Data confirm UK Q1 GDP growth slowed to 0.4% q/q, outlook uncertain ahead of EU membership referendum

A second estimate from the Office for National Statistics (ONS) has confirmed that UK GDP growth slowed to 0.4% quarter on quarter (q/q) in the first quarter of 2016 from 0.6% q/q in the fourth quarter of 2015. The first-quarter 2016 slowdown was likely to have been influenced by heightened domestic and global economic uncertainties, most notably an increasing focus on the June referendum on UK membership of the European Union. In fact, first-quarter 2016 GDP expansion of 0.4% q/q was the equal weakest performance (with the third quarter of 2015) since the fourth quarter of 2012. Growth had been in a range of 0.4–0.6% q/q throughout 2015, when GDP growth slowed to 2.3% overall from a nine-year high of 2.9% in 2014.

Year-on-year (y/y) GDP growth dipped to 2.0% in the first quarter of 2016, the lowest rate since the first quarter of 2013. It was down from 2.1% in the fourth quarter of 2015, 2.2% in the third quarter, 2.6% in the first quarter, and a peak of 3.0% in the second quarter of 2014.

Q1 growth dependent on services sector

Uncomfortably for hopes of balanced UK economic activity, GDP growth in the first quarter of 2016 was entirely dependent on the services sector. Construction output contracted markedly, while there was also a drop in industrial production as manufacturing output declined anew.

Output growth in the dominant services sector was decent in the first quarter of 2016, but nevertheless slowed to 0.6% q/q from 0.8% q/q in the fourth quarter of 2015; it was up 2.7% y/y. All services sectors saw q/q growth in the first quarter of 2016, led by distribution, hotels, and catering (up 1.1%) and transport and communication (up 0.7%). Growth in output in business services and finance slowed to 0.5% q/q from 0.7% q/q in the fourth quarter of 2015. Output in the government and other services sector rose 0.4% q/q.

Disappointingly, industrial production contracted by 0.4% q/q in the first quarter of 2016, as it had done in the fourth quarter of 2015, and was up just 0.1% y/y. Industrial production suffered in the first quarter of 2016 as manufacturing output contracted anew (by 0.4% q/q) after edging up 0.1% q/q in the fourth quarter of 2015 (which had been its only expansion during 2015). Manufacturing output has struggled as it has been held back in particular by weak foreign orders, which have been constrained by muted global growth and sterling's past strength. There was also a 2.3% q/q drop in mining and quarrying activity in the first quarter of 2016. However, utilities output rose 0.4% q/q.

Additionally, construction output fell 1.0% q/q and was down 1.8% y/y in the first quarter of 2016. This followed limited growth of 0.3% q/q in the fourth quarter of 2015 and contraction of 1.6% q/q in the third quarter. It should be borne in mind that there are still significant doubts about the accuracy of the construction data, and survey evidence still pointed to expanding activity in the first quarter even if it softened.

Negative net trade weighs down on Q1 growth

On the expenditure side of the UK economy, GDP growth in the first quarter was again limited by markedly negative trade, which knocked 0.4 percentage point off growth. This followed negative contributions of 0.3 percentage point in the fourth quarter of 2015 and 1.1 percentage points in the third quarter. This was in marked contrast to the second quarter of 2015 when net trade had added 1.7 percentage points to q/q growth (the best performance in four years). In fact, net trade was erratic throughout 2015, as there was a negative contribution of 1.2 percentage points in the first quarter.

Exports of goods and services disappointingly fell 0.3% q/q in the first quarter of 2016, having only edged up by 0.1% q/q in the fourth quarter of 2015 and dropped by 0.5% q/q in the third quarter. Consequently, the y/y increase in exports slowed to 2.1% in the first quarter of 2016 from 2.2% in the fourth quarter of 2015 and a peak of 6.9% in the second quarter. Muted global growth remains a constraint for UK exports, while it will take time for the overall weakening of the pound seen in the early months of 2016 to feed through to help exporters.

Meanwhile, imports of goods and services rose 0.8% q/q in the first quarter of 2016 following increases of 0.9% q/q in the fourth quarter of 2015 and 2.9% q/q in the third quarter. Even so, the y/y increase in imports slowed to 2.0% in the first quarter from 4.7% in the fourth quarter of 2015 and 6.7% in the third.

Consumer spending healthy in Q1, but business investment falls

Domestic demand rose 0.7% q/q in the first quarter of 2016, as it had done in the fourth quarter of 2015. However, y/y growth in domestic demand moderated to 1.7% in the first quarter from 2.5% in the previous quarter.

