7% in August, consumer price inflation largely trended lower after reaching a peak of 3.1% in November 2017 to end 2018 at 2.1%. Consumer price inflation started 2019 by dipping to a 25-month low of 1.8% in January 2019. This took it slightly below the Bank of England’s 2.0% target rate. Inflation largely came down as the impact of sterling’s marked depreciation on import prices (especially for oil and commodities) after the June 2016 referendum vote to leave the EU waned. A marked falling back in oil prices after they reached a four-year high in late October helped bring inflation down to January’s low when there was also a marked downward impact in January itself from Ofgem’s cap on consumer energy prices coming into effect. UK: CPI inflation 5 4 Forecast 3 % year Inflation edged back up to 1.9% in February where it remained in March. Upward pressure on inflation in March came from higher fuel and transport prices. There was also an upward impact from clothing and footwear and miscellaneous goods and services. However, this was countered by drops in the annual rate of increase in food prices and recreation and culture goods. Core inflation was stable at 1.8% in March, having dipped to this level in February from 1.9% in January. 2 1 0 Despite stabilising at 1.9% in March, consumer price inflation looks likely to edge just above 2% in the near -1 term, partly due to Ofgem’s increase in the energy 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Source: EY ITEM Club price cap in April. Recent firmer oil prices also look set to have a near-term upward impact on inflation. However, there looks to be a good chance that inflation could dip back under 2% over the summer. Consequently, we see inflation averaging 1.9% over 2019. Despite their recent firming, relatively muted oil prices are a significant factor behind the lower inflation outlook. While Brent oil traded at $75/barrel for the first time since November 2018 in April, it is still well down on last October’s four-year high of $86.7/barrel. We expect Brent oil to average $72/barrel over 2019, which would be little changed from an average of $71.1/barrel in 2018. Price pressures further down the supply chain are relatively muted, although they have come off the lows seen in January 2019. Producer input prices fell 0.2% m/m in March, causing the y/y increase to edge back to 3.7% after rising to 4.0% in February from 2.6% in January (the lowest since mid-2016); they had been as high as 10.7% in September 2018. The annual increase in producer output prices was stable at 2.4% in March after moderating to 2.1% in January (the lowest since October 2016) from 3.3% in October 2018. Meanwhile, domestic inflation pressures are expected to be relatively modest over the coming months amid likely lacklustre UK growth. Admittedly, unit labour costs rose 3.1% in 2018, which was the sharpest increase since 2013 and the consequence of increased earnings growth and poor productivity. However, while annual earnings growth was stable at a decade-high rate of 3.5% in the three months to February, it is still relatively moderate compared to long-term norms and is showing signs that it may have peaked for now at least, despite the tight labour market. Annual earnings growth dipped to a five-month low of 3.2% in February itself. Firms are generally keen to limit their total costs in a challenging and uncertain environment. Fragile consumer confidence will probably deter workers from pushing hard for markedly increased pay rises despite recent higher inflation and a tight labour market. Consumer price index (CPI) inflation is seen as firming modestly to average 2.0% in 2020 as stronger GDP growth increases domestic inflationary pressures. However, an expected firmer pound will help to limit the rise in inflationary pressures while oil prices are seen relatively stable overall, with Brent again averaging around $70/barrel over 2020. 25 Forecast in detail Retail price index (RPI) inflation will be higher than the CPI measure over the forecast period. This is largely due to the so-called ‘formula effect’ (i.e. the different methods of aggregation between the RPI and CPI measures that place an upward bias on RPI) and the impact of a gradual increase in interest rates on mortgage interest payments. 3. Activity GDP growth slowed to 1.4% in 2018 from 1.8% in both 2017 and 2016. This was the equal weakest performance (with 2012) since 2009. GDP growth slowed to just 0.2% q/q in Q4 2018 after picking up to 0.7% q/q in Q3 (when it was buoyed by the heatwave) from 0.4% q/q in Q2 and expansion of just 0.1% q/q in Q1 (when economic activity suffered markedly from extreme cold weather). Year-on-year growth eased back to 1.4% in Q4 2018 after improving modestly to 1.6% in Q3 from 1.4% in Q2 and 1.2% in Q1, and this was the weakest annual growth performance since Q2 2012. On the expenditure side of the economy, GDP growth in Q4 2018 was held back by business investment contracting for the fourth successive quarter and at an increased rate of 0.9% q/q, causing it to be down 2.5% y/y. Overall investment contracted 0.6% q/q in Q4 and was down 1.1% y/y. Despite the sharp drop in business investment, the overall decline in investment was helped by a rise in government investment (up 0.5% q/q). Meanwhile, net trade made a modest negative contribution to fourth quarter growth as import growth of 2.1% q/q outstripped export growth of 1.6% q/q. % 0.4 Consumer spending growth was stable at 0.3% q/q and 1.6% y/y in Q4 2018. Support to growth came from government spending rising 1.3% q/q after contracting over the previous two quarters; it was up 1.0% y/y. There was also a pick-up in Q4 in inventories including alignment adjustments and balancing adjustments. However, stocks being held by UK companies were reported to have fallen modestly in Q4 which was somewhat at odds with reports of a number of companies looking to protect their supplies of inputs and finished goods by stockpiling amid heightened concerns of a disruptive Brexit. UK: Contributions to quarterly GDP growth 0.3 0.2 0.1 0.0 -0.1 -0.2 -0.3 -0.4 ConsumerInvestment Govt. InventoriesNet trade spending consumption Q3 2018 Other Q4 2018 Source: Haver Analytics On the output side of the economy, fourth-quarter GDP expansion of 0.2% q/q was limited by industrial production contracting 0.8% q/q while construction output was down 0.5% q/q. There was also reduced growth of 0.5% q/q in the dominant services sector. We forecast GDP growth to dip to 1.3% in 2019. This assumes that a UK–EU withdrawal arrangement ultimately comes into effect at the end of October. While the UK will formally leave the EU on 31 October, nothing much is expected to change immediately as the withdrawal arrangement essentially preserves the status quo until at least the end of 2020. Furthermore, we suspect that the withdrawal arrangement will likely end up being extended. Following estimated expansion of at least 0.4% q/q in Q1 2019 (lifted significantly by stock-building), we expect GDP growth to be limited to 0.2% q/q in both Q2 and Q3. With Brexit potentially being delayed until 31 October and the domestic political environment fraught, prolonged uncertainty is seen weighing down on economic activity. Businesses’ willingness to invest and commit to major new projects is expected to be particularly affected while consumers may well be more cautious about making major purchases — particularly if the labour market falters. There is also likely to be a hit to economic activity from some unwinding of the stockpiling that occurred in Q1. Meanwhile, lacklustre global growth — especially the slowdown in the eurozone — is likely to hamper UK exports. On the assumption that the UK does indeed leave the EU on 31 October, we expect an easing of uncertainty to help the economy. Even so, growth may well still be limited to 0.2%–0.3% q/q in Q4 2019 as a degree of caution persists among businesses, in particular, and consumers in the run-up to the UK’s exit from the EU and in the immediate aftermath. 26 Forecast in detail GDP growth is forecast to improve to 1.5% in 2020. Economic activity is seen picking up gradually through the year, with expansion projected around 0.4% q/q in Q1 and Q2, and 0.5% in Q3 and Q4. Consumer spending growth is seen picking up modestly amid reasonably solid real income growth, modest employment growth and firmer confidence. Meanwhile, business investment growth is seen being lifted by reduced uncertainties and an ongoing need/desire to save labour and lift productivity. Meanwhile, net trade is seen essentially in balance over 2020. 4. Consumer demand Consumer spending proved more resilient than most other sectors of the economy in 2018 as it expanded 1.7%. Nevertheless, this was still the slowest expansion in private consumption since 2012 and was down from growth of 2.1% in 2017 and 3.1% in 2016. Furthermore, consumer spending growth eased back from 0.5% q/q in both Q1 and Q2 2018 to 0.3% in Q3 and Q4. There were a number of factors at play though which affected overall consumer spending, particularly in Q1, Q2 and Q3 2018. Consumer spending in Q1 2018 was adversely affected by the extreme cold weather during late February and March weighing down on retail sales. However, there was a spike in spending on household goods and services, and on health. The second quarter was boosted by some catch-up in retail sales from Q1 2018 while there was a boost to spending from the football World Cup and warm weather. The football World Cup and the summer heatwave further boosted retail sales in Q3 2018, but overall consumer spending was held back by a sharp drop in new car sales in September. Car sales and retail sales were soft in Q4 2018 but there was higher spending on household goods and services. % Consumer spending has seemingly showed impressive UK: Retail sales volumes (inc. fuel) resilience so far during 2019, at least in terms of retail 3.0 sales. Specifically, retail sales volumes jumped 1.1% 2.5 m/m in March and were up 6.7% y/y (the best annual 3m/3m gain since August 2016). This followed healthy gains of 2.0 0.6% m/m in February and 0.9% m/m in January so 1.5 retail sales volumes were up an impressive 1.6% q/q 1.0 over Q1 2019. Retail sales in March were reportedly 0.5 helped by warm weather particularly lifting sales of 0.0 textiles and clothing. It is also conceivable that retail -0.5 sales could have gained a lift in March from stockpiling -1.0 of some goods by consumers wary of a disruptive Brexit -1.5 m occurring in late March. There were some limited reports of this occurring. It is also possible that some consumers brought forward purchases amid concern Source : Haver Analytics prices could rise if a disruptive Brexit in late March led to sterling weakening sharply. Retail sales in February had reportedly also got overall help from the warm weather (which particularly lifted sales at garden centres and for sales of sporting equipment) while January’s sales were seemingly buoyed by consumers looking to take advantage of the clearance sales. In addition to the strong m/m gain this year, the 6.7% y/y jump in retail sales volumes in March was lifted by the fact that retail sales had taken a serious hit in March 2018 from the severe weather. However, there are signs that consumer spending