Eight months after the U.K. voted in an historic referendum to leave the EU, and just weeks away from the triggering of the formal Article 50 process to leave the bloc, U.K. financial conditions remain broadly favorable to growth, in our view. What has started to show up in the data, however, is that demand for funding from both businesses and households is softening. This supports our view that the U.K. economy is set to slow gradually over this year.
- In view of Brexit uncertainties ahead, the Bank of England will continue to "see through" inflation overshooting and keep rates low for long, despite a material upward revision to growth.
- Meanwhile, we are seeing weakening business demand for loans, and a cooling of the consumer spending spree that almost entirely drove GDP growth in 2016.
- We believe these are the first signs of the gradual slowing of GDP growth that we expect for 2017.
Monetary Policy Is Set To Remain Ultra-Accommodative
In July 2016, the month following the referendum, many sentiment and other survey indicators dipped substantially, pointing to a marked deterioration of the U.K. economy. In view of these and the Bank of England's own downward revision to GDP growth, in early August 2016 it implemented a set of measures to support the economy in an environment perceived by many as more adverse. Among others, the measures included a cut of the policy rate to 0.25% from 0.5% and an extension of quantitative easing to encompass the buying of corporate bonds, with the stated aim of pushing down corporate yields to make corporate funding cheaper, for the first time directly on the bond markets. In view of the data and expectations at the time, these policy measures were a strong signal of support to the markets, and we think they have underpinned the good performance of the U.K. since the referendum.
Now, at the beginning of 2017, with GDP growth for the referendum year coming in at a strong 1.8%, it almost seems like the referendum shock had never happened--were it not for a much weaker sterling that has so far hardly recovered from the initial depreciation after the referendum and currently still trades about 15% weaker against the U.S. dollar. The weaker sterling pushed up import prices, which is stoking inflation, directly and as producers gradually pass on costs via the production chain. With producer price inflation at 20.5% in January, inflationary pressure is still building, but is likely to have already pushed consumer price inflation over the 2% target by now, after reaching 1.8% in January.
As widely expected, the BoE's Monetary Policy Committee (MPC) in its February meeting decided once again to "see through" what it believes will be a temporary inflation overshoot and keep rates and its other easing measures unchanged. What was remarkable, however, was that it did this while presenting a materially improved outlook for GDP growth in 2017 (now expected at 2%, compared with its 1.4% outlook previously), and while leaving the inflation forecast virtually unchanged (as wage pressures should be contained due to more than earlier expected slack in the labor market). This less hawkish assessment confirms our view that much more needs to happen for the MPC to find a reason to start raising rates. As a consequence, the policy rate should stay low for a long time. We see this stance changing in the near term only if inflation were to gain much more pace than currently expected, if it accelerated, say, to above 5% (which we think might require another 7.5%-10% depreciation of sterling, all other things being equal).
Funding Demand From Business Softens
The BoE's Credit Conditions Survey (CCS) for the fourth quarter of 2016 suggests that credit availability has remained largely unchanged since 2014, following two phases of sustained improvement in the aftermath of the financial crisis. Moreover, at the beginning of 2017 the U.K.'s major banks remain well capitalized and, according to the BoE's recent stress test exercise, could broadly withstand severe stresses. They are lending, and they are ready to lend more. However, while corporate financing costs have continued to edge even lower, thanks to an ultra-accommodative monetary policy, demand appears to have started to slip somewhat following the Brexit referendum, according to the CCS. Indeed, loan applications declined in the third quarter of 2016 across all sizes of business, and remained at the new lower level in the fourth quarter. The decline was particularly marked for small and midsize enterprises (SMEs) in the second half of 2016. Weaker demand from SMEs is particularly worrying because they typically rely much more heavily on bank loans than larger businesses.
On a sectoral level, the survey also shows materially weaker demand from commercial real estate businesses. Incidentally, commercial real estate is the single most important sector to which banks seem to actually have cut credit availability, largely reflecting the sensitivity of prime commercial real estate in London (and especially The City) to uncertainty about the future EU status of financial institutions after Brexit.
It is worthwhile pointing out that actual data on businesses' total net external financing raised (see chart 1) does not paint as bleak a picture as the surveys. While the data show a clear decrease of flows in 2016 to a monthly average of £1.8 billion in fourth-quarter 2016, from £2.3 billion in the third quarter and £3.3 billion in the first half of 2016, the average for 2016 as a whole, at £2.7 billion, was still greater than that for 2015 at £2.1 billion. Moreover, looking at the broader trend, net external finance raised has so far remained close to post-crisis highs.
Similarly to net external funding data, broad money lending components show some, albeit not yet material, slowing of recent trends (see chart 2). Aggregate net lending growth started accelerating from the beginning of 2015, and reached its highest growth rate of 6.8% year on year in the referendum month of June 2016, before gradually softening to 5.3% in January 2017. That's still well above nominal GDP growth and consistent with the recovery phase of the credit cycle. It is important to note that the gap between nominal GDP growth and credit growth could narrow even more, in view of inflationary pressures as well as Brexit-related uncertainties ahead.
Inflation Squeeze Slows Household Spending Growth
A striking feature of lending in recent years is the strong increase in consumer credit, with year-on-year growth exceeding 10% since May 2016 (10.3% still in January). In our view, a good part of this is due to some loosening in underwriting standards and cheaper pricing amid greater competition, as lenders search for higher-margin business. This also applies to car dealership finance, which, according to the BoE, comprised around 30% of unsecured consumer lending last year. Another reason is that consumers may have brought some spending forward into 2016 in anticipation of higher inflation in 2017.
The annual growth numbers hide some interesting detail. Looking at the recent monthly flows, net consumer credit actually slowed recently--notably in December and January--where seasonally adjusted unsecured lending to households was, at £1 billion and £1.4 billion, significantly lower than the £1.6 billion average in the 11 months to November 2016. In our view, this is a sign that the consumer spending spree that almost entirely drove GDP growth in 2016 is likely to have started cooling. It is further supported by a decrease in retail sales volumes, with the January three-month rolling average declining for the first time since 2013. The chill over consumer spending also casts doubt on the BoE's recent upward revision of 2017 GDP growth, given that its forecast depends largely on slowing but still rather robust consumer spending growth, supported by favorable credit conditions. Sufficient, cheap credit might be available, but demand for credit may be softening as inflation starts to squeeze household budgets more than households can hope or afford to offset over longer periods by taking out more unsecured loans, especially given still relatively high household debt (in 2016 an average of 130% of disposable income).
Overall, we think credit supply conditions remain relatively favorable and are supporting the economy, in particular thanks to the BoE's continued very accommodative stance. However, these favorable conditions will not be able to completely offset the expected adverse impact of pronounced Brexit-related uncertainty and the inflation squeeze on household budgets in particular. U.K. demand for funding from both businesses and households has been softening somewhat at the beginning of this year, which we believe are the first signs of the gradual slowing of the economy that we expect for 2017.