Economic Review -The impact of high oil prices on the UK economy - Fourth Quarter (continued)

• So far the ‘soft-patch’ that the US economy has fallen into in recent months has been concentrated mostly in the consumer sector. Unfortunately, the consumer slowdown shows few signs of abating yet. Households continue to suffer under the combined weight of high oil prices, rising interest rates, the fading boost from past tax cuts and a faltering labour market.

• Underlying retail sales growth has been lacklustre. Furthermore, declining consumer confidence suggests there is little hope of an imminent rebound in the pace of consumer spending.

• The industrial sector has been largely insulated from events in the consumer sector. For this reason the ISM manufacturing index, which is usually a good leading indicator of movements in the wider economy, has recently proved to be over-optimistic. Accordingly, although it still points to robust GDP growth ahead, this is unlikely to be borne out by the hard data.

• If the consumer slowdown does not abate, then eventually rising inventories are likely to force manufacturers to curb plans for new production. This has already happened in the autos sector, where the excess inventory problem is most acute. However, leaner inventories in the rest of the economy have provided producers with at least a temporary respite.

• Overall, we expect GDP growth to slow from 4.2% this year, to only 2.5% in 2005, before rebounding modestly to 2.8% in 2006.

• Firms may also decide to cut back further on new hiring if final demand growth does not pick up soon. Employment growth has already slowed dramatically in recent months from several big monthly gains in the spring. The latest indications are that payroll employment will continue to expand at around 150,000 per month. Although this would be better than we saw in June and July, it would still only be enough to keep pace with population growth and, therefore, prevent the unemployment rate from rising.

• Weaker employment growth will put less upward pressure on wages and prices. The inflation outlook has improved dramatically from a few months back, confirming that much of the recent surge in underlying inflation was transitory.

• Accordingly, along with the slowdown in the real economy, this has encouraged the view that the Fed will be more cautious in raising interest rates in 2005 than the markets previously thought. We continue to expect rates to rise to only 3.0% next year, and see the risks that rates will go up or down in 2006 as evenly balanced. 

• As well as weaker economic growth, the dollar is increasingly vulnerable to worries over the huge current account deficit, which hit a record of 5.7% of GDP in the second quarter. US consumer slowdown shows no sign of abating Analysis: The world economy

• The recovery in the euro-zone remains modest. In the second quarter of 2004, GDP grew by 0.5% quarter-on-quarter, compared to 0.6% in the first. Year-on-year growth increased to 2.0%, from 1.3% in Q1. However, looking ahead, growth is subject to a number of downside risks.

• In the second quarter, as in the first, the main contribution to growth came from exports. But the world economy is slowing during the second half of 2004 and we expect this to continue in 2005. Indeed in Germany, the region’s largest economy, the contribution to growth from domestic demand was actually negative in the second quarter. Therefore, Germany’s recovery is especially fragile as it is particularly exposed to a downturn in world demand.

• In France, by contrast, recent growth has come from domestic demand, especially personal consumption. But this was partly due to temporary tax breaks designed to stimulate spending. As the effects of these fade, we could see growth falling back here as well.

• In the euro-zone as a whole, consumer confidence remains soft and is pointing to only very slow growth in personal consumption. High unemployment and fears over both pensions and welfare reforms continue to be the main drags on consumer spending.

• Industrial production growth in the euro-zone appears to have already peaked in May of this year. The purchasing managers’ index (PMI) is now consistent with industrial output growth of below 2.0%.

• Overall, we expect euro-zone GDP growth of 1.9% in 2004, with a similar rate of 2.0% in 2005. Labour market reform is the main hope for stronger growth further ahead. In this respect the trend towards longer working hours in Germany is encouraging, though much more needs to be done. 
• Despite the euro-zone’s unspectacular performance, we expect renewed strength in the value of the euro versus the dollar, as concerns over the US twin deficits come to the fore and US growth disappoints.

• Inflation in the euro-zone has increased only modestly, despite record high oil prices. Indeed, core inflation has remained below 2%. The 50% year-on-year increase in oil prices we have seen so far has added roughly 0.5 percentage points to the headline rate. However, this effect will drop out after one year as long as inflationary expectations and wage demands remain subdued, as they have so far. We therefore expect headline inflation to fall well below the ECB’s 2% ceiling in 2005.

• ECB comments have been somewhat hawkish of late. But with only modest euro-zone growth and low inflation, despite high oil prices, we expect the ECB to keep rates on hold at 2% over the remainder of 2004, and probably throughout 2005 as well.

• After a roller-coaster ride since the late 1990s, 2004 will be the second successive year of decent economic growth in Japan. We expect growth of nearly 4%.

• However, a run of softer data over the summer is already signalling a slowdown in 2005. Industrial production, household spending and unemployment have all been disappointingly weak. The second quarter GDP report also showed a broad-based deceleration in domestic demand, with only net exports holding steady.

• Growth is therefore expected to slow to around 1.3% in 2005. But we would see this as a return to more sustainable rates of growth rather than a sign of failure. Adverse demographics, reflected in a declining labour force, mean that trend growth in Japan is probably only 1-1.5%.

• In contrast, China looks set to maintain a high rate of growth for many years to come. Indeed, the growth rate of 9.7% in the first half of this year was only slightly above the average of 9.4% since economic reforms began in the late 1970s.

• There are some valid concerns about the sustainability of the high level of investment, but China also has very high domestic savings. This contrasts with the excessive reliance on overseas capital that contributed to the Asian Crisis in the rest of the region in the late 1990s.

• The Chinese government has taken measures to limit spending in some areas, notably property speculation, while encouraging increased investment in physical and social infrastructure. Overall, the strategy is to rebalance the economy away from investment towards higher consumer spending, which may have little net effect on growth.

• Concerns about Chinese over-heating are also overdone. Headline inflation has accelerated above 5%, but this is essentially due to higher food prices. Agricultural output is now recovering after a poor harvest in 2003, and monetary growth is slowing sharply. Inflation should therefore fall back to around 3% in 2005.

• Globally, underlying inflation also remains well under control. Despite the spike due to higher oil prices, core inflation in the OECD countries remains below 2% – which is an historic low. Inflation expectations are also subdued, helping to limit the impact of higher headline inflation on wage demands.

• Overall, we expect world GDP growth to accelerate from 3.2% in 2003 to around 4.5% in 2004, before moderating again to 3.7% in 2005 as the US and Japan slow.

• World growth is likely to remain around these levels in 2006. Further structural reform might allow the euro-zone to maintain growth of 2% plus, and Japan to pick up again. But the unwinding of the economic imbalances in the US will take several years to work through, keeping world growth subdued.

• Growth in the UK economy now looks to have peaked, with higher interest rates finally starting to slow household activity.

• After dipping to 0.7% in the first quarter of this year, quarterly GDP growth accelerated back to 0.9% in the second quarter. This took the annual growth rate from 3.4% up to 3.6%, the third consecutive quarter of above-trend growth.

• However, we think that this is as good as things are going to get. Taken together, the activity balances of the CIPS manufacturing, services and constructions surveys are suggesting that growth will slow in the third quarter.

• Although this is likely to leave growth overall this year at a robust 3.3%, thereafter we expect the slowdown in activity to intensify as a sharp consumer slowdown threatens to dent economic growth.

• After a temporary rebound in the first quarter, consumer spending rose by just 0.6% q/q in the second quarter. And excluding retail sales, which have recently been boosting overall spending growth, non-retail spending actually fell by 0.1% on the quarter.

• But retail sales have also shown more recent signs of slowing. Although sales rose by 0.6% in August, this just reversed July’s fall and was supported by aggressive price discounting. The underlying trend has clearly deteriorated – the three month growth rate has fallen steadily from its peak of 2.0% in March.

• More generally, the factors determining consumer spending have recently started to weaken – even the resilient labour market. Although unemployment remains historically low, employment growth now appears to have stalled.

• Meanwhile, the housing market downturn finally appears to have arrived. A 0.6% monthly drop in the Halifax house price index in August has added to a mounting body of weak anecdotal and survey evidence.

• Admittedly, the housing market could yet bounce back, especially if households are reassured that interest rates are near their peak – after all, house price inflation slowed in 2003 only to later resurge. Moreover, uncertainty remains over whether the landing will be a soft or hard one, given that annual house price inflation is still around 20%.

• However, we continue to believe that, with the market so overvalued, house prices will drop by around 20% over the next two to three years. Indeed, the monthly profile of house prices in the last few months has been strikingly similar to the late 1980s slowdown.

• Moreover, the sharp drop in new buyer enquiries reported by RICS and the 23% fall in new mortgage approvals – a leading indicator of house price inflation – since May do little to support the argument that the housing downturn will be gradual.

• If house prices drop by 20% as we expect, net housing wealth would show a sharp deterioration, even assuming that debt rose no further. It suggests that this would prompt a sharp upswing in the savings ratio. We therefore think that consumer spending growth will slow sharply from 3.0% this year to just 1% or so next year and 1.5% in 2006.

• Given this, a key concern is whether other parts of the economy will be able to sustain strong GDP growth in the face of a consumer and housing slowdown.

• On a positive note, corporate profits have continued to stage a strong recovery, rising at a real annual rate of 9.0% in the first quarter. This has helped to sustain the recovery in business investment, which in turn has continued to drive the recovery in total investment growth.

• However, the manufacturing recovery now appears to have faltered before it really got going. Manufacturing output fell in July for the second consecutive month. Moreover the previously more optimistic surveys have now moved back in line with the official data, supporting the possibility that this set-back could be more than temporary.

• We expect the recovery to progress modestly at best, not least because firms are struggling to sell their goods abroad. Net trade made no contribution to growth in the second quarter, no doubt due in part to the recent strength of the sterling exchange rate. • This has been reflected in a deterioration of the trade balance. The trade in goods and services deficit has steadily deteriorated for the last five months, widening to £3.7bn in July.

• Admittedly, within this, strong import growth has masked a mild recovery in export growth. And looking ahead, sterling has now dropped back from its near two-year high. We expect this fall to continue, as US and euro-zone interest rates continue to rise while those in the UK fall later next year in response to the housing downturn.

• However, it will take some time for exporters to feel the benefit from these effects. And in the meantime, external demand appears to be faltering. Indeed, the CIPS survey is consistent with no further recovery in export growth for now.

• The upshot is that we expect overall GDP growth to slow to 2.3% in 2005. Given our more bearish view on the housing downturn and its effect on consumer spending, we think that the consensus and Bank of England forecasts look a bit optimistic.

• We expect house prices to continue to fall throughout 2006, although the blow to consumer spending will be cushioned by interest rates cuts. Lower rates should also put downward pressure on sterling. However, any re-balancing towards the external sectors of the economy will continue to be hindered by sluggish external demand. Overall GDP growth in 2006 is therefore likely to remain below trend at around 2.3%.

• UK consumer price inflation has remained remarkably subdued in the face of the sharp rise in oil prices and other commodity prices over the last year.

• CPI inflation has stayed well below its 2% target. And while RPI inflation has climbed a bit thanks to higher interest rates (lifting mortgage payments), RPIX has drifted down as house price inflation has slowed and is back below its old 2.5% target.

• That headline inflation has remained so subdued despite the rise in energy costs is testament to the weakness of underlying price pressures in the economy. Excluding energy, CPI inflation was just 0.9% in August, beneath the 1% lower limit (for overall inflation) below which the Monetary Policy Committee is required to write an open explanatory letter to the Chancellor.

• Despite the very benign picture at the retail level, however, there are signs of a build-up of costs pressures further back down the supply chain. Forced higher by the 50% rise in oil prices over the last year, producer input price inflation has climbed to its highest rates since 2001.

• Input prices account for only a small portion of producers’ total costs, however, and total costs have continued to rise less quickly thanks to smaller increases in other elements like unit wage costs. Although unit wage costs have recently stopped falling in manufacturing, they have not risen either.

• Nonetheless, producer output price inflation has climbed to its highest rate since 1996, suggesting that firms have taken advantage of recent signs of some pick-up in demand to widen their profit margins a little.

• How much of this increase in pipeline inflation pressure feeds through into the high street will be a key determinant of the behaviour of inflation over the next year or so. The rise in output price inflation points on the face of it to a rise in CPI goods inflation from recent negative rates to +2% or higher, enough to lift total CPI inflation by 1% or more.

• However, it’s clear that the relationship between goods prices at the factory gate and in the high street is not particularly close and we doubt that goods inflation will rise very far in this instance.

• For a start, the upward pressure on raw material costs could ease over the coming months if, as we expect, oil prices and other commodity prices start to slip back as world demand softens.

• Secondly, recent signs of a renewed downturn in manufacturing output suggest that firms may be forced to reverse at least some of the increase in their margins. Price expectations as recorded by the CBI have recently risen but could quickly turn back down if activity continues to disappoint.

• Third, any rise in domestically-produced goods prices should continue to be at least partly offset by falling import prices in response to the strength of the exchange rate.

• And finally, the ultra-competitive conditions in the high street suggest that retailers are likely to have to absorb a large portion of any rise in costs in their own margins rather than passing it on to consumers.

• These conditions have continued to be most evident in the clothing and footwear sector where, having eased in the previous year or two, price deflation has intensified again over the last year as price-sensitive consumers have kept margins under pressure.

• Meanwhile, prices of high-tech goods like audio equipment and computers will no doubt continue to plummet as they have done over recent years.

• While these forces should help to limit any rise in goods inflation in response to higher costs, however, inflation in the services sector has continued to look rather more robust.

• This has mainly reflected continued strong price rises in administered areas like transport, as well as in education and restaurants & hotels.

• Nonetheless, recently announced increases in utility prices, partly reflecting the strength of oil prices, are set to maintain this trend in the near term. Electricity and gas prices have already been rising quickly in recent months and look set to accelerate further over the coming months.

• This could put some upward pressure on CPI inflation over the next six months or so. However, if we are right in expecting domestic demand to weaken over the next year or two in response to a major downturn in the housing market, then services inflation is likely to ease back down in time.

• Overall, then, while CPI inflation looks likely to rise from its very low levels over the next year or so in response to a modest rise in goods inflation and higher utility prices, we expect it to remain below its 2% target and to ease back down towards the end of next year and beyond in response to a general weakening of demand in the economy.

• This is a rather lower profile for inflation than that most recently predicted by the Monetary Policy Committee. Accordingly, along with a sharp downturn in the housing market and weaker international conditions, lower-than-expected inflation will be another factor allowing the MPC to bring interest rates back down again in the second half of next year.

• Unemployment remains at a historically low level, yet wages growth remains remarkably subdued. And with signs of a softening in labour market activity, the labour market continues to present little inflationary concern.

• Unemployment continues to trend lower – albeit at a more modest pace. The claimant count measure of unemployment has now been falling for 15 months. And in the three months to July, the wider ILO measure fell to its lowest level since records began in 1984, reversing recent rises

• However, the continued fall in unemployment has been primarily due to a decline in the workforce, rather than new job creation employment growth appears to have stalled.

• The number of Workforce Jobs has barely risen since the start of the year, posting an increase of just 10,000 in the second quarter. And the more frequent Labour Force Survey measure of employment fell for the third three month period running in the three months to July.

