Global Insight Perspective | |
Significance | GDP growth was modestly above, or in line with, trend growth for a fourth successive quarter. |
Implications | Resilient growth in the third quarter makes it even more likely that the Bank of England will raise interest rates by a further 25 basis points in November, given its concerns about inflation risks. |
Outlook | We expect growth to slow modestly over the coming months, resulting in overall GDP expansion of 2.6% in 2006 and 2.5% in 2007. |
GDP grew 0.7% quarter-on-quarter (q/q) in the third quarter of 2006, according to a preliminary estimate from the Office for National Statistics (ONS). The economy had also expanded by 0.7% q/q in the first quarter of 2006 and both the fourth and third quarters of 2005. Consequently, the third quarter of 2006 was the fourth successive quarter that the economy had grown modestly above, or in line with, trend growth (widely believed to be 0.6-0.7% q/q). Growth had previously been limited to 0.2-0.6% q/q in the second half of 2004 and the first three quarters of 2005. Meanwhile, year-on-year (y/y) growth improved to 2.8% in the third quarter of 2006. This was the highest level since the third quarter of 2004 and up from 2.6% in the second quarter of 2006, 2.3% in the first and a 12-year low of 1.6% in the second quarter of 2005.
Service Sector Leads the Way
On the output side, growth in the third quarter continued to benefit from robust service-sector activity. The service sector expanded by 0.8% q/q and 3.4% y/y, although this was modestly down from growth of 0.9% q/q and 3.7% y/y in the second quarter. Particularly robust expansion in the third quarter was seen in business services and finance (up 1.4% q/q and 5.2% y/y). However, growth in the distribution, hotels and catering sector slowed to 0.2% q/q and 3.2% y/y in the third quarter from 0.9% q/q and 3.5% y/y in the second, primarily due to slower activity in the retailing sector after a very robust second quarter. Output in the transport, storage and communications sector rose by 0.6% q/q and 2.6% y/y in the third quarter, while government and other services expanded 0.3% q/q and 1.6% y/y.
Manufacturing Sector Extends its Recovery
Industrial production increased 0.3% q/q and 0.4% y/y in the third quarter. It had previously stagnated in the second quarter, after healthy growth of 0.8% q/q in the first quarter. Overall industrial production was limited in the third quarter, as it had been in the second, by a sharp decline in mining and quarrying output (down 3.0% q/q and 6.6% y/y). These declines in mining and quarrying output were influenced by special factors, as well as by routine maintenance to oil rigs in the North Sea. However, energy supply industries' output rebounded to grow 0.8% q/q in the third quarter, having plunged 2.6% q/q in the second quarter. Even so, output was still down 2.5% y/y in the third quarter.
Particularly encouragingly, manufacturing output rose by a further 0.7% q/q in the third quarter, having expanded 0.7% q/q in the second quarter and 0.9% q/q in the first quarter. As a result, manufacturing output was up by 1.5% y/y in the third quarter, which was the best performance since the third quarter of 2004. Furthermore, it was the first time that manufacturing output had expanded for three successive quarters since 2003/04. Finally, construction output increased 0.5% q/q in the third quarter of 2006, following growth of 0.5% q/q in the second quarter and 0.8% q/q in the first. Construction output was up 1.7% y/y in the third quarter.
Consumer Spending Likely Moderated
Details of the expenditure side of GDP in the third quarter are yet to be released. However, it is clear that consumer spending moderated to some extent from the very rapid expansion of 0.9% q/q seen in the second quarter, given that retail sales rose by 0.8% q/q in the third quarter compared to 1.9% q/q expansion in the second quarter. Retail sales account for around 35% of total consumer spending. However, survey evidence indicates that business investment probably remained robust in the third quarter, after expanding strongly in the first half of 2006.
Outlook and Implications
Going forward, we suspect that consumer spending growth will be relatively muted, particularly compared to the robust levels seen during 1993-2004, as its upside is limited by a number of factors. These include moderate earnings growth, higher interest rates, a rising tax burden, markedly increased utility bills and elevated debt levels. Furthermore, unemployment is rising, while an increasing number of people have significant concerns about their pension situation.
The downside of personal expenditure should be limited by high employment and still relatively low interest rates. Although the Bank of England raised its key interest rate from 4.50% to 4.75% in August and a further 25-basis-point hike looks likely in November, we expect interest rates to then stay at 5.00% for an extended period. Furthermore, we expect prices to remain largely contained due to intense competition, despite the recent efforts of some companies and retailers to push up prices. Current healthy housing-market turnover and overall markedly firmer house prices, together with a recent overall pick-up in mortgage equity withdrawal, will also provide some support to consumer spending, although we do not expect house prices to see sustained significant increases.
Having picked up significantly in the first half, business investment should be relatively robust in the near term at least. Investment should be supported by relatively upbeat business confidence, increasing capacity constraints in some sectors, generally strong corporate balance sheets, healthy returns on capital and still relatively low interest rates. However, the upside for investment could be limited by company margins continuing to be significantly squeezed by high input prices and intense competition (particularly in the retailing and manufacturing sectors). In addition, several companies are facing large shortfalls in their pension schemes, which threaten to take an increasing toll on their capital. Finally, some companies have significant concerns about the longer-term economic outlook.
Further strong public investment and expenditure will support growth over the rest of 2006 and during 2007, as the government has already committed further significant spending in fiscal years 2006/07 and 2007/08 towards improving public services. Nevertheless, the boost to growth from the public sector will diminish markedly further ahead, as the government seeks to improve public finances.
Meanwhile, ongoing relatively robust growth in the Eurozone should provide further support to U.K. exports in the near term at least. However, we expect U.K. exports to lose significant momentum in 2007 because we suspect that Eurozone growth may falter to some extent. In addition, U.S. growth is projected to moderate significantly. Consequently, Global Insight forecasts global growth to slow markedly from 3.9% in 2006 to 3.3% in 2007. On top of this, the pound traded at a two-year high on its trade-weighted index in September, and we believe that it will trend up further against the U.S. dollar over the medium term. Nevertheless, we suspect that this will be countered by sterling easing back against the euro.
Consequently, we suspect that growth will be modestly softer overall during the final quarter of 2006 and throughout much of 2007. As a result, in our October monthly interim forecast, we projected U.K. GDP growth to improve from 1.9% in 2005 to 2.6% in 2006, but then to edge back to 2.5% in 2007. As third-quarter GDP growth of 0.7% q/q and 2.8% y/y was very close to our projection of 0.63% q/q and 2.7% y/y, we see no need to change this forecast.
Meanwhile, the resilience of GDP growth in the third quarter probably makes an interest-rate hike in November a done deal. Although annual GDP growth of 2.8% was modestly below the Bank of England's forecast of 3.13% in its August Inflation Report, the shortfall is insufficient to deter the central bank from raising rates to 5.00%, given the rise in both core consumer price inflation and the retail price deflator in September, survey evidence indicating that retailers and businesses are increasingly seeking to push through price hikes, surging money-supply growth and its concerns that that pay settlements could move markedly higher in the 2007 pay rounds.