UK Q4 GDP growth edges up to 0.5% q/q, reliant on services sector and consumers

A second estimate from the Office for National Statistics (ONS) confirms that UK GDP growth edged up to 0.5% quarter on quarter (q/q) in the fourth quarter of 2015 from 0.4% q/q in the third quarter. This followed growth of 0.6% q/q in the second quarter and 0.4% q/q in the first. Consequently, GDP growth was in a range of 0.4–0.6% q/q throughout 2015. In contrast, GDP growth was 0.6–0.8% q/q throughout 2014 and 0.6–0.9% q/q throughout 2013. Year-on-year (y/y) GDP growth moderated to 1.9% in the fourth quarter of 2015, which was the weakest annual rate of expansion since the first quarter of 2013. This was down from 2.1% in the third quarter of 2015, 2.4% in the second quarter, 2.8% in the fourth quarter of 2014, and a peak of 3.0% in the second quarter of 2014. Overall GDP growth came in at 2.2% in 2015, which was down from a nine-year high of 2.9% in 2014. Growth had also been 2.2% in 2013.

Q4 growth dependent on services sector

Uncomfortably for hopes of balanced UK economic activity, GDP growth in the fourth quarter of 2015 was entirely dependent on the services sector. Construction output contracted modestly, as did industrial production (with manufacturing output flat).

Output in the dominant services sector expanded at an increased rate of 0.7% q/q in the fourth quarter, which was up from expansion of 0.6% q/q in the third quarter, 0.5% q/q in the second quarter, and 0.3% q/q in the first quarter; it was up 2.2% y/y. Fourth-quarter service-sector growth was led by distribution, hotels, and catering (up 1.4% q/q and 4.6% y/y), while there was also healthy q/q expansion in the business, services, and finance sector (up 0.7% q/q and 1.8% y/y) and in the transportation and communications sector (up 0.9% q/q and 3.7% y/y). Output was up 0.2% q/q and 0.5% y/y in the government and other services sector.

However, industrial production dipped 0.5% q/q in the fourth quarter, which was the first contraction in 2015 and limited y/y growth to 0.6%. Industrial production had previously expanded by 0.1% q/q in the third quarter, 0.7% q/q in the second, and 0.4% q/q in the first. Manufacturing output stabilised q/q in the fourth quarter after contractions in both the third (down 0.4% q/q) and second (down 0.6% q/q) quarters, but it was still down 1.0% y/y. Meanwhile, mining and quarrying output fell back 2.3% q/q in the fourth quarter after marked growth in the third (up 2.2% q/q) and, especially, second (up 7.6% q/q) quarters. It was still up 8.7% y/y in the fourth quarter. Mining and quarrying output was helped in the third and second quarters by fewer maintenance shutdowns in the North Sea in 2015 and also most likely by tax breaks in the March 2015 budget. Also limiting industrial production in the fourth quarter, utilities output dipped 2.4% q/q and 1.3% y/y.

Additionally, construction output contracted 0.4% q/q in the fourth quarter and was up just 0.4% y/y. Construction output had previously contracted 1.7% q/q in the third quarter following expansion of 0.5% q/q in the second quarter and 2.1% q/q in the first quarter. It should be borne in mind that there are still significant doubts about the accuracy of the construction data, and survey evidence pointed to expanding activity in the fourth quarter even if it came well down from its peak levels.

Negative net trade weighs down on Q4 growth

On the expenditure side of the UK economy, GDP growth in the fourth quarter was again limited by markedly negative trade, which knocked 0.4 percentage point off growth. This followed a negative contribution of 1.0 percentage point in the third quarter. This was in marked contrast to the second quarter, when net trade had added 1.7 percentage point to q/q growth (the best performance in four years). In fact, net trade was erratic throughout 2015, as there had been a negative contribution of 1.2 percentage point in the first quarter.

Exports of goods and services fell 0.1% q/q in the fourth quarter, which limited the y/y increase to 2.1%. Exports had previously fallen back 0.5% q/q in the third quarter after a jump of 3.0% q/q in the second quarter. UK exports were hampered by sterling's strength, particularly against the euro. Meanwhile, imports of goods and services rose 1.2% q/q in the fourth quarter and were up 4.8% y/y. Imports had previously risen by 2.7% q/q in the third quarter after a relapse of 2.4% q/q in the second quarter.

Consumer spending healthy

Domestic demand rose 0.8% q/q in the fourth quarter and was up 2.7% y/y. Household spending was again robust in the fourth quarter, expanding 0.7% q/q following gains of 0.8% q/q in the third quarter, 0.9% q/q in the second quarter, and 0.8% q/q in the first quarter; consequently it was up 3.1% y/y in the fourth quarter. Although earnings growth relapsed in the fourth quarter from peak levels around July/August 2015, consumers continued to benefit from negligible inflation as well as high and rising employment. Significantly, the ONS reported that compensation of employees rose 0.7% q/q and 3.1% y/y in the fourth quarter.

