The U.K. Economy is Slowing on Real Pay Squeeze and Brexit Uncertainty

S&P Global Ratings
Written By: Boris Glass and Jean-Michel Six
S&P Global Ratings
Written By: Boris Glass and Jean-Michel Six

A little more than a year since the Brexit referendum, the U.K. economy is still holding up much better than many previously predicted. But growth has now started to slow, and is set to remain on a moderate trajectory as imported inflation squeezes household budgets and uncertainty about the outcome of the EU exit negotiations dampens investment. The boost to net exports from sterling depreciation will be insufficient to offset the weakness in domestic demand. We forecast GDP growth of 1.4% this year, 0.9% next year, and 1.4% a year on average in 2019-2020. This forecast is subject to considerable risks, mostly on the downside, stemming mainly from Brexit uncertainties.

Overview

  • We expect that a decline in real wages this year, followed by moderate rises at best next year, will weigh on U.K. household spending growth.
  • A boost to net exports from the weaker pound is unlikely to to offset weakness in domestic demand.
  • We forecast GDP growth will slow to 1.4% this year and 0.9% in 2018. Brexit uncertainties pose downside risks to this forecast.
  • We expect the Bank of England's current ultra-accommodative stance to continue over the medium term, and no rate hike before mid-2019.

High Inflation Squeezes Household Spending Power

Strong GDP growth of 1.8% in 2016 was almost exclusively due to extraordinarily robust consumer spending, which expanded by 2.8% (see table 1). Reliance on consumers for growth will continue this year, as other sectors are unlikely to contribute much (see chart 1). Yet, as nominal pay growth remains moderate, high inflation at 2.9% in May has now started to squeeze household spending power. Household spending growth already slowed in Q1, to 0.3% compared to 0.7% just a quarter earlier. The real pay squeeze is set to weigh on consumption throughout the rest of the year and into next. Given its reliance on the consumer, we forecast GDP will also continue to grow at a more moderate pace.

Chart+-+Contribution+to+UK+GDP+Growth

The surge in consumer spending in 2016 was partly financed by unsecured consumer credit, which grew at double-digit rates, a trend that continued into this year. On aggregate, the household savings rate declined to 3.3% in Q4 2016, from 6.5% a year earlier (and 8% on average over 2010-2015). It fell further to 1.7% in Q1 this year, according to recent Office of National Statistics (ONS) data. The fact that even a continued sizable credit expansion could not prevent the slowdown in consumer spending illustrates the magnitude of the squeeze that weighs on consumer spending.

Support from consumer credit is unlikely to last at the current levels. In response to the recent expansion, the Bank of England (BoE) Financial Policy Committee has increased the countercyclical capital buffer it applies to U.K. lending institutions from 0% to 0.5%--a reversal of the easing measures introduced last July in response to the outcome of the Brexit referendum. It has also indicated that a further increase to 1% may follow later this year. This could mean that U.K. lenders may ultimately have to increase their capital buffers by £11 billion. While it is likely that less credit will be available to consumers, and possibly to businesses, the exact impact remains unclear. Moreover, the supply of unsecured consumer credit could be further dampened following the BoE Prudential Regulation Authority's publication of its investigation into underwriting standards earlier this month, which gives lenders until September to examine and justify their unsecured consumer lending practices.

However, some relief to the squeeze is likely in mid-2018, when we expect inflation to slow again after the impact of higher import and producer prices on inflation falls off, provided that sterling does not see another significant depreciation. Indeed, there are currently no new price pressures in the pipeline. Producer price inflation, which ultimately feeds into shop price inflation, already peaked in January at 20%, falling to 11.6% in May (see chart 2). We expect inflation to stay around the current level of 2.9% (on the non-harmonized measure) and to average 2.7% this year as a whole, before slowing to 2.3% next year.

Chart+-+Consumer+and+Producer+Price+Inflation

Pay Growth Will Stay Moderate, Despite Relative Labor Market Resilience

Some increase in wages to compensate for inflation should underpin pay growth from 2018. Overall, however, we expect nominal wage growth will remain relatively moderate, at a little above 2% this year, and only slightly higher in 2018. We see several reasons for this. First, we believe that Brexit uncertainties have weakened workers' bargaining position. Furthermore, despite a record-low unemployment rate, there is still some slack in the labor market beneath the surface, for example in the form of involuntary part-time jobs. Low productivity is also set to limit pay growth. Nevertheless, we expect the labor market in terms of job numbers will remain relatively resilient, as there is still some catch-up hiring in progress. This will mitigate the impact of the slowdown in growth on employment, in our view. Therefore, the real pay squeeze should not be exacerbated by falling employment.

Only A Moderate Boost From External Trade

It is not yet clear exactly to what extent exporters have benefitted from the much weaker exchange rate. The impact is obfuscated partly by lots of noise in recent trade data, not least caused by flows of non-monetary gold (in both directions). But what is clear from an analysis of trade deflators is that U.K. exporters, in particular of goods, have to some degree raised prices rather than increasing their export share or even tapping into new markets altogether. These increases, while discretionary in some cases, have likely been necessary in industries that rely heavily on imports of intermediate products that have now become much more expensive.

Even so, we still expect some strengthening of export performance, and forecast export growth at 3.0%-3.5% per year in 2017-2020. It nevertheless looks unlikely that, overall, the export boost could be strong enough to offset weakness in domestic demand. Imports are part of this story. Although weaker import volumes will contribute to boosting net trade, this contribution will be constrained by a lack of sufficient domestic alternatives that could enable substitution of now in theory cheaper domestic production for more expensive imports. Where deeper supply chain relationships are concerned, such as in the auto, aerospace, and defense sectors, such substitution might be impossible in the near term. Overall, we expect net exports to contribute only between 0.2 and 0.3 percentage points a year to growth on average over 2017-2020.

Business Investment In Wait-And-See Mode

Uncertain times are often opportunities for investors, and the new pre-Brexit reality is no exception. However, while certain industries might benefit, such as legal and other advisory, technology, and tourism (owing to the weaker exchange rate), it is difficult to see an upside for the economy as a whole--at least until relevant details emerge from the Brexit negotiations. In the meantime, businesses are working on their contingency plans and, on balance, are shelving rather than executing investment plans. As a result, we expect investment activity to remain relatively muted this year and next. We expect a moderate recovery to start in 2019, by which time the U.K. trade arrangement with the EU should be mostly fleshed out, if not negