Economic Review - Outlook for 2005 (continued) -Analysis - Financial Services

Analysis: The world economy

US imbalances pose serious threat to growth

The US economy continued to deliver above-trend growth of 3.9% in the third quarter of 2004, despite higher energy prices. However, the economy’s imbalances, which continue to increase, pose a very serious threat to growth in the next few years. The main worry is the state of consumer finances.

We expect GDP growth to slow to around 2.5% in 2005 and 2006, well below the consensus forecast of 3.5% for 2005. The key leading indicators are already showing a deterioration in the outlook.

Consumers again acted as the bedrock for the economy last year, despite fairly modest employment gains and lacklustre income growth. With consumer confidence falling recently too, it appears to be only a matter of time before consumers begin to slow their spending.

Strong consumer spending coupled with modest income growth has reduced the personal savings rate to a wafer thin 0.2%. This is unsustainably low.

Along with the deterioration in the Federal budget deficit, this decline in private sector savings pushed the current account deficit to a record 5.7% of GDP in the second and third quarters of 2004.

Concerns over the returns that foreigners will demand to fund a deficit of that magnitude by buying US assets have begun to weigh more heavily on the dollar in recent months, causing a rapid depreciation.

However, although the dollar has fallen markedly against the euro and yen over the last two years, its decline in overall trade-weighted terms has been more modest. This is because the dollar is pegged to the Chinese renminbi and has actually been appreciating against the Mexican peso. Both of these countries are roughly as important as Japan in US trade.

We expect the dollar to fall to at least $1.40 against the euro and to ¥90 against the yen this year. But even a depreciation of that magnitude will not be enough to reduce the current account deficit sufficiently. The necessary adjustment will also require substantially higher household saving, and therefore slower consumer spending.

Fortunately, the weaker dollar should not push inflation markedly higher, because strong competition prevents importers from fully passing on price increases. Instead, they seem more inclined to absorb the dollar’s depreciation in lower profit margins to avoid losing market share. Strong competition and ample capacity should also prevent producers from passing on higher unit labour costs.

The Fed is still likely to return rates to more ‘normal’ levels. However, the favourable inflation outlook, and below-trend growth in 2005 means that the ‘normal’ level for the Fed funds rate in these conditions could be as low as 3.0%, slightly below market expectations.

Euro-zone: faltering recoveries in both Germany and France

The recovery in the euro-zone is increasingly fragile, led by weakness in its two largest economies. There was a clear loss of momentum in 2004, with GDP rising by only 0.3% q/q in the third quarter after growth of 0.5% in Q2 and 0.7% in Q1.

Household savings are in good shape – unlike in the US – but consumer confidence is still at a low level. This suggests that spending growth will remain weak.

The euro-zone purchasing managers’ index (PMI) is also consistent with stagnant industrial output in the months ahead.

Recent data suggest that the recoveries in Germany and France are most vulnerable. GDP growth slowed to only 0.1% q/q in both countries in the third quarter of last year.

In Germany, exports had previously been the motor of the recovery, but they fell by 1.1% q/q, while personal consumption and domestic demand remained weak.

Indeed, the German unemployment rate has continued to rise. Though this is partly due to technical changes in the claimant count, high labour costs and weakening demand have reduced hiring plans. Some companies have also re-located production abroad, especially to the new member countries of the EU.

The strengthening euro is likely to hit Germany particularly hard, as exports form a relatively large part of its total economy.

The two main German business sentiment indicators have deteriorated significantly in recent months. The Ifo survey is now consistent with flat year-on-year industrial production growth in Germany. The ZEW survey is even more pessimistic.

In France, exports grew in the third quarter of last year, but personal consumption fell by 0.1% q/q. The effect of temporary government incentives to stimulate personal consumption is already fading and underlying consumer confidence remains subdued.

Overall, after euro-zone GDP growth of around 1.8% in 2004, we expect a slowdown to only 1.3% in 2005, before a slight recovery to 1.8% in 2006. Given the focus on economic imbalances in the US, the danger is that the euro will strengthen further against the dollar in 2005.

Market expectations for a series of interest rate increases have been scaled back. With subdued core inflation, and the economic recovery showing increasing signs of petering out, we expect the European Central Bank (ECB) to leave rates on hold at 2% throughout 2005 and 2006.

Indeed, continued euro strength and weak data may yet see rates cut, though with the repo rate already at historic lows and both liquidity and lending growth already buoyant, the ECB will be cautious about taking this step. The more likely outcome would be a further loosening of fiscal policy.

Soft landing for Japan, no landing for China

Recent data have raised concerns about the outlook for Japan. Real GDP rose by a feeble 0.1% q/q in Q3 2004, after a fall of 0.1% in Q2. Nominal GDP was flat in Q3, after a fall of 0.6% in Q2. However, big questions remain over the quality of the data.

If the economy was indeed flirting with recession, we would expect this to have been reflected in the surveys of consumer and business sentiment. Instead these surveys, notably consumer confidence, have held up pretty well.

We would usually give this survey evidence more weight than the ‘hard’ data, which are often implausibly volatile from month to month, and even from quarter to quarter. In particular, the weak GDP numbers in Q2 and Q3 last year followed suspiciously strong growth in the previous four quarters, culminating in astonishing growth of 1.7% q/q in 2004 Q1.

These previous growth rates were well above any realistic estimate of trend growth in Japan. One possible explanation is poor seasonal adjustments, and one way to get round this is to look at the year-on- year rates. This gives a more favourable impression: annual growth slowed from 4.0% in Q1 but was still a respectable 2.5% in Q3.

Looking forward, we expect Japanese GDP growth to slow further, averaging 1.3% in 2005 before picking up again to 2.0% in 2006. This would be a little below the consensus, but close to the long-term trend growth rate.

Worries over the recent rise in the yen against the dollar are overdone. Focusing purely on this bilateral exchange rate misses the key point that the dollar has been weakening across the board, including against most of Japan’s trading partners. A better guide to Japan’s competitiveness is therefore the real trade-weighted index, which measures the yen’s movements against a basket of currencies and adjusts for national differences in inflation. This index has hardly budged over the last few years

The upshot is that Japan is heading for a soft landing in 2005, while the yen remains on track for 90 against the dollar.

In contrast, the debate about whether China is heading for a soft landing or a hard landing ignores a third possibility: the rapid expansion could just keep on going. We expect growth of around 8-9% in 2005 and 2006, in line with the long-term trend. A steep fall in inflation has eased concerns about overheating and monthly activity data suggest that the authorities are successfully rebalancing growth away from investment towards consumption.

Summarising the global picture, headline inflation has picked up slightly in response to rising energy costs, but core inflation remains at historic lows. Headline inflation should therefore fall back in 2005 as oil price pressures ease and economic growth generally disappoints This will also keep global interest rates low.

Analysis: UK output and activity

Housing market downturn to slow spending growth…

Activity in the UK economy has recently hit a softer patch. We expect growth to weaken further in 2005 as the housing market downturn slows household spending growth and global activity weakens.

Quarterly GDP growth dipped to 0.4% in the third quarter of 2004, down from 0.9% in the second. This took the annual growth rate down from 3.6% to 3.1%. There are tentative signs that activity may have rebounded somewhat in the fourth quarter. A weighted average of the activity balances of the CIPS manufacturing, services and construction surveys is consistent with growth of around 0.8%.

Any rebound, however, is likely to prove temporary. The prospects further ahead look rather less hopeful, given growing doubts over the ability of the corporate sector to compensate for weaker household spending growth over the next year or two.

Household spending rose by just 0.5% in Q3 2004, the smallest increase since 2003 Q1 when the Iraq war dented consumer confidence. Non-retail spending growth has been subdued for some time, but now high street spending has started to slow too.

The 1.1% rise in retail sales volumes in Q3, though clearly still robust, was well down on the 1.8% rises recorded in the first two quarters of 2004 Although sales rose by 0.6% in November, this followed a 0.5% fall in October and was the result of heavy discounting in the run-up to Christmas.

With the factors which have underpinned the recent spending boom continuing to weaken, we expect this slowdown to intensify. Most importantly, the housing downturn has picked up pace. Buyer enquiries have dropped, seller times have risen and the number of mortgage approvals has fallen significantly from the peak at the end of 2003.

This weakening in activity has also fed through into prices; in most of the last few months, at least one of the Nationwide or Halifax house price indices has fallen. We still think that falling buyer confidence will cause prices to drop by 20% or so over the next two to three years.

Admittedly the link between the housing market and consumer spending has recently weakened. Nonetheless, we doubt that it has broken down completely, as households are unlikely to feel spendthrift when their housing wealth is dropping. Indeed, in the late 1980s, the correlation between household spending and house prices also seemed to break down, only to re-establish itself once house prices started to fall.

The housing market aside, other factors are also likely to prove less supportive of spending. We expect households’ total debt servicing costs to remain close to their early ‘90s peak, as the record level of debt keeps repayments high.

…while doubts remains over the outlook for the external sector

Even the formerly resilient labour market no longer seems to be strengthening, with claimant count unemployment remaining broadly flat in recent months. Households also face another hit to their disposable income in the next couple of years, as the deterioration in public finances makes it likely that taxes will have to rise by £10bn or so per annum.

The good news is that we expect the benign inflation outlook to allow the MPC to cut interest rates in response to these factors. Nonetheless, we still expect household spending growth to slow sharply from 3% last year to 1.5% or so in 2005 and 2006. This is a sharper slowdown than the consensus expects, partly because we expect bigger house price falls.

Whether or not other parts of the economy will be able to compensate remains to be seen, but the early signs are not encouraging. Indeed, in Q3 2004, neither trade nor investment made a positive contribution to GDP growth. The industrial recovery has now fizzled out, with a renewed downturn in manufacturing output.

Moreover, the output expectations balance of the CBI Monthly Trends survey is currently pointing to a further deterioration. The CIPS survey is more positive, indicating growth of 4% or so. But it was similarly upbeat in the first half of last year, only for the official data to fail to follow suit.

The one piece of good news is that exports rose by a robust 1.9% on the quarter in Q3, albeit offset by strong import growth. Looking ahead, exporters should eventually benefit from a drop in the sterling trade-weighted index. Although sterling is set to strengthen against the dollar as concern grows about the US twin deficits, it should weaken against the euro – the UK’s more important trade partner.

In the meantime, however, exports will suffer from any further weakening in global demand. At the end of last year, the CBI’s measure of export orders reversed earlier gains to return to the lower levels seen at the start of 2003.

Meanwhile, business investment showed a quarterly rise of just 0.1% in Q3 2004. Manufacturing investment contracted by 1.2%, with the CBI survey of investment intentions pointing to further weakening ahead. The ability of firms to finance further investment is in doubt, given that higher oil prices and weaker output have damaged profit expectations.

The upshot is that the corporate sector may not be in a position to drive forward overall growth as the boost from consumer and government spending fades. We expect GDP growth to slow to 2.0% in 2005, down on 3.3% or so for 2004, and lower than the consensus. Given our more pessimistic stance on the housing market, and given that we expect house prices to keep falling until 2007, growth is likely to improve only modestly to 2.2% or so in 2006.

Analysis: UK inflation

Energy prices lift inflation

The outlook for inflation has deteriorated a little in recent months as higher energy prices have lifted CPI inflation and cost pressures have continued to build. But strong competition in the high street should mean that inflation presents no barrier to lower interest rates later in 2005 and in 2006.

UK inflation has shown signs of creeping higher in recent months. CPI inflation has nudged higher from the very low levels seen in the autumn, while other measures like RPI and RPIX have also risen.

So far, the pick-up has been modest. CPI inflation has remained comfortably below its 2% target and no higher than the rates seen earlier in the summer.

What’s more, the bulk of the recent increase has reflected higher energy prices, as petrol prices have risen further in response to high oil prices and gas and electricity bills have also risen sharply.

Excluding energy, CPI inflation has stayed below 1%. So were it not for energy prices, Mervyn King would already have written to the Chancellor explaining why inflation has fallen more than 1% below the 2% target.

Nonetheless, there are fears of a more meaningful pick-up in inflation over the next year or so in response to the significant build-up of cost pressures further back down the inflation pipeline. Producer input price inflation has risen sharply on the back of the surge in oil prices.

Admittedly, other elements of costs have continued to grow less quickly. Although manufacturing unit wage costs have recently started to rise in annual terms, the pick-up has so far been modest. As a result, a weighted measure of producers’ total costs has risen rather less quickly than input prices alone.

Nonetheless, producer output price inflation has still risen sharply in recent months, suggesting that manufacturers may have succeeded in widening their margins a little. If this increase were to be replicated in full in the high street, CPI inflation could pick up much further.

However, we think there are several factors which are likely to limit any impact on CPI inflation. 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 Even if oil prices hold constant, the upward influence on inflation (as opposed the price level) will, of course, fade over the next year.

Strong competition to limit cost pass-through

Secondly, the recent renewed downturn in manufacturing output suggests that producers may be forced to reverse at least some of the increase in their margins. After trending higher over the last several years, there are signs that manufacturers’ own price expectations as recorded by the CBI have recently flattened off.

Thirdly, and most importantly, the extremely 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.

The historically close relationship between producer output prices and, after a lag, core retail goods prices has already broken down in the last year or so. While output price inflation has been rising for the last three years, core goods inflation has turned down sharply.

Within the goods sector, the effects of strong competition have probably been most evident in the clothing and footwear sector, where prices have continued to tumble by more than 5% per annum.

Part of this reflects falling costs as productivity in the sector has increased and retailers source an increasing proportion of supply from lower cost overseas economies. But strong competition also appears to have played a part and these pressures look set to intensify as the growth of household spending slows over the next year or so.

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, inflation in the services sector has continued to look rather more robust.

In addition to utility prices, this has mainly reflected strong price rises in administered areas like transport, as well as in education and restaurants & hotels.

These areas could continue to put upward pressure on inflation over the coming months. However, our expectations of a sharp slowdown in the growth of household spending over the next year suggest that services inflation will ease lower in time.

Overall, then, while CPI inflation may well rise further over the next few quarters 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 2005 in response to strong competitive pressures and weakening demand.

This is a rather lower profile than predicted by the MPC in the November 2004 Inflation Report. Accordingly, we expect lower than expected inflation to allow the MPC to respond to the downturn in the housing market by cutting interest rates quite aggressively over the next year.

Analysis: UK labour market

Labour market activity starts to soften

Recent months have seen some signs of a pick-up in wages growth in response to the tightness of the labour market. However, with labour market activity likely to weaken in line with the general economy over the next year or two, wages growth should not pose a major threat to the inflation outlook.

The downward trend in claimant count unemployment has started to show signs of tailing off, with two recent rises ending a 15 month run of consecutive falls. Admittedly the rises were marginal and left the claimant count rate unchanged at 2.7%. Nonetheless, they suggest that unemployment may be close to the trough in this cycle.

The ILO measure (which includes those looking for work but not claiming benefit) has continued to fall, dropping by 65,000 in the three months to October. However, this lags the claimant count series and tends to be more volatile. The decline in the wider measure of the pool of available labour in the economy - the number of people classified as inactive but looking for work - has recently tailed off.

Although employment growth has recently rebounded somewhat on the LFS measure, the less volatile Workforce Job series has continued to show a steady decline in growth. In fact, without the boost from the public sector, private sector employment on this measure fell in each of the first three quarters in 2004.

Meanwhile, average earnings growth has recently edged higher. The headline (3 month average) growth rate including bonuses was 4.1% in October, down from a peak of 5.3% in March. But excluding bonuses, growth has accelerated steadily to reach 4.4% in October, the highest since May 2002.
Yet pay settlements remain closely anchored to 3%, while the Recruitment & Employment Confederation measure of regular pay has eased. With activity showing signs of softening, we expect earnings growth to rise to just 4.5% in both 2005 and 2006 from last year’s 4.4%. It should therefore still fail to breach the 4.5% threshold above which the MPC has worried about wages pressures.

In any case, any pick-up in earnings growth could be mitigated by faster productivity growth, which hit 3% in Q2 2004. The rise in manufacturing productivity growth in 2003 has now been mirrored in the services sector, meaning that unit labour costs have remained contained. Productivity growth could accelerate further if average hours worked finally rise, or as a delayed response to the late ‘90s investment boom.

Overall, we expect the unemployment rate to rise from 2.7% to 3.0% as the economy slows over the next two years. However, there is a risk of a bigger rise if the housing downturn triggers major job losses in consumer-related industries. In the last housing downturn, unemployment did not start to rise until almost a year after house prices first fell.

Analysis: UK monetary policy

Interest rates to drop to 3.5% in 2006

Having raised interest rates aggressively last summer, the Monetary Policy Committee kept rates on hold in the last four months of 2004.This pause is already comparable in length to some of the previous peaks and troughs in interest rates under the MPC.

Although there is still a possibility of one more rate hike in the current cycle, the news on the economy and signals from the MPC itself suggest that rates may well have already peaked. Recent months have seen an unprecedented degree of unity amongst MPC members, with the last eight interest rate decisions being unanimous.

Looking ahead, the financial markets have begun to consider the possibility of lower interest rates over the next year. Short sterling futures contracts are pricing in a small reduction in rates.

However, we see scope for rates to fall much further in response to the downturn in the housing market, weak global conditions and subdued inflation. If the number of mortgage approvals continues along its recent downward path, it will soon be consistent with sharp falls in house prices.

And together with continued weakness in the external sectors, overall GDP growth is set to slow to just 2.0% in 2005 and 2.2% in 2006.

Meanwhile, a modest rise in inflation in the next couple of years will not be a barrier to lower interest rates.

Accordingly, we think that the markets are underestimating how far interest rates are likely to fall. Indeed, they have been guilty of being too pessimistic on interest rates at the start of the calendar year in 12 of the last 15 years, although admittedly they got it pretty much spot on last year.

And although the prospect of lower interest rates relative to those in the US and the euro-zone could put the sterling exchange rate under further downward pressure, we do not believe that this would stop interest rates from falling against the background of a sharply weakening housing market and moderating consumer spending growth.

We think that the first cut in interest rates will come in the spring, with rates ending the year at 4.0%. And as the housing market is set to remain weak for a couple of years, we see interest rates falling all the way to 3.5% by the end of 2006.

As such, there is plenty of scope for market interest rate expectations and bond yields to continue to trend downwards over the next two years.

Analysis: UK public finances

Taxes to rise by £10bn after the election

Gordon Brown acknowledged the continued poor performance of the public finances by yet again revising his forecasts for borrowing higher in December’s Pre-Budget Report (PBR).

The forecast for public sector net borrowing (PSNB) in 2004-05was lifted from £33bn to £34.2bn, just below last year’s total. Meanwhile, the forecast for current borrowing (which excludes borrowing for investment) was raised from £11bn to £12.5bn. The projections for the next few years were also nudged higher.

Needless to say, the new forecasts left Mr Brown on track to meet his own Golden Rule, albeit by a reduced margin of just £8bn. Given that the Treasury’s average forecast error in predicting borrowing one year ahead is £10bn, the margin for error is wafer thin.

What’s more, the Chancellor’s figures continue to rely heavily on two optimistic assumptions. First, that the economy grows strongly, expanding by another 3% to 3.5% in 2005. This is much more optimistic than the consensus forecast or that of the Monetary Policy Committee.

And second, that the public finances respond very favourably to the strength of the economy. The latest evidence provides little encouragement on this front. Tax receipts have so far grown at a rate of close to 6% this year, well below the 8% rate forecast in the 2004 Budget and the revised forecast of 7.7% in the PBR.

The Treasury has suggested that higher oil revenues will boost receipts in the remaining months of this year, but they look unlikely to make up all of the shortfall and, in any case, non-oil receipts have undershot expectations.

What’s more, tax receipts are only one half of the problem. Current spending has so far grown more rapidly than predicted this year.

The upshot is that we expect Mr Brown’s forecasts to once again prove too optimistic. We expect a PSNB of some £36bn in 2004-05, with a similar total in 2005-06. We also expect the current budget to remain further in deficit than the Chancellor’s figures imply.

Our forecasts suggest that the Golden Rule is in real danger of being broken, although the fact that the economic cycle over which it applies is not expected to end until early 2006 means that the Chancellor can delay any corrective action until after the general election, expected in spring 2005.

Once the election is over, however, decisive action is likely to be required to put the public finances back on to a sustainable footing. We continue to expect tax increases of the order of £10bn per annum from 2006-07.

The high levels of borrowing, coupled with a heavy gilt redemption schedule, suggest that gilt issuance is likely to remain close to current levels of £50bn per annum, or even rise further, in the next few years.

Analysis: UK external trade

Weak global growth and the strong pound to hold back exports

The UK’s trade position continued to deteriorate in the second half of last year. Indeed, the trade in goods and services deficit reached a record high as exports failed to respond to the strength of global activity.

The rapid growth of OECD GDP over the last year might normally be consistent with UK export growth of around 8% p.a., but exports grew at only half that rate in Q3 2004.

Part of this is probably a result of the heavy exposure of UK exports to weak economies and only light exposure to rapidly expanding areas. For instance, nearly half of UK exports go to the euro-zone while only 1% goes to each of India and China.

But the ongoing strength of the sterling trade-weighted index (TWI) is probably more important. What’s more, the official index probably understates sterling’s real strength. It is based on trade flows in goods only and excludes most Asian countries. Since the UK sends a much higher share of its services exports to America, and since much of Asia is tied to the dollar, the trade-weighted index over-weights the importance of the euro and under-weights the dollar.

Since the pound has been weak against the euro and strong against the dollar, the result is an under-estimate of sterling’s strength. Recalculating the index to include trade in services and more of the UK’s trading partners would leave sterling some 5% higher than under the official TWI.

That all said, the 4.3% annual rise in exports in Q3 2004 was a big improvement on the annual falls seen earlier in the year. But even this may not be sustained. Indeed, export volume growth has already started to slow on a three-month-on-three month basis, while export orders are lower than they were six months ago.

Furthermore, world demand is set to become less supportive for UK exports Accordingly, we are more pessimistic on the prospects for a decent export recovery.

But we are still hopeful that there will be an improvement on the other side of the equation, as import growth moderates in line with the more subdued growth of UK household spending. Accordingly, we expect the trade in goods and services deficit to narrow from just over £40bn in 2004 to around £36bn in 2005 and to £30bn in 2006.

As far as the other elements of the current account are concerned, we would not be surprised to see a moderation in the investment income surplus in the near-term as the weakness of the dollar reduces repatriated profits in sterling terms.

And with current transfers unlikely to do anything out of the ordinary, we expect that the current account will improve from just around £28bn last year to £25bn this year and around £20bn in 2006.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

UK: Economic Review - Outlook for 2005 (continued) -Analysis

Login to Mondaq.com

Why Register with Mondaq

Your Organisation