on services was less impressive over Q1 2019 than retail sales. Specifically, the Bank of England’s regional agents reported in their Q1 survey of business conditions (published in March) that “annual growth in consumer services values remained modest — even compared with a year ago when activity was adversely affected by the severe winter weather.”13 Meanwhile, private new car sales fell at a significantly reduced rate of 0.8% y/y over Q1 2019 after contracting markedly overall during the last four months of 2018. We expect consumer spending growth to slow to 1.4% in 2019. Despite apparent resilience in Q1, there looks to be a genuine possibility that cautious consumers will limit their spending over the coming months as a consequence of prolonged Brexit uncertainties and a highly uncertain domestic economic and political environment. Markit’s UK Household Finance Index showed consumers’ willingness to make major purchases — 13 Agents’ summary of business conditions — 2019 Q1, Bank of England, 21 March 2019. See bankofengland.co.uk/agentssummary/2019/2019-q1 27 Forecast in detail such as cars and holidays — fell sharply in March to the lowest level since September 2017, and was at one of the lowest levels for five years. Meanwhile, the GfK Consumer Confidence Index in March was only marginally above its lowest level since mid-2013, seen in January and December. While these weak confidence readings were obviously influenced by the originally scheduled UK exit from the EU on 29 March, it remains to be seen how consumers react to the deadline being extended flexibly to 31 October. Early evidence came from the Markit survey which showed some improvement in April; although, significantly, households’ willingness to make major purchases remained weak, as it improved only slightly from March’s low. On a positive note for consumer spending prospects, real earnings growth has improved markedly since mid2018 and currently stands at the highest level since late 2016. Annual earnings growth was stable at 3.5% in the three months to February, which was the best level for a decade and up from 2.4% in mid-2018. Meanwhile, inflation fell back to a 25-month low of 1.8% in January, although it edged up to 1.9% in February. Consequently, real earnings growth is now up to 1.6%; this is up from 0.1% in mid-2018 and is the best level since mid-2016. Also helping matters, employment jumped 179,000 in the three months to February to a record high of 32.721 million. However, it is by no means certain that the recent improvement in consumer spending power will continue — inflation edged up to 1.9% in February and March from a 25-month low of 1.8% in January, while annual earnings growth fell back to a five-month low of 3.2% in February from 3.9% in January. This ties in with a number of recent surveys suggesting pay awards could be levelling off after recent improvement. Also significantly, the budgets of some households will continue to be pressured by the cash freeze on working-age welfare benefits. Consequently, we expect real household incomes to rise by 1.5% in 2019, which would be down from an increase of 2.1% in 2018. 8 UK: Real household income and spending Forecast 6 Household income 4 2 % year Indeed, the suspicion has to be that the labour market and earnings growth will increasingly struggle to sustain their recent strength as companies tailor their behaviour to a relatively lacklustre domestic economy, prolonged Brexit uncertainties and a challenging global environment. It should also be borne in mind that despite its recent improvement, consumer purchasing power is still no more than reasonable compared to past norms. 0 -2 -4 Household spending -6 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Source: EY ITEM Club There are other factors which may limit consumer spending over the coming months, although we doubt higher interest rates will be one of them with the Bank of England very possibly set to sit tight on monetary policy through 2019. In particular, with the household saving ratio being very low, consumers may at the very least be keen to avoid further dissaving — especially given current major uncertainties. Meanwhile, lenders have cut back on the availability of unsecured consumer credit. Indeed, the latest Bank of England’s credit condition survey indicated that lenders reduced the amount of unsecured credit available to consumers in Q1 2019 for the ninth successive quarter, and they expected to reduce it further in Q2. Additionally, lenders were reported to have modestly further tightened their lending standards for granting unsecured consumer loan applications in Q1 2019, which was the tenth successive quarter of tightening standards. A further tightening of lending standards is anticipated over Q2 2019. Latest Bank of England data shows that annual unsecured consumer credit growth slowed to 6.3% in February; this was the lowest rate since September 2014 and was down from 6.5% in January, 6.6% in December 2018 and a peak of 10.9% in November 2016. Consumer spending growth is seen as improving modestly to 1.7% in 2020, helped by reduced uncertainty following the UK’s exit from the EU with a deal. However, the upside for consumer spending in 2020 may well be limited by only stable growth in real household disposable income. Earnings growth is seen remaining around 3.2% in 2020 while employment growth is expected to rise by around 0.6%. Consumer price inflation is seen slightly higher overall at 2.0%. Real household disposable income is seen growing by 1.5%. Additionally, the Bank of England is expected to raise interest rates twice in 2020 by a total of 50 basis points, taking them up to 1.25%. 