Economic Review - Second Quarter 2005 (continued) -Analysis - Industry Updates & Analysis

Analysis: The world economy

US growth to slow sharply by 2006

The US economy performed strongly last year, with GDP growth of 4.4%. We expect growth to slow to 3.3% this year as rising interest rates tighten the cyclical screw. Growth is then expected to slow further to 2.5% in 2006 as the economy’s structural problems centring on the current account deficit, Federal budget deficit, and the over-valued housing market begin to bite.

For now at least, business activity remains relatively firm. The resurgence in business spending was one of the most eye-catching developments of last year. But given the even bigger rebound in corporate profits, investment growth was actually relatively disappointing. With profits stalling as productivity growth moderates, we expect business investment growth to slow this year. However, low borrowing costs should prevent business spending from collapsing.

Retail sales growth remained buoyant last year too, despite record high gasoline prices and lacklustre employment growth in the second half. But modest income growth meant that households had to run their savings rates down to wafer-thin levels.

Households have been using gains in real estate wealth to fund spending. A housing slowdown this year should therefore contribute to slower spending growth. House prices rose by 10.8% last year, the fastest pace since the early 1970s.

The upshot is that house prices are now more over-valued than ever before. The average house costs over 3.5 times the annual disposable income of each employee, compared to a peak of 3.2 in the late 1970s boom and 3.1 in the late 1980s.

The growth rate of house prices fell close to zero in the aftermath of both of those two previous booms. Accordingly, since valuations in the current boom are now more severe, there is the real risk of outright declines in prices this time. However, we expect only a modest increase in mortgage interest rates, which are linked to long-term Treasury yields. That should prevent a complete collapse in the housing market.

The run-down in household savings alongside the big Federal deficit resulted in a further widening of the current account deficit to 6.3% of GDP by the end of last year. This is clearly an unsustainable position. It will require higher domestic saving (and therefore lower growth) and a substantial further fall in the dollar’s value to reduce it.

Despite the dollar’s fall and higher oil prices, inflation remains fairly well contained. Accordingly, the markets believe the Fed can aff o rd to continue with its measured pace of 25 basis point rate increases at each meeting for most of this year, taking rates to around 4% by the end of 2005. In contrast, we anticipate that the Fed will stop raising rates at 3.5% as signs of slower growth begin to emerge later this year.

Euro-zone: Growth to slow as euro strengthens

The weakness of the euro-zone economy in the second half of 2004 has prompted most observers to cut their forecasts for 2005. GDP grew by only 0.2% q/q in both the third and fourth quarters. However, we have been wary of the strength of the recovery for some time and have kept our forecast for 2005 at 1.3%, down from 1.8% in 2004.

In the industrial sector, there has been some encouraging news on new orders for capital goods and transportation equipment, but the overall outlook is still for subdued growth. The euro-zone PMI has improved only slightly in recent months and is consistent with industrial production growth of only 1% y/y in the months ahead.

In the consumer sector, the growth of personal consumption accelerated to 1.3% y/y in Q4 from 0.9% y/y in Q3. But the levelling off in the European Commission’s index of consumer confidence suggests that consumption growth will fall back to around 1.0% y/y in the coming quarters.

The aggregate euro-zone numbers also disguise diverging growth in the major economies. For example, national data show German consumer spending grew by only 0.2% q/q in Q4, whereas in France spending rose by 1.2% q/q. However, we expect French spending to slow sharply in 2005, moving back in line with underlying consumer confidence as the effects of temporary tax breaks begin to fade.

Despite weak growth prospects in the euro-zone, we expect the euro to hit $1.50 against the dollar by end-2005, given that foreign exchange markets are focused more on economic imbalances in the US.

Euro-zone headline inflation is slightly above the ECB’s 2% ceiling, mainly due to the impact of high oil prices. But their contribution to inflation should fall later on in the year, as oil prices were already high in much of 2004. The stronger euro will also serve to dampen import prices more generally.

