U.K. GDP Growth Confirmed at 0.6% in Q1 2006

GDP Growth Stable in Q1 2006

GDP grew by 0.6% quarter-on-quarter (q/q) in the first quarter of 2006, according to the Office for National Statistics (ONS). This confirmed the ’flash’ estimate released in late April. The first-quarter 2006 growth rate therefore matched the 0.6% q/q expansion achieved in the fourth quarter of 2005, and was up from growth of 0.5% q/q in both the third and second quarters of 2005 and a mere 0.2% q/q in the first. Meanwhile, year-on-year (y/y) growth improved to 2.2% in the first quarter of 2006, which was the highest level since the fourth quarter of 2004 and up from the 12-year low of 1.6% seen in the second quarter of 2005.

Improved Industrial Output Offsets Moderation in Services Growth

On the output side, a significant pick-up in industrial production in the first quarter of 2006 countered a moderation in service-sector activity. Specifically, industrial production rose by 0.8% q/q during January–March, which was the best performance since the third quarter of 1999. Indeed, industrial production contracted throughout 2005, with the result that it was still 0.9% y/y lower in the first quarter of 2006. Industrial production was lifted by higher gas and oil extraction, as well as increased electricity and gas output. In addition, manufacturing production expanded by 0.7% q/q, following contraction of 1.1% q/q in the fourth quarter of 2005. However, manufacturing output was still down by 0.6% y/y.

However, service-sector expansion slowed to 0.6% q/q and 3% y/y in the first quarter of 2006, from 1% q/q and 3.1% y/y in the fourth quarter of 2005. Indeed, this was the weakest q/q performance since the fourth quarter of 2004. Service-sector activity was held back in the first quarter by output in the distribution, hotels, and catering sector rising by a very modest 0.4% q/q and 1.9% y/y. In contrast, robust expansion was seen in business services and finance (up 0.9% q/q and 3.9% y/y). Elsewhere, transport, storage, and communication output rose by 0.6% q/q and 3.1% y/y, and government and other services expanded by 0.5% q/q and 2.7% y/y. Meanwhile, construction output accelerated to 0.7% q/q and 1% y/y in the first quarter of 2006, from 0.2% q/q and 0.4% y/y in the fourth quarter of 2005.

Consumer Spending Muted

On the expenditure side, a very marked slowdown in consumer spending growth in the first quarter of 2006 was offset by a substantial pick-up in business investment and exports. Overall, domestic demand was up by 1% q/q and 2.6% y/y in the first quarter of 2006, partly lifted by a £882 million (US$1.65 billion) rise in the level of inventories (including an alignment adjustment). Despite the strong rise in exports though, net trade still reduced overall GDP growth by 0.4 percentage point in the first quarter as imports expanded even more rapidly.

Consumer spending moderated substantially in the first quarter of 2006 after picking up in the latter months of 2005. Indeed, consumer spending growth slowed to a mere 0.2% q/q in the first quarter of 2006 from 0.7% q/q in the fourth quarter of 2005. It was up by 1.7% y/y. Despite the fourth-quarter pick-up, consumer spending had expanded by a relatively modest 1.7% overall in 2005, which was the weakest performance for 10 years. While record high employment, a firmer housing market (which underpinned a rise in mortgage equity withdrawal in the fourth quarter of 2005), attractive prices on the high street amid intense competition and relatively low interest rates are supportive to consumer spending, it is still being pressurised by a number of factors.

These include moderate wage growth, a rising tax burden (added to by an average 4.5% increase in council tax in 2006), markedly higher utility bills, strong petrol (gasoline) prices, and elevated debt levels. Furthermore, unemployment is rising, while an increasing number of people have concerns about their pension situation. Households' real disposable income growth was relatively muted in both 2004 and 2005 as the tax burden increased. Specifically, it rose by 2.1% in 2005 and 2% in 2004, compared with 2.8% in 2003. Meanwhile, the savings ratio climbed to 5% in 2005, after sinking to 4.3% in 2004, the lowest level in more than 40 years, indicating that consumers were tightening their belts and seeking to rebuild their savings. The savings ratio actually climbed to 5.5% in the third quarter of 2005, from 3.9% in the fourth quarter of 2004, although it fell back to 4.8% in the fourth quarter of 2005.

