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13 / May / 2016

UK Economy Overview

The UK finished 2015 ahead of many developed economies with the economy growing by 2.2%pa. Going forward Office for Budget Responsibility (OBR) forecasts close to the long-term average economic growth of 2.0% in 2016 and 2.2% in 2017. IMF expects the UK economy to remain amongst the fastest growing advanced economies in the next five years, outstripped only by the US.

Last year the UK economy continued to be services-led with an output rising 2.1%p.a. Manufacturing weakened  due to continued sluggish growth in the euro area and stronger pound, whilst construction output remained volatile. Albeit the latest Markit/CIPS PMI show rising levels of activity, the most recent readings are below their peaks. Broad expectation is that services will continue to lead the economy whilst recovery in construction and manufacturing  will remain muted.

A key feature of 2015 was the ‘no-flation’ environment with the yearly CPI figure of 0%, the lowest rate since 1934. Today’s data illustrates an economy that distinctly lacks inflationary pressures and any further fall in commodity prices would suggest lower inflation for longer. Inflation is significantly below the BoE target of 2% and with weaker economic growth expected going forward interest rates are likely to be kept lower for longer. In fact, the latest forecasts anticipate the first rate hike in the second half of 2017 and markets imply rises towards the end of the 5-year period. Lower interest rates should continue to support consumer spending and business investment, particularly in case of SMEs, but could add to the risk of asset price bubbles.

The labour market continued to strengthen over the year with the latest employment rate at 74.1%, the highest level since records began. Employment was initially led by part-timers and self-employed, but the growth has broadened to include full-time employees. Although jobs growth has been very strong in the past three years, it grew on the back of muted productivity growth as the workforce efficiency have not recovered since 2007. The UK productivity gap is one of the largest in the leading economies and currently stands at 14%.  Having said that the output per job has recovered to its pre-recession value suggesting that any growth in overall productivity is attributable to more workers employed for longer hours. Moreover, with aging population and below pre-recession capital expenditure, it is difficult to see a rebound to a long term levels in productivity growth. The concerns over productivity creates further doubt over wage growth. Despite seeing a tightening in labour market conditions this has not translated into sustained levels of growth in average wages. Wage recovery has largely been down to ultra-low inflation which is less likely to continue in 2016 meaning that any wage growth in the year ahead will have to be pegged to improving productivity levels. Despite this, we do expect a gradual increase in earnings growth over 2016-17 as the labour market tightens further and the National Living Wage comes into effect in April, but this will be a slow process. Although not at pre-recession levels, real earnings growth should remain positive over the period assuming jobs growth remains strong, as expected.

The real wage growth seen in 2015 has supported consumer expenditure levels. Consumer spending growth is predicted to be somewhat stronger than overall GDP growth at around 3% in 2016, with a boost from lower oil prices, subdued inflation and increased real earnings growth. However, if real earnings do not rebound in the medium term, consumer expenditure is likely to start slowing as households become more reluctant to further reduce savings.

After growing strongly, business investment has recently disappointed amidst political concerns and associated downside risks. Investment fell at its fastest rate in almost two years at the end of 2015. Business confidence is affected by increased international market volatility relating to slowdown in China and overcapacity in the emerging markets, as well as conflicts in the Middle East and the EU referendum. These create uncertainty that continues to weight on the investment optimism. Now that the referendum date is set some investment decisions have been put on hold by firms. Weighted PMI has declined suggesting that investment intentions across all sectors weakened.

It is anticipated that UK growth will remain solid in 2016 and 2017, however somewhat slower than previously expected. The chancellor has recently blamed a weaker global economy for the downward revisions in growth, whilst OBR pointed out weakness in productivity growth.  Although the global economic outlook is weaker, largely resulting from concerns over China and emerging markets, the UK’s direct exposure is limited implying that the impact is likely to be modest. If anything investment sentiment is most likely to be affected the most.