28 Forecast in detail 5. Housing market The housing market has been largely muted in recent months, although there are varying performances across regions with the overall national picture dragged down by the poor performance in London and parts of the South East. Latest data from the Bank of England shows that mortgage approvals for house purchases fell back to 64,377 in February after rising to 66,696 in January from 64,112 in December and a seven-month low of 63,897 in November. February’s dip in mortgage approvals to 64,377 took them back towards the lower end of the 63,000–68,000 range that has broadly held for the past two years. They were 17.5% below their long-term (1993–2019) average of 80,847. Additionally, latest survey evidence on the housing market is largely downbeat and suggests that heightened Brexit and economic uncertainties are fuelling buyer caution. Most notably, the influential Royal Institution of Chartered Surveyors (RICS) reported that their March survey showed “little departure from the subdued picture evident across the sales market for several months now. Forward-looking indicators suggest this lack of momentum is likely to continue for a while longer, although perceptions on the 12-month outlook are a little more sanguine”.14 Specifically, new buyer enquiries fell for an eighth month running in March and the rate of decline was still appreciable despite slowing from February’s drop level. RICS observed that “when disaggregated, demand reportedly fell to a greater or lesser degree across all parts of the UK”. Newly agreed sales were also down for the eighth successive month while the average time taken to sell a property remained at 19 weeks (the longest since the series started in 2017). The RICS’ house price balance edged up to a still very weak -24% in March from -27% in February, which had been the lowest level since May 2011. UK: House prices 20 15 Forecast 10 % year 5 0 -5 -10 -15 -20 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Source : EY ITEM Club Meanwhile, recent house price data has been largely very soft. Indeed, the latest ONS/Land Registry figures show house prices fell 0.8% m/m in February, which was the sixth successive decline. Consequently, the y/y increase in house prices slowed markedly to just 0.6% in February; this was the lowest annual rate since September 2012 and down from 1.7% in January, 2.0% in December 2018, 4.5% at the end of 2017 and a peak of 5.1% in October 2017. The annual increase in UK house prices was dragged down by prices in London plunging 2.0% m/m and 3.8% y/y in February, which was the eighth successive annual decline and the sharpest since mid2009. There was also a y/y drop of 1.8% in the South East in February, the first annual decline for the region since October 2011; house prices were down 1.7% m/m. Latest data from the Nationwide shows annual house price inflation at just 0.7% in March after dipping to a near six-year low of 0.1% in January. The Halifax has been a recent outlier on the house price front, reporting that annual house price inflation was 2.6% in the three months to March, having spiked as high as 2.8% in the three months to February from just 0.8% in the three months to January and a low of 0.3% in the three months to November (which had been the lowest since December 2012). The fundamentals for house buyers have been challenging for an extended period. While consumer purchasing power has been improving since mid-2018, it is still relatively limited compared to long-term norms after consumers faced a prolonged serious squeeze on purchasing power. Consequently, house prices are currently stretched relative to earnings. According to the Halifax, the house price to earnings ratio was still as high as 5.60 in March after spiking to 5.71 in February (the highest level since November 2017) from 5.40 in January; this is well above the long-term (1983–2019) average of 4.27. Additionally, housing market activity remains hampered by relatively fragile consumer confidence and limited willingness to engage in major transactions. Indeed, consumer confidence in March was only marginally above the five-and-a-half year low seen around the turn of the year, according to the GfK survey. Furthermore, Markit’s UK Household Finance Index showed consumers’ willingness to make major purchases — such as houses and cars — fell sharply in March to the lowest level since September 2017 and was at one of the lowest 14 March 2019: UK Residential Market Survey, “Brexit impasse continues to challenge the market”, RICS, 11 April 2019. See rics.org/globalassets/rics-website/media/knowledge/research/market-surveys/uk-residential-market-survey-march-2019-rics.pdf 29 Forecast in detail levels for five years. Caution over making major purchases is currently being magnified by heightened uncertainties over Brexit. Although the deadline for Brexit has now been extended from 29 March to a flexible 31 October, Markit’s Household Finance Index showed that consumer’s willingness to make major purchases only edged up in April from March’s low. It is possible that the avoidance of a ‘no-deal’ Brexit at the end of March could provide a modest boost to the housing market through easing some of the immediate uncertainty and concerns. However, we suspect it is more probable that with Brexit most likely being delayed until 31 October, prolonged uncertainty will weigh down on the housing market and hamper activity. Consumers may well be particularly cautious about committing to buying a house, especially as house prices are relatively expensive relative to incomes. Also it looks questionable