Furthermore, there has already been a sharp fall in core inflation, to 1.4% in February. The upshot is that inflationary pressures remain subdued.

With the recovery still fragile, we expect the ECB to leave interest rates on hold at 2% this year. Indeed, the ECB has recently revised down its own GDP growth forecast for 2005, from 1.9% to 1.6%.

However, the ECB has also made it clear that it would like to see rates return to more ‘normal’ levels eventually and the latest rhetoric has been relatively hawkish. The central bank is increasingly concerned about rising house prices, the rapid growth of the money supply, and the loss of fiscal discipline. This suggests that upside risks to interest rates are increasing. Nonetheless, with the euro strong and rising, the ECB will hold off from raising rates until the economic recovery shows much clearer signs of regaining momentum.

Japan and China to beat expectations

The Japanese economy is at a turning point. According to the official data, Japan slipped back into recession in the middle two quarters of last year, before mustering growth of just 0.1% q/q in the final quarter. However, the monthly data for January and February have shown a strong rebound.

This may simply be a case of the official data catching up with reality. Consumer confidence has been trending higher, benefiting from a clear recovery in the labour market. Business confidence has dipped but remains at a relatively high level. The upshot is that the recession in mid-2004 appears to have been largely a ‘technical’ correction from the suspiciously strong growth of 1.4% q/q in 2003 Q4 and 1.5% q/q in 2004 Q1.

The quarterly profile means it is almost inevitable that average GDP growth will be slower in 2005 than the 2.6% achieved in 2004 as a whole. Last year’s growth was also well above most estimates of the sustainable long-term trend for Japan, given the ageing of the population. Nonetheless, our forecast of 1.5% for 2005 is comfortably above the latest consensus of 0.9%.

In turn, this suggests some upside risks to Japanese inflation and interest rates – albeit from a very low starting point. We expect consumer price inflation to be slightly positive in 2005 (compared to the consensus for another year of mild deflation), then to accelerate to around 1% in 2006.

The Chinese economy grew by 9.5% last year, close to the average since reforms began in the late 1970s. More importantly, the authorities appear to be succeeding in their attempts to rebalance growth away from investment towards consumption.

The monthly data on industrial production and retail sales suggest that growth has remained strong in the first quarter of 2005. The one negative has been a sharp fall in the growth of imports in the first two months of the year, which may reflect data problems over the Chinese New Year.

Strong growth may keep fears of ‘overheating’ alive. Consumer price inflation did indeed double in February to 3.9%, from 1.9% in January. However, this reflected a jump in food price inflation. This suggests that the supply problems responsible for the surge in food price inflation in 2004 are lingering a little longer than expected. Nonetheless, food price inflation is likely to fall back again in the coming months, just as it did last year. Inflation excluding food remains well below 2%.

Summarising the global picture, headline inflation has picked up slightly in response to rising energy costs. However, core inflation in the OECD economies remains close to historic lows at around 2%. Headline inflation should fall back in 2005 as the upward pressure from oil prices eases and economic growth generally disappoints. This will also keep global interest rates relatively low.

Analysis: UK output and activity

Slowdown in household spending growth to intensify

The UK economy has begun the year with a decent amount of momentum. But with the growth of household spending already weakening and set to slow further, we expect GDP growth to slow sharply over the next year.

Quarterly GDP growth came in at 0.7% in Q4 2004, an improvement on the 0.6% rise seen in Q3. The annualised growth rate of 2.8% was therefore in line with the economy’s trend growth rate of around 2.7%.

But we expect this pick-up in growth to be temporary. Indeed, growth in Q1 was 0.6%, consistent with weighted average of the CIPS manufacturing, services and construction surveys. And beyond that, it remains doubtful whether the corporate sector will be up to the task of driving the economy as household and government spending slow.

Household spending growth continued its downward trend in Q4, rising by just 0.2% q/q. Retail spending – previously the driver of total spending – continued to slow. And the slowdown appears to have continued into Q1. After a disappointing Christmas/New Year performance, retail sales rose by just 0.2% in February. Non-food sales fell at their sharpest rate since March 1992 in the three months to February.

