Global Insight Perspective | |
Significance | GDP growth of 0.6% quarter-on-quarter in January-March was broadly in line with trend growth for a second successive quarter, as a significant pick-up in industrial production countered a moderation in service-sector activity. Details of the expenditure side of the economy in the first quarter have yet to be released, but it is likely that higher business investment helped to offset softer consumer spending. |
Implications | Year-on-year growth of 2.2% in the first quarter exactly matched the Bank of England's forecast in its February Inflation Report, reinforcing expectations that interest rates are set to remain unchanged for several more months to come. |
Outlook | Future growth still depends critically on developments in consumer spending, and we suspect that this will be relatively muted. We are also sceptical that business investment and exports will be able to substantially compensate for lacklustre consumer spending on an extended basis, thereby allowing the economy to significantly rebalance. Consequently, we believe that GDP growth will be limited to 2.2% in 2006. This underpins our belief that the Bank of England will ultimately trim interest rates by 25 basis points, although we do not expect any action until at least August. |
GDP Growth Stable in First Quarter of 2006
GDP grew by 0.6% quarter-on-quarter (q/q) in the first quarter of 2006, according to a 'flash' estimate from the Office for National Statistics (ONS). This matched the fourth-quarter 2005 performance, 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. The first-quarter growth performance was almost exactly in line with the 0.6% q/q and 2.3% y/y expansion forecast by Global Insight.
Recovering Industrial Production Counters Moderation in Services Expansion
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 was estimated to have risen by 0.7% 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 1% 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 0.5% q/q, following contraction of 1.1% q/q in the fourth quarter of 2005.
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 section being unchanged q/q and rising by just 1.5% y/y. In contrast, robust expansion was seen in business services and finance (up 0.9% q/q and 4% y/y), and transport, storage and communication (up 0.9% q/q and 3.4% y/y). 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 Probably Moderated
No breakdown was released of the expenditure side of GDP in the first quarter of 2006. Nevertheless, it seems likely that consumer spending lost some momentum, after improving in the latter months of 2005. Significantly, retail sales volumes fell by 0.7% q/q in the first quarter, having risen by 1.6% q/q in the fourth quarter of 2005. While it needs to be borne in mind that retail sales only account for some 35% of consumer spending, the breakdown of the services output data also pointed to softer personal expenditure.
This suspected slowdown in consumer spending was probably partly countered by a pick-up in business investment following its disappointing contraction in the fourth quarter of 2005. In addition, exports are also likely to have strengthened, helped by improved Eurozone growth, although imports also appear to have increased.
Outlook and Implications
We expect growth to be modestly below trend throughout much of 2006, as consumer spending is relatively lacklustre in the face of a weaker labour market, moderate earnings growth, the recently higher tax burden (added to by an average 4.5% increase in council tax in 2006), markedly higher utility bills, still-strong petrol (gasoline) prices, and elevated debt levels. Furthermore, an increasing number of people have concerns about their pension situation. The downside of personal expenditure should be limited by still relatively high employment, very attractive prices on the high street amid intense competition, and lower interest rates (the Bank of England cut its key interest rate by 25 basis points in August 2005, and we expect a further trimming to occur later this year, although not before August). Recently stronger housing-market turnover and firmer house prices, together with a pick-up in mortgage equity withdrawal in the fourth quarter of 2005, may also provide some support to consumer spending, although we do not expect house prices to see sustained, significant increases.
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 in the near term at least 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 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, 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 2006/07 towards improving public services. Nevertheless, the boost to growth from the public sector will gradually diminish. While the recent overall softer performance of the pound and healthier growth in the Eurozone should provide welcome support to U.K. exporters, 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 3.7% in 2006, but then to moderate to 3.1% in 2007. On top of this, we believe that the pound will make renewed gains against the U.S. dollar over the medium term, as the latter is pressurised by the huge U.S. current-account deficit, 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 2.2% in 2006 and 2.6% in 2007.