whether the labour market and earnings growth will sustain their recent strength as companies tailor their behaviour to a relatively lacklustre domestic economy, prolonged Brexit uncertainties and a challenging global environment. Consequently, we suspect house prices will rise only 1% over the year and would not be at all surprised if they stagnate. There are positives for the housing market — consumers’ purchasing power has clearly picked up since mid2018 (real earnings growth has improved from 0.1% in the three months to June 2018 to 1.6% in the three months to February). Employment has risen strongly recently and is at a record high while mortgage interest rates are still at historically low levels. Indeed, the Bank of England could very well sit tight on interest rates through 2019. Further out, the Bank will likely only hike rates gradually and to a limited extent thereafter. However, it should be borne in mind that the share of outstanding mortgages on variable interest rates has fallen to a record low of around 35%, which is half the peak level of 70% in 2001. Meanwhile, a shortage of houses on the market will also likely offer some support to prices. The latest RICS survey showed new instructions fell for the ninth month running in March. Furthermore, the rate of decline increased for the fourth successive month in March. Consequently, average stock levels on estate agents’ books in March remained at the lowest level in the survey’s history. Even if ultimately successful, the Government’s recent — and ongoing — initiatives to boost house building will take time to have a significant effect so are unlikely to markedly influence house prices in the near term at least. We expect house prices to rise by a modest 2.5% over 2020 on the assumption that the UK exits the EU with a deal on 31 October and a resultant dilution of uncertainty and modestly improving economic activity supports housing market activity. However, with houses still relatively expensive compared to incomes and the Bank of England expected to raise interest rates twice (by a total of 50 basis points), the upside for house prices is seen as limited. If the UK ultimately leaves the EU at the end of October without a deal, we suspect that house prices could fall 5% over 2020 amid heightened uncertainty and weakened economic activity. 6. Company sector Disappointingly and worryingly, business investment fell 0.9% q/q in Q4 2018, which was the fourth successive decline and caused it to be down 2.5% y/y. This followed q/q declines of 0.6% in Q3, 0.4% in Q2 and 0.6% in Q1. This was the first time that business investment had fallen for four successive quarters since the deep economic downturn of 2008/9. Business investment contracted 0.4% overall in 2018 following growth of 1.5% in 2017. The steeper decline in business investment in Q4 2018 strongly suggests that already cautious businesses were even more reluctant to commit to capital expenditure as doubts mounted as to whether a Brexit transition arrangement would come into being in late March and companies looked for greater clarity over the UK’s likely long-term relationship with the EU. The Bank of England’s regional agents reported in their Q1 2019 survey of business conditions (published in March) that investment intentions for the next 12 months in the manufacturing sector were the lowest for nine years: “Contacts mostly cited Brexit uncertainty as the main reason for holding back investment, with some choosing instead to build cash reserves or inventories. However, companies continued to invest in replacing essential kit or in projects with a short payback period. Contacts in some companies, particularly 30 Forecast in detail those with overseas owners, said that investment was being diverted outside the UK. But many contacts believed there could be a rebound in investment if a Brexit deal was agreed.” The agents additionally reported that investment intentions had edged down in the services sector but were still positive: “Investment in IT and digital capabilities continued to grow. Many professional and financial services firms continued to invest in artificial intelligence and automation, often in response to tight labour market conditions. Some contacts in the logistics and transport sectors reported investing in additional capacity. But investment in the retail sector remained mostly weak.” 15 We strongly suspect that business investment contracted for the fifth successive quarter in Q1 2019 as Brexit uncertainties deepened. Furthermore, we believe it is highly likely that business investment will continue to contract in Q2 and Q3 2019. Given the flexible extension of Brexit to 31 October, the fraught domestic UK political environment and weakened global economic activity, it is hard to imagine anything else but further weakness in business investment until late 2019 at least. Consistent with this view, a quarterly survey of Chief Financial Officers — carried out during 26 March–7 April after it became clear that the UK would not be leaving the EU on 29 March — released in mid-April by Deloitte found that “Large businesses are clearly looking to protect themselves against risk by raising cash levels and bulletproofing balance sheets. They appear to be battening down the hatches for tougher times ahead. While last week’s announcement on a further deferral of the UK’s departure from the EU removes an immediate unknown, the continuation of uncertainty is causing much frustration for UK businesses. As well as stashing cash, many continue to delay investment. Businesses remain in a period of further limbo.”16 If the UK does indeed leave the EU with