The slowdown has come despite the continued support of a robust labour market. Average earnings growth has picked up, alongside historically low unemployment.

The slowdown in spending is therefore more likely to be a reflection of households adjusting down their expectation of future housing wealth gains, against the background of record levels of indebtedness.

We still expect house prices to fall by 20% or so over the next two or three years. Despite monthly fluctuations in the Nationwide and Halifax indices, the annual growth rates of both have slowed in line with previous falls in mortgage approvals. What’s more, approvals have so far followed a strikingly similar path to that seen in the early 1990s, suggesting that the housing market could be on course for a similar "hard landing".

Meanwhile, a fall in house prices reduces housing wealth, but not mortgage debt. We expect households’ debt servicing costs including debt repayments – almost three times bigger than interest payments alone – to remain close to record highs.

The recovery in equity prices will provide only a limited boost to household spending, given that much of financial wealth is locked into pension funds and illiquid assets.

And although we expect only a slight rise in unemployment, a solid labour market isn’t sufficient to keep household spending growing solidly. Despite the sharp rise in unemployment in the early 1990s, growth of real household disposable income held up pretty strongly. But spending still fell outright, as people saved a greater share of income as the housing market slowed.

External sector to improve – but not by enough

The upshot is that we expect household spending growth to slow sharply from the 3.1% seen in 2004 to around 1.5% this year and next. But with the MPC able to respond by cutting interest rates aggressively, spending growth will still be much stronger than in previous housing downturns.

Nonetheless, our forecast is lower than that of the consensus, reflecting our more bearish view on both the abruptness of the housing market adjustment and the adverse impact this has on household spending.

Meanwhile, the public sector is also set to become less supportive. The government is forecasting spending to slow from last year’s 4.7% to just 3% in 2005 and 2006. And given the deterioration in the public finances, we expect taxes to have to rise by around £10bn p.a. after the general election.

Together government and consumer spending make up 85% of GDP. As such, the rest of the economy has considerable work to do to compensate for a slowdown in these areas.

Investment has recently grown strongly, rising by 5.6% in 2004. The Treasury is forecasting government investment (10% of all investment) to rise by 30% in 2005. But investment in private dwellings, which makes up 25%, is likely to fall as the housing market slows.

Meanwhile, it is hard to see how business investment, the remaining 65%, will continue its sustained momentum in the face of increased demand uncertainty. The CBI investment intentions balance indicates that manufacturing investment in particular is set to fall sharply.

Indeed, although output in the industrial sector has risen for the last three months in a row, it did the same last year only to start falling again. Nonetheless, we expect manufacturing output to rise by 2% in 2005 and 2.5% in 2006, after 1.5% growth last year.

The export recovery also seems to be gathering momentum, with export volumes rising by a solid 6.5% in the three months to January compared to last year. But so far this has been more than matched by stronger import growth, implying that net trade remained a drag on overall economic growth in Q4.

A consumer slowdown should prompt import growth to slow. But the export recovery might also run out of steam given that we expect growth in the UK’s export markets to weaken. We expect the sterling trade-weighted index to fall, but it will take some time for companies to see the benefits.

The upshot is that we expect the industrial sector to recover – but not by enough to offset slower growth in the other parts of the economy. We expect GDP growth of about 2.0% in 2005, below last year’s 3.1% and below both the Treasury’s and Bank of England’s forecasts. Growth is likely to improve only modestly to 2.2% or so in 2006, as house prices continue to fall.

Analysis: UK inflation

Cost pressures still strong…

Despite a build-up of cost pressures in the UK economy, slowing activity and intense competition are likely to limit any further rise in consumer price inflation over the next year or two.

Having crept higher in the second half of last year, UK inflation stabilised in the early months of 2005. CPI inflation has held comfortably below its 2% target, while RPIX has remained below its old 2.5% target.