In addition, government spending rose 0.5% q/q and 2.5% y/y in the fourth quarter, while there was a positive contribution of 0.2 percentage point from the inventories and statistical adjustment factor.

However, total investment edged down 0.1% q/q in the fourth quarter, as it had done in the third quarter following strong gains in both the second (1.6% q/q) and first (1.4% q/q) quarters. This caused y/y growth to moderate to 2.7% in the fourth quarter from a peak of 6.1% in the first quarter of 2015. Total investment was held back in the fourth quarter by business investment relapsing 2.1% q/q after healthy gains of 1.2% q/q in the third quarter, 0.9% q/q in the second quarter, and 2.4% q/q in the first. The fourth-quarter relapse in business investment was reportedly influenced by asset disposals in the transportation equipment sector, but it may well also have been influenced by increased uncertainty over the outlook. Compensating for the fourth-quarter decline in business investment, there was a notable increase in investment in private-sector dwellings (2.7% q/q). General government investment was up 1.5% q/q.

Finally, domestic demand in the fourth quarter was helped by an appreciable contribution of 0.7 percentage point from a change in inventories and the statistical adjustment. This was clearly a correction after a negative contribution of 2.2 percentage points in the third quarter.

Outlook and implications

IHS currently expects UK GDP growth to be 2.1% in 2016. The UK economy's expansion is currently being pressurised by heightened global growth concerns and financial market volatility, while there is mounting domestic uncertainty as the referendum on UK membership of the European Union looms on 23 June. Although opinion polls are currently tight, we still expect the UK to vote to stay in the EU. Nevertheless, economic activity (particularly business investment) may be dampened by uncertainty ahead of the referendum.

Positively for growth, ongoing low commodity and oil prices should keep UK inflation (0.3% in January) low, thereby supporting consumers' purchasing power along with record-high and rising employment. Admittedly, earnings growth has relapsed recently, but it should ultimately make renewed gains amid a tightening labour market. Muted oil and commodity prices will also help companies' margins, which should be supportive for business investment along with generally healthy company cash positions and relatively favourable credit conditions overall. A growing number of businesses are likely to need to invest to expand capacity given now-extended growth, while a tighter labour market and the introduction of the National Living Wage in April could increasingly encourage companies to invest in plant and equipment and in production processes to try to save labour.

Furthermore, the recent substantial weakening of sterling from an overall elevated level should help UK exporters, although they are likely to be hampered by muted global growth until later on in 2016. Meanwhile, monetary policy is likely to remain very accommodative for some considerable time to come. The Bank of England now looks unlikely to raise interest rates before 2017 and will then act only gradually, although fiscal policy is set to be tighter over the next three years.

IHS assumes that reduced uncertainty after a decision to stay in the EU, improved global growth, higher employment, and still decent purchasing power will underpin an improvement in UK GDP growth to 2.5% in 2017.

Growth forecasts for 2016 and 2017 will be slashed if UK votes to leave EU

Were the UK to vote to leave the EU in the 23 June referendum, we would revise down our GDP growth forecasts markedly for the second half of 2016 and for 2017. We believe that there would be several significant immediate and medium-term negative repercussions for the UK economy from a vote for an EU exit, regardless of whether or not the UK would be better off in the long run outside the bloc. In particular, we think that there would be a hit to business confidence and investment from heightened uncertainty and concerns, while employment plans could also be weakened. Additionally, we believe that heightened market concerns and uncertainties would cause sterling to fall sharply. Furthermore, foreign direct investment and portfolio investment flows into the UK would probably take a major hit, which would make financing the UK's large current-account deficit much more of a problem and reinforce the downward pressure on sterling. It is also very likely that the UK's financial market woes would be compounded by the credit rating agencies downgrading the UK's rating. A sharp fall in sterling would be likely to lead to a substantial rise in consumer price inflation, thereby eroding consumers' purchasing power. This would damage consumer spending along with likely reduced employment plans and some hit to consumer confidence.

The prospective negative effects on UK economic activity from a vote to leave the EU would most probably be compounded should it quickly become clear that negotiations with the EU over the UK exit were messy and antagonistic, particularly relating to new trade agreements and access to the European single market. Alternatively, constructive and meaningful progress on the UK's post-exit relationship with the EU would be likely to increasingly dilute some of the concerns and uncertainties for the UK economy and limit the fallout from a decision to leave the bloc.