Marked Improvement in Business Investment

The sharp slowdown in consumer spending was countered by a marked rebound in gross fixed capital formation after it had faltered in the fourth quarter of 2005. Specifically, total investment rose by 1.5% q/q in the first quarter of 2006, following contraction of 0.5% q/q in the final quarter of 2005. As a result, total investment was up by 3.7% y/y in the first quarter. This pick-up in gross fixed capital formation was primarily due to a recovery in business investment. Indeed, business investment rose by 1.7% q/q in the first quarter of 2006, after a drop of 0.9% q/q in the fourth quarter of 2004. This pushed the y/y increase in business investment up to 2.8% from 1.3%. Capital spending in the recovering manufacturers sector saw particular improvement (up 7% q/q and 12.4% y/y), while there was also a rebound in investment in construction and other production (up 18.1% q/q and 7.9% y/y). Less welcome, investment in the services sector eased back by 1.8% q/q and 0.1% y/y.

General government investment fell by 1.9% q/q in the first quarter of 2006. However, this followed very strong expansion of 3.4% q/q in the fourth quarter of 2005 and 15.4% q/q in the third quarter. Consequently, government investment was still 5.5% y/y higher in the first quarter of 2006. The government is still investing heavily at the moment as it strives to improve public services and education. Meanwhile, government consumption rose by 0.6% q/q and 4.6% y/y in the first quarter of 2006. This followed robust expansion of 1.2% q/q in the fourth quarter of 2005.

Exports and Imports Both Up Markedly

Exports of goods and services rose by a very healthy 4.7% q/q in the first quarter of 2006, thereby building on the improvement seen in the fourth quarter of 2005, when they rose by 2.2% q/q. Consequently, exports were up by 11.9% y/y in the first quarter of 2006. Clearly, improved Eurozone growth since mid-2005 and relatively healthy growth in the United States are supporting U.K. exports, while the pound has been reasonably competitive overall. Indeed, the pound fell to a two-year low on the Bank of England's trade-weighted index in early April, although it has since rebounded fairly markedly.

However, imports of goods and services were even stronger in the first quarter of 2006, growing by 5.5% q/q and 12% y/y. This was up from growth of 1% q/q and 4.8% y/y in the fourth quarter of 2005. Hence, net trade reduced overall GDP growth by 0.4 percentage point in the first quarter of 2006, having lifted overall growth by 0.3 percentage point in the fourth quarter of 2005.

Outlook and Implications

Latest indicators suggest that the economy started off the second quarter relatively well. Furthermore, growth may well receive a modest boost in the second quarter from sales related to the football World Cup. Nevertheless, we expect growth to be only in line with its trend rate – or even modestly below trend - throughout much of 2006.

Future growth still depends critically on developments in consumer spending, and we suspect that this will be relatively muted for some time to come as the dampening factors outlined above continue to have an impact.

Business investment should pick up to a limited extent in 2006 and 2007 after a relatively disappointing overall performance in 2005, although its ability to compensate for continuing relatively moderate consumer spending is likely to be limited by significant concerns and uncertainties among companies about the outlook, an expected further modest easing back in corporate profitability from the peak level seen in the second quarter of 2005, squeezed margins in many sectors (particularly manufacturing and retailing), and many companies' growing pension shortfalls. Even so, investment should be supported by generally robust corporate balance sheets, low financing costs, a largely healthy equity market (despite the recent correction), and the perceived need of many companies to upgrade or expand capacity after holding off from significant investment for an extended period. In addition, profitability should remain relatively healthy.

Further strong public investment and expenditure will support growth in the near term, as the government has already committed further significant spending in fiscal year (FY) 2006/07 towards improving public services. Nevertheless, the boost to growth from the public sector will gradually diminish. Meanwhile, healthier growth in the Eurozone and a relatively competitive pound should provide support to U.K. exports, although we suspect that the upside for Eurozone domestic demand will remain relatively limited over the coming months. Furthermore, we expect global growth to lose some momentum towards the end of 2006 and during 2007. Specifically, we forecast global growth to edge up from an estimated 3.6% in 2005 to 3.8% in 2006, but then to moderate to 3.3% in 2007. On top of this, we believe that the pound will trend up against the U.S. dollar over the medium term, as the dollar is pressurised by the huge U.S. current-account deficit and the eventual ending of the U.S. interest-rate tightening cycle by the Federal Reserve, although this should be countered by sterling easing back against the euro.

On balance, we expect GDP growth to improve relatively gradually, from 1.8% in 2005 to 2.4% in 2006 and 2.6% in 2007.