What’s more, stripping out the upward effects of recent increases in gas and electricity bills and petrol prices, underlying (excluding energy) inflation has remained even lower.

Nonetheless, there are still fears that inflation could yet rise more significantly as the economy approaches full capacity and the sharp rises in costs seen over the last year or two feed through into the high street.

Rates of domestic producer input and output price inflation have remained at high levels, with the former climbing to its highest rate since 1995 in response to the latest rise in oil prices.

Meanwhile, import price inflation has also picked up in recent months and looks set to rise further if our expectation of a fall in the pound over the coming months proves correct.

Finally, average earnings growth has remained close to the 4.5% level that the Monetary Policy Committee has previously identified as the maximum consistent with the inflation target on a sustainable basis. (See Analysis: UK Labour Market)

But there are a number of reasons why any further rise in CPI inflation is likely to be modest. First, pressures on capacity look likely to ease somewhat later this year as economic growth slows below its trend rate. (See Analysis: Output & Activity.) In any case, the historical relationship between inflation and the amount of spare capacity in the economy, as indicted by the output gap, has been far from close or certain.

Second, the worst of the upward pressure on producers’ raw material costs may now be over. Provided that oil prices do not continue to rise from current levels, their upward effect on input price inflation should begin to fade over the coming months.

Third, as far as wage pressures are concerned, the pick-up in average earnings growth has been accompanied by a significant acceleration in the growth of productivity over the last year or so.

… but strong competition to limit cost pass-through

It is not yet clear whether this productivity pick-up is purely a cyclical reflection of the recent strength of GDP growth or a more fundamental improvement which will be sustained.

Nonetheless, for now at least, the effect has been to keep a tight lid on the growth of unit wage costs, suggesting that the inflation pressures emanating from the labour market are rather weaker than the earnings figures alone might suggest.

Finally, even if cost pressures continue to mount, we suspect that the very intense competitive conditions still evident in the high street will force retailers to absorb most of the increase in their margins.

The previously close relationship between producer output price inflation and, after a lag, the core goods element of the retail prices index has broken down dramatically over the last year or two, with goods prices continuing to fall at an ever faster pace despite the rise in costs. In other words, there are still no signs at all that the cost increases of recent years are yet working their way into the high street.

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

However, other areas such as household goods and furniure have also seen prices falling at a faster rate in recent months. This might reflect a weakening of demand for such items as the housing market begins to soften. If this is the case, these pressures look likely to intensify as the housing market and associated areas of household spending continue to slow.

While we expect these forces to keep a lid on goods inflation, inflation in the services sector has remained rather more stubborn . In addition to the recent increases in utility prices, this has mainly reflected strong price rises in administered areas like transport, as well as in education and restaurants & hotels.

Nonetheless, while CPI inflation may creep up a bit further over the coming months as energy prices keep rising and goods inflation perhaps edges a touch higher, 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. And with the influence of house prices likely to turn negative later this year and next, RPIX could fall below CPI inflation.

Our forecasts are some way below the profile published by the MPC in its February Inflation Report. Accordingly, we continue to 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

Resurgence in activity unlikely to last

Labour market activity remains resilient, prompting concerns that the recent pick-up in wage growth has further to go. But activity is unlikely to strengthen much further in the face of weakening economic growth, suggesting that wage inflation will remain contained.

Claimant count unemployment has reverted to its downward trend since the end of 2004 after a brief pause towards the end of last year. But the ILO measure has recently risen again. But this could be because the recent strength of the economy has encouraged more people to look for work without registering for benefits – thus moving from inactivity to unemployment, under the ILO terminology.

Employment growth has picked up pace sharply, with the robust rise in the Workforce Jobs measure in 2004 Q4 confirming the increases already seen in the more timely Labour Force Survey measure.

However, growth continues to be driven by the public sector. Moreover, the rises in employment have been largely matched by rises in the workforce. This suggests the pool of labour is larger than the unemployment figures alone imply, reducing the danger that higher employment will prompt a pick-up in wage inflation. Adding the number of inactive workers wanting a job to the unemployed more than doubles the amount of available labour.