a deal on 31 October, this should underpin a pick-up in business investment. However, it is very possible that business investment may only stabilise in Q4 2019, as companies remain cautious in the run-up to the UK’s exit. Furthermore, a number of companies may well be wary about stepping up their investment in the immediate aftermath of the UK leaving the EU, even with a deal, as they may want to see how the UK economy performs for a while after Brexit before committing themselves, especially to costly investments. It is also likely that the upside for business investment will be limited by ongoing substantial uncertainties about the nature of the UK’s long-term relationship with the EU. It could also be pressurised in the latter months of 2020 with the transition arrangement under the UK’s withdrawal agreement from the EU scheduled to finish at the end of that year — although the suspicion is that this will need to be extended. Still relatively cheap and available credit — as well as recent reasonable rates of return — are supportive to investment. Latest ONS data shows that the net rate of return for non-financial UK companies averaged 12.4% over 2018. While this was down from 12.8% in 2017 and 13.0% in 2018, it was still above the long-term (1997–2018) average of 12.0%. UK: Business investment and GDP 15 Business investment 10 Forecast 5 0 % year Nevertheless, there are supportive factors for business investment which will hopefully limit the downside over the coming months and then underpin appreciable improvement in 2020. -5 -10 GDP -15 -20 -25 Additionally, the Bank of England’s February quarterly 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Inflation Report observed “Survey measures suggest Source: EY ITEM Club firms are operating with limited spare capacity which should increase the incentive for firms to invest.”17 Indeed, business investment is likely to be lifted by some firms looking to increasingly invest in automation to make up for labour shortages and to try to boost productivity. Furthermore, the recent extended weakness of business investment suggests that some 15 Agents’ summary of business conditions — 2019 Q1, Bank of England, 21 March 2019. See bankofengland.co.uk/agentssummary/2019/2019-q1 16 The dash for cash: Deloitte CFO Survey: 2019 Q1, Deloitte, 15 April 2019. See www2.deloitte.com/uk/en/pages/finance/articles/deloitte-cfo-survey.html 17 “Inflation Report — February 2019“, Bank of England, 7 February 2019. See bankofengland.co.uk/-/media/boe/files/inflationreport/2019/february/inflation-report-february-2019.pdf?la=en&hash=8487F69ED26692F4697D363A4E47111D1B0503D3 31 Forecast in detail companies have delayed replacing plant and equipment or investing in new processes, and this will eventually need to be addressed. Overall, we expect business investment to contract by 1.9% in 2019, and then to rise by 2.5% in 2020. 7. Labour market and wages The jobs market proved surprisingly strong in 2018 given the economy’s relatively muted performance and mounting uncertainties over the outlook centred on Brexit. However, it was only in the second half of 2018 that there were signs that the tighter labour market was feeding through to lift earnings growth. The relative unresponsiveness of pay to the apparent tightness of the labour market suggests that labour market slack has not been exhausted. Employment rose 444,000 (1.4%) over 2018 to end at a record 32.597 million in the three months to December, taking the employment rate up to 75.8% (the highest since records began in 1971). Unemployment on the Labour Force Survey (LFS) measure came down from 1.463 million in the three months to December 2017 to 1.363 million in the three months to December 2018, taking the unemployment rate down from 4.4% to 4.0%. The labour market continued to exceed expectations at the start of 2019. Indeed, the data for the three months to January was particularly strong with employment up 222,000 (the largest gain since the three months to November 2015) to a new record high of 32.714 million. The employment rate also reached a new peak of 76.1%. Unemployment fell 35,000 in the three months to January to 1.335 million; this caused the unemployment rate to dip to 3.9%, which was the lowest since the three months to January 1975. Even allowing for the fact that employment is a lagging indicator and the economy had seen robust growth over Q3 2018, this was still a remarkably resilient performance given the softness of the economy in Q4 2018 and (underlying) in Q1 2019, the weakened global economic situation and the increasing uncertainties as to whether or not the UK would leave the EU with a deal on 29 March. While the latest jobs data are still strong, there are hints that the labour market could be starting to fray. The level of employment only edged up slightly further to 32.721 million in the three months to February when the rate of growth slowed to 179,000. The employment rate was stable at 76.1%. Meanwhile, unemployment dipped by 27,000 in the three months to February to stand at 1.343 million. This was actually slightly up on 1.335 million unemployed in the three months to January, while the unemployment rate remained at 3.9%. UK: Unemployment rate 9 8 ILO Forecast 7 6 5 % Certainly, some surveys had indicated that a growing number of employers are now adopting a ‘wait and see’ approach on employment given the current heightened uncertainties. For example, the KPMG and REC/IHS Markit Report on Jobs for March revealed permanent job placements fell for the second time in three months in March (and were only flat in February). These were the first such declines since mid-2016. Additionally, placements of temporary workers in March were reported to be at the second lowest level (after January 2019) for two-and-a-half years. 