• Together with the fact that average hours worked are at their lowest level since records began in 1992, total hours worked fell in July to their lowest level so far this year. The recent tightening of the labour market therefore seems to have ground to a halt.

• Admittedly employment growth tends to lag GDP growth, which has recently picked up. However, any consequent recovery in employment growth is likely to prove temporary, given that we expect GDP growth to fall back sharply in 2005.

• The slowdown in activity is likely to ensure that earnings inflation remains benign. After a bonus-related surge at the start of the year, average earnings growth has now settled back below the 4.5% threshold that the MPC has in the past considered a cause for inflation concern. Excluding bonuses, the headline (three month) growth rate was 4.2% for the third month running in July. We expect average earnings growth of 4.4% this year and 4.7% next year.

• Although the annual growth of unit wage costs picked up in the first quarter from 2.3% to 2.7%, this was a result of the bonusrelated earnings surge in earnings, and should drop back in Q2. Indeed, the recent pick-up in productivity will reduce the extent to which wage inflation passes through into prices inflation.

• Overall, the labour market is set to remain robust – we expect the claimant count unemployment rate to fall from 2.7% this year to 2.5% next year and in 2006.

• But this was also the case in the early 1990s, when unemployment did not start to rise until after house prices began to fall. Accordingly, a robust labour market now will not be enough to prevent a housing market downturn and a slowdown in consumer spending growth.

• After rising five times in this upward cycle – to 4.75% in August – there is a growing body of evidence suggesting that interest rates are getting very close to a peak.

• The Monetary Policy Committee has raised interest rates largely to prompt slowdowns in consumer spending and the housing market, which now appear to be underway. (See Analysis: UK Output and Activity)

• This has prompted a marked change in tone from the MPC. It was only a few months ago that the Committee was worrying that the housing market was failing to respond to higher interest rates. But September’s MPC minutes acknowledged that "the further signs that the UK housing market was cooling might mean a greater risk of a more abrupt correction to house price inflation".

• As a result, market interest rate expectations have eased back and are now consistent with interest rates peaking at around 5.0%. This is consistent with our view that the MPC will raise interest rates once more, as GDP growth is still comfortably above trend and the sterling exchange rate has started to fall.

• Perhaps more important, though, is where interest rates go after that. The markets currently expect interest rates to remain broadly flat for the next couple of years, as shown by the spread between interest rate expectations for the end of 2005 and 2004, which is closer to zero than at any other point since July 2002.

• Admittedly, interest rates have been slow to respond to falling house prices during each of the last three major house price adjustments. But this would be the first housing market adjustment under the MPC, and it is likely to be more responsive.

• Indeed, the MPC has kept interest rates unchanged at previous peaks and troughs for an average of just six months. When interest rates have changed direction, they have subsequently moved more quickly than the markets have anticipated.

• Accordingly, we think that a sharp slowdown in the housing market will prompt the Committee to cushion the blow to the rest of the economy by cutting interest rates in the second half of next year. And as our forecast is for the housing market adjustment to play out over two years or so, we think that interest rates will end 2005 at around 4.5% and 2006 at around 4.0%.

• As such, there is plenty of scope for market interest rate expectations and bond yields to fall back. And as interest rates in the US and the euro-zone are likely to rise while they fall in the UK, we expect sterling to fall over the next two years.

• Admittedly, a falling pound would limit the pace and extent of interest rate reductions, but we do not believe it would stop rates from falling altogether against a background of a sharply weakening housing market.

• The public finances have continued to show little improvement in response to the pick-up in economic activity over the last year. Public sector net borrowing (PSNB) has so far followed a very similar path to that seen in the early months of 2003-04.

• Admittedly, this leaves borrowing broadly on track to meet the Chancellor’s full-year forecast for PSNB of £33bn, just below last year’s total. However, this is explained in part by the relative weakness of net investment, which has risen by a cumulative £1bn only in the first five months of the year compared to last year.

• Stripping out investment, the current budget has also followed last year’s path closely. But this leaves it on track to overshoot Mr Brown’s Budget 2004 forecast of a deficit of £11bn by around £10bn.

• Given that Mr Brown’s forecast showed him meeting his own Golden Rule – which requires the current budget to be in balance or surplus over the economic cycle – by just £11bn, this suggests that the Rule is now in very serious danger of being broken.

• The one glimmer of hope is that the growth of current expenditure has slowed sharply from the rapid rates seen through much of last. However, at 6.6% in the first five months, it remains above the 5.1% forecast in the 2004 Budget.

• Even if spending growth slows further, this may well be offset by further disappointment on the receipts side. Receipts growth has so far fallen well short of the Chancellor’s Budget forecast of 8% growth this year.

• What’s more, receipts growth could weaken further if high oil prices and a housing market downturn begin to slow economic growth over the coming quarters, as looks likely. Although GDP looks set to meet Mr Brown’s forecast of 3.0% to 3.5% this year, he is likely to have to revise down his forecast of similar growth next year in November’s Pre-Budget Report.

• The upshot is that, while the public finances are no longer deteriorating, borrowing is unlikely to fall back over the next few years as the Chancellor has predicted. We expect PSNB to hold up rather more stubbornly.

• This in turn means that the current budget is likely to remain deeper in deficit, suggesting that significant tax increases will ultimately be required if the Chancellor is to meet his own Golden Rule. We still expect tax hikes of the order of £10bn after the general election, likely to be held in spring 2005.

• The rise in public borrowing in recent years has already led to a sharp upturn in gross gilt issuance. Our forecasts for borrowing, coupled with a projected increase in gilt redemptions, suggest that gross gilt issuance is likely to stay close to recent levels of around £50bn per annum, if not rise a bit, over the next few years.

• The UK’s external position has still not benefited from the upturn in global activity. The trade in goods deficit widened from £14.3bn in Q1 to £14.5bn in Q2, which took it to a record high.

• The main problem is that the growth of export volumes has remained uncharacteristically weak. In contrast to the strong pick-up seen in response to the global recovery of 1999, exports have hardly risen.

• Part of this is probably due to the strength of sterling, and that UK exporters have not fully offset the higher exchange rate with lower sterling prices.

• But most of it is probably a result of the shape of the global recovery. Economic growth has been strongest in the US and Asia. But the UK sells over 50% of its exports to the euro-zone, where activity has remained weak. An average of US, Japanese and euro-zone import growth, weighted according to the UK’s export share, has picked up only modestly.

• As a result of all this, even the previously optimistic survey evidence is no longer consistent with a significant improvement in export volumes.

• What’s more, whereas in the last two decades the UK’s trade in goods position has always had a decent oil surplus to fall back on, this is being eroded, in line with the depletion of the UK’s North Sea oil reserves.

• Thankfully, the outlook on the services side is a lot more optimistic, mainly as National Statistics recently revised up its estimates of the services surplus. This was enough to offset the poor performance of trade in goods and narrow the trade in goods and services deficit marginally from £10.0bn in Q1 to £9.9bn in Q2. But the goods and services trade position is still likely to deteriorate from £33bn last year to around £38bn this year.

• However, there are two reasons why it is likely to improve in the next few years. First, imports should ease back as the UK consumer boom comes to an end. Second, exports may soon receive a boost from a modest pick-up in euro-zone activity and from a weaker exchange rate. (See Analysis: UK Monetary Policy) We think that this will be enough to narrow the traded deficit to around £24bn in 2005 and £13bn in 2006.

• As far as the other elements of the current account are concerned, the high oil price is likely to support the already robust investment income balance as UK oil companies continue to repatriate profits from abroad.

• And with the current transfers balance unlikely to do anything out of the ordinary, we expect the overall current account deficit to widen to around £25bn this year before narrowing to around £15bn in 2005 and £10bn in 2006.

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