Underlying average earnings growth excluding bonuses has continued to rise, and could accelerate further if pay settlements keep rising in response to last year’s rise in RPI inflation, the basis for most pay bargains.

Equity markets have sustained last year’s recovery, pointing to relatively strong bonuses during the start-of-year bonus period. Even so, growth including bonuses has remained below 4.5%, which the MPC considers the maximum consistent with stable inflation.

What’s more, the structural factors which have helped contain wage inflation over the last few years should remain in place, including the anchoring of inflation expectations and higher immigration, which has helped to ease labour shortages. The Home Office estimates that 80,000 people from abroad have registered to work in the UK since EU accession in May ‘04.

As such, we expect earnings growth to accelerate from 4.4% last year to just 4.6% in 2005, before dropping to 4.2% in 2006. We also expect further strong private sector productivity growth – which reached 2.8% y/y in Q4, leaving unit labour costs growth at 1.5% y/y, a jump from Q3, but still lower than for most of the last four years. At least part of this rise seems structural; productivity growth has usually already slowed sharply by this stage of the economic cycle, as firms hoard labour as output growth slows.

Overall, we expect the unemployment rate to rise modestly from 2.7% to 3.0% by 2006. But there is a risk of a bigger rise, given that recent employment gains have been concentrated in the housing and consumer sectors, where we expect activity to slow sharply.

Analysis: UK monetary policy

Interest rates will be falling by the end of the year

The near-term interest rate outlook is finely balanced, with a clear possibility that the next move could be upwards. However, even if this is the case, we still think that rates will be on a downward path by the end of the year.

A general strengthening of the economic data prompted a marked turnaround in market interest rate expectations. Whereas at the start of the year the markets were expecting the next move in interest rates to be down, they are now discounting a rise.

This movement was compounded by the Monetary Policy Committee, which became more hawkish. At February’s meeting, Paul Tucker was the first member to deviate from the majority for nine months, and vote for higher rates since they were last raised in August 2004. What’s more, he was joined by Sir Andrew Large at March’s meeting.

However, we think that the Committee has become too hawkish given the continued weakness of the housing market and consumer related data. Indeed, the Committee itself identified this as a key downside risk in February’s Inflation Report.

Although there is some evidence that downward pre s s u re on house prices eased at the beginning of the year, mortgage approvals are still falling and are consistent with house price inflation of close to zero in around six months’ time.

Furthermore, it appears that the weaker housing market – and/or expectations of a further weakening – is prompting consumers to tighten their belts. Underlying retail sales (excluding food) fell by 1.7% in the three months to February – the weakest performance since March 1992.

Some Committee members may be concerned that rates should be higher at this stage in the economic cycle. And although it is possible this may led to a rate hike, we believe that the next move in interest rates could still be down, as it becomes clear that the recent consumer slowdown is not just temporary.

Although lower interest rates would put downward pressure on sterling, the subsequent upward impact on inflation will not be enough to stop rates falling altogether.

Admittedly, our year-end forecast of 4% interest rates looks testing, but a sharp housing market adjustment could see rates drop all the way to 3.5% by the end of next year.

And even if interest rates were to rise in the next few months, this would only further undermine the housing market and consumer confidence, possibly resulting in even sharper falls in interest rates.

Either way, then, there is plenty of scope for market interest rate expectations and bond yields to reverse their recent rises and to trend downwards over the next couple of years.

Analysis: UK public finances

Post-election tax hikes still in store

Having acted as an important support for the economy over the last few years, the public finances are set to become a drag on growth as taxes rise after the general election.

The most recent news on the public finances has brought little sign of the improvement in the fiscal position predicted by Mr Brown in his March Budget. Admittedly, public sector net borrowing has continued to follow a very similar path to that seen last year, leaving it in line with Mr Brown’s full-year forecast.

But the picture continues to be flattered by the unanticipated weakness of public sector net investment. Excluding this, current borrowing is set to overshoot last year’s Budget forecast by up to £5bn.

The result is that the already wafer-thin margin built into the Golden Rule has narrowed even further, to just £6bn. Given that the Treasury’s average error in predicting borrowing one year ahead is £10bn, there is a clear danger that the Rule will be broken in the current cycle (expected to end in late 2005).

Regardless of this, the big picture is one of a major deterioration in the fiscal position over the last five years. And the Chancellor’s forecasts imply very little improvement over the next few years, with public sector net borrowing (PSNB) expected still to total £24bn in 2008-09.

What’s more, even these forecasts rely on two optimistic assumptions. First, that the economy continues to grow at a robust pace over the next year or two. Should our own weaker GDP growth forecasts prove correct, borrowing could be £10bn a year higher than Mr Brown expects by 2007-08.

And second, that the public finances respond very favourably to the strength of the economy, with the ratio of tax receipts to GDP rising sharply over the next few years without further increases in tax rates.

Even if Mr Brown’s optimism is borne out and borrowing follows the path he has predicted, we suspect that he will want to take action to put borrowing on a more decisive downward trend in the early years of this parliament. After all, Mr Brown raised taxes by around £8bn p.a. after each of the last two elections, even though the public finances were in rather better shape then they are now.

The upshot is that we continue to expect tax increases of the order of £10bn p.a. the bulk of which will probably come in the 2006 Budget. This should mean that, having had a positive influence on GDP growth in recent years, the public finances are likely to act as drag on the economy in the foreseeable future.

With public borrowing set to remain high and a heavy schedule of redemptions ahead, over the next few years annual gilt issuance looks set to remain close to this year’s total of some £53bn.

Analysis: UK external trade

Export recovery may run out of steam

Hopes that the external position will eventually start to benefit from the strength of the global economy remain, even though there has been little impact so far.

In the second half of last year the trade in goods deficit widened to £30.3bn from £27.7bn in the first half. What’s more, even the usually robust trade in services surplus eased from £9.9bn to £9.2bn.

But this latest deterioration was not as bad as it looked since the headline figures hid quite a reasonable rebound in exports. In volume terms, the three-month annual growth rate of goods exports rose from -4.5% in March of last year to +6.5% in January 2005.

There is a danger, though, that this export recovery will soon run out of steam. To start with, the possibility of higher domestic interest rates will support the strong sterling exchange rate in the near-term and continue to leave UK exporters uncompetitive in world markets.

And more importantly, global economic growth is probably past its peak. Indeed, Our world GDP growth forecast – when weighted by countries’ importance to UK exports (the US and euro-zone alone absorb 66% of all UK exports) – points to quite a slowdown in UK export growth.

Although we don’t expect export growth to peter out altogether, survey measures of export orders have already started to moderate.

But any slowdown in export growth is likely to be more than offset by a moderation in import growth, as the domestic consumer slowdown gathers pace.

Moreover, if sterling weakens later in the year – as domestic interest rates start to fall – after the initial upward impact on the cash value of imports, rising import price inflation sometime next year should ease import growth further.

Accordingly, we expect the trade in goods and services deficit to narrow from just under £40bn last year to around £37bn this year and £30bn in 2006. However, net trade is still likely to be a drag on net trade this year, and to add only 0.3% to annual GDP growth next year.

As far as the other elements of the current account are concerned, the investment income surplus doubled from £4.0bn in Q3 of last year to £8.2bn in Q4 – a record high. But this is unlikely to be sustainable, not least because a fall in the oil price from current highs is likely to hit oil companies’ profits and result in a drop in repatriation to the UK.

And with the current transfers balance unlikely to do anything out of the ordinary, the overall current account deficit is likely to narrow marginally from £26bn 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 - Second Quarter 2005 (continued) -Analysis

Login to Mondaq.com

Why Register with Mondaq

Your Organisation