Household spending was again robust in the first quarter, expanding 0.7% q/q and 2.6% y/y. This followed expansion of 0.6–0.8% q/q throughout 2015. Economic fundamentals were still relatively favourable for consumers in the first quarter, although there was a marked narrowing of the positive gap between earnings growth and inflation from the peak levels seen in the third quarter of 2015, while employment growth slowed. Although the ONS reported that compensation of employees rose by a decent 0.7% q/q in the first quarter of 2016, the y/y growth rate was stable at 3.3%, which was down from 3.8% in the third quarter of 2015 and a peak of 4.3% in the second quarter.

Meanwhile, government spending rose 0.4% q/q and 2.1% y/y in the first quarter, which was similar to the 0.3% q/q and 2.1% y/y growth seen in the fourth quarter of 2015.

Disappointingly, business investment fell 0.5% q/q and was down 0.4% y/y in the first quarter of 2016. This was likely to have been significantly influenced by heightened caution ahead of June's referendum on EU membership. Business investment had previously fallen by 2.0% q/q in the fourth quarter of 2015 after healthy gains of 1.3% q/q in the third quarter, 0.7% q/q in the second quarter, and 2.9% q/q in the first quarter. The fourth-quarter 2015 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.

Despite the 0.5% q/q drop in business investment, total investment grew 0.5% q/q in the first quarter of 2016 and was up 1.1% y/y. This was helped by a 2.5% q/q increase in general government investment.

Finally, the inventories and statistical adjustment factor was essentially flat in the first quarter of 2016, having made a positive contribution of 0.4 percentage point to q/q GDP growth in the fourth quarter of 2015.

Outlook and implications

IHS suspects that GDP growth could be as low as 0.2% q/q in the second quarter, amid heightened uncertainty in the run-up to the 23 June referendum on EU membership. In particular, this is expected to weigh down on business investment, and it may well also limit consumers' willingness to spend on big-ticket items. Muted global growth will also hamper UK economic activity in the near term at least. Significantly, the purchasing managers reported overall services, manufacturing, and construction output growth at a 37-month low in April. However, the possibility that growth could prove to be more resilient has been lifted by decent April retail sales growth and an improved May Confederation of British Industry (CBI) industrial trends survey

On the assumption that the UK votes to stay in the EU, IHS expects economic growth to strengthen in the second half of 2016, helped by several supportive factors. Still low oil and commodity prices and a much more competitive pound should help UK growth, while the Bank of England is unlikely to raise interest rates until well into 2017. Consumers should benefit over the second half of 2016 from increases in employment, while purchasing power will be helped by still muted consumer price inflation (seen averaging 0.6% over 2016). Admittedly, earnings growth currently remains weak after relapsing from 2015 peak levels, but it should gradually pick up over the coming months thanks to a tighter labour market and April's introduction of the National Living Wage.

Meanwhile, companies are expected to undertake investment that was delayed in the run-up to the EU referendum, while they also may look to step up labour-saving investment, given a tighter labour market and the National Living Wage's introduction. Healthy margins (helped by low oil and commodity prices), decent profitability overall, companies' generally robust cash positions, low interest rates, and supportive lending conditions should also benefit business investment.

However, the upside for growth is likely to be limited by tighter fiscal policy and only a gradual pick-up in global growth from current muted levels. Consequently, we see UK GDP growth coming in at 1.8% overall in 2016. However, there is a very real risk that the economy may not bounce back that well in the second half of 2016 even if there is a vote to stay in the EU. There is the danger that caution among businesses and consumers could persist following a likely very weak second quarter. UK GDP growth is forecast to improve to 2.4% in 2017. A more settled domestic backdrop, improved global growth, higher employment, and still decent purchasing power should underpin economic activity. The Bank of England is likely to only edge up interest rates in 2017, although fiscal policy will continue to weigh down on growth.

Growth forecasts would be cut markedly should UK vote to leave EU

Were the UK to vote to leave the EU in June's referendum, we would revise down our GDP growth forecasts markedly for the second half of 2016 and for 2017. Indeed, our GDP growth forecast for 2016 would most likely be cut from 1.8% to 1.4% or less, while our 2017 GDP growth forecast could well be taken down from 2.4% to around 0.8%.

An appreciable hit to business confidence from a vote to leave the EU would be likely as a result of heightened uncertainty, leading to reduced investment and employment plans. 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 coming from market concerns. It is also very likely that the UK's financial market woes would be compounded by the credit rating agencies downgrading the UK's credit rating. The expected sharp fall in sterling would be highly likely to lead to a substantial rise in consumer price inflation, thereby eroding consumers' purchasing power. This would damage consumer spending alongside likely reduced employment plans and a negative impact on consumer confidence. Weakened public finances would limit the government's scope to respond with fiscal stimulus. However, a markedly weaker pound would be likely to boost UK exports.

The prospective hit to UK economic activity from a vote to leave the EU would most likely be compounded if it quickly became clear that negotiations over the UK's future relationship with the bloc 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 future relationship with the EU would be likely to increasingly dilute some of the concerns and uncertainties for the UK economy and limit the fall-out from a "leave" decision.