4 3 2 Claimant count 1 Looking ahead, we expect employment growth to slow 0 over the rest of 2019 after its robust start to the year, as 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 lacklustre economic activity increasingly feeds through Source: EY ITEM Club to have an impact, as well as still significant uncertainties over the outlook despite an expected Brexit deal being reached by the end of October. Employment growth may also be limited by increased difficulties in finding suitable candidates in some sectors. Specifically, we expect employment growth to be 1.0% over 2019 (largely due to the strong gains at the start of the year), with the unemployment rate edging back up to 4.0% by the end of the year. With the economy expected to improve modestly in 2020 and uncertainties reduced by the UK having left the EU with a deal, we expect employment to rise by 0.6%, with the unemployment rate edging back down to 3.9%. 32 Forecast in detail The second half of 2018 saw earnings growth trending up after a relapse in Q2. Specifically, ONS data shows that annual total average weekly earnings growth climbed to 3.5% in the three months to December, which was the best level since mid-2008. It was up from 2.4% in the three months to June 2018. Meanwhile, annual regular earnings growth (which strips out sometimes-volatile bonus payments) stood at 3.4% in the three months to December, which was also the best level for a decade. It was up from 2.7% in the three months to June 2018 and had been as low as 2.1% in the three months to August 2017. Nevertheless, this needs to be put into perspective — while earnings growth stood at a decade-high rate at the end of 2018, it was still below the 4%–5% pace seen before the financial crisis. Latest data shows that total annual earnings growth was still up at a decade-high rate of 3.5% in the three months to February, while regular earnings growth was at 3.4% in the three months to February, having also got as high as 3.5% in the three months to January. However, there were signs in the latest earnings data that pay growth could have peaked for now at least. Specifically, annual total earnings growth dipped to a five-month low of 3.2% in February from 3.9% in January, while regular earnings growth fell back to a five-month low of 3.1% from 3.7% in January. However, it has to be borne in mind that monthly earnings data can be volatile (and in the case of total earnings growth, influenced by bonus payments which can also be erratic). We suspect that earnings growth could well level off following its recent gains and could even see a slight easing back in the near term. This reflects our suspicion that the UK labour market will lose momentum and companies will increasingly look to limit pay. While survey evidence indicates that labour market tightness has been pushing up starting salaries and, seemingly, also salaries for people switching jobs, the rate of increase does seem to have come off the highs that were seen in the latter months of 2018. Meanwhile, there is survey evidence that while employers have recently been giving modestly higher pay increases for their existing staff, the increases have been somewhat limited and in some surveys are showing signs of levelling off. Furthermore, latest productivity developments are hardly conducive to granting higher pay increases. Latest preliminary ONS data show that output per hour was down 0.1% y/y in Q4 2018 as it could only rise 0.3% q/q. This completed an underwhelming overall productivity performance for 2018, with erratic movements. Productivity had previously fallen 0.2% q/q in Q3, risen 0.3% q/q in Q2 and declined 0.5% q/q in Q1. This can only fuel concern over the UK’s overall weakened productivity performance since the 2008/9 downturn. Consequently, we forecast earnings growth to average 3.2% over 2019 (on a National Accounts basis) and to remain around this level in 2020. While up from an average of 3.0% over 2018, it is down from the peak rate of 3.5% seen around late 2018/early 2019. 8. Trade and the balance of payments Net trade was a modest drag on UK GDP growth in 2018, knocking 0.2ppts off the rate of expansion. This was in contrast to 2017 when net trade added 0.5ppts to GDP growth, one of the biggest gains from this source in the last 25 years. Growth in real exports of goods and services slowed sharply from a six-year high of 5.6% in 2017 to an eight-year low of just 0.1% in 2018. Meanwhile, growth in real imports of goods and services moderated from 3.5% in 2017 to a seven-year low of 0.7% in 2017. The factors which assisted with the healthy positive trade contribution in 2017 — robust global growth, particularly in the eurozone, and sterling’s post-referendum weakness — became less favourable in 2018. In particular, eurozone growth slowed markedly in the second half of 2018. Meanwhile, having weakened noticeably from an average of 82.0 in 2017 to an average of 77.4 in 2017 (with a low of 76.6 in Q3 2017), sterling’s trade-weighted index firmed modestly to average 78.5 in 2018. To put it another way, the ‘sweet spot’ enjoyed by UK exporters shrank. Net trade made a small negative contribution of 0.1ppts to GDP growth in Q4 2018. However, the underlying performance was weaker than this. Exports of goods and services rose 1.6% q/q in Q4 although they were only up 0.2% y/y. Furthermore, the export performance in Q4 2018 was exaggerated as the ONS reported that “there was a sizeable export of Non-Monetary Gold (NMG) in Quarter 4 2018, reflected in an offsetting fall in the acquisition less disposal of valuables component, which helps explain the size of the contribution of gross capital formation”. The ONS explained, “Movements in NMG do not affect headline GDP as these are recorded 33 Forecast in detail as equivalent offsetting impacts, but this is reflected in contributions to GDP growth.” 18 Meanwhile, imports of goods and services rose a larger 2.1% q/q in Q4 2018 and were up 2.6% y/y. We suspect that net trade made a negative contribution to GDP growth in Q1 2019. It is very possible that there was a lift to imports coming from UK companies stockpiling supplies of raw materials, intermediate products and finished goods from abroad to guarantee supplies amid fears of a disruptive Brexit at the end of March. While Brexit has been delayed, this did not happen until late March and there remained a possibility that the UK could leave the EU in Q2 without a deal. Net trade is expected to make a negative contribution to UK GDP growth in 2019. This is expected to be partly the consequence of slower global growth, notably including weakened expansion in the eurozone. Additionally, we suspect that sterling will be modestly firmer overall in 2019 compared to 2018. Specifically, sterling’s trade-weighted index is seen as rising from an average of 78.5 in 2018 to 80.1 in 2019. Consequently, we expect net trade to have a clear negative impact on GDP growth in 2019. We expect net trade to be essentially in balance in 2020 on the assumption that global growth has at least stabilised, with some improvement seen in the EU. However, we expect a clear firming in sterling over 2020 following the UK leaving the EU with a deal at the end of October 2019, with the trade-weighted index averaging 83.9. The UK’s weakened trade performance contributed to a renewed widening in the current account deficit to £81.6 billion (3.9% of GDP) in 2018 after it had narrowed markedly to a five-year low of £68.4 billion (3.3% of GDP) in 2017 from £102.8 billion (5.3% of GDP) in 2016. The total deficit on trade in goods and services widened appreciably to £31.0 billion in 2018 from £23.9 billion in 2017. Additionally, there were increases in the deficits on primary income to £26.7 billion in 2018 from £23.6 billion in 2017 and on secondary income (mainly transfers) to £24.0 billion in 2018 from £20.9 billion in 2017. UK: Current account 8 Forecast 6 4 % of GDP 2 0 -2 -4 -6 -8 -10 -12 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Goods Services IPD Net transfers Current account Source: EY ITEM Club The current account deficit increased further to £23.7 billion (4.4% of GDP) in Q4 2018 after widening to £23.0 billion (4.3% of GDP) in Q3 from £17.3 billion (3.3% of GDP) in Q2 and £17.7 billion (3.4% of GDP) in Q1. An increased trade deficit contributed to the elevated current account deficit in Q4 2018, while there was also an increased and marked shortfall on the primary income account. This was mainly due to reduced profits made by UK investors on their foreign direct investment. The current account is expected to widen modestly further to £85.1 billion (3.9% of GDP) in 2019, primarily due to an increased trade deficit. It is seen as coming down a little to £81.7 billion (3.6% of GDP) in 2020 as the trade deficit narrows. An expected modest firming of the pound later on in 2019 and in 2020 should boost the UK’s overseas investment income when translated into sterling. IPD= interest, profit 18 GDP quarterly national accounts, UK: October to December 2018, Office for National Statistics, 29 March 2019. See ons.gov.uk/releases/gdpquarterlynationalaccountsukoctobertodecember2018 34 EY | Assurance | Tax | Transactions | Advisory Ernst & Young LLP ey.com/uk/item About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organisation, and may refer to one or more of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organisation, please visit ey.com. About EY ITEM Club EY ITEM Club is the only non-governmental economic forecasting group to use the HM Treasury’s model of the UK economy. ITEM stands for Independent Treasury Economic Model. HM Treasury uses the UK Treasury model for its UK policy analysis and Industry Act forecasts for the Budget. EY ITEM Club’s use of the model enables it to explore the implications and unpublished assumptions behind Government forecasts and policy measures. Uniquely, EY ITEM Club can test whether Government claims are consistent and can assess which forecasts are credible and which are not. Its forecasts are independent of any political, economic or business bias. The UK firm Ernst & Young is a limited liability partnership registered in England and Wales with Registered number OC300001 and is a member firm of Ernst & Young Global Limited Ernst & Young LLP, 1 More London Place, London, SE1 2AF. © ITEM Club Limited. 2019. Published in the UK. All Rights Reserved. ED None All views expressed in the EY ITEM Club Spring Forecast 2019 are those of ITEM Club Limited and may or may not be those of Ernst & Young LLP. Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive or sufficient for making decisions, nor should it be used in place of professional advice. Neither the ITEM Club Limited, Ernst & Young LLP nor the EY ITEM Club accepts any responsibility for any loss arising from any action taken or not taken by anyone using this material. If you wish to discuss any aspect of the content of this newsletter, please talk to your usual EY contact. This document may not be disclosed to any third party without Ernst & Young LLP’s prior written consent. Reproduced with permission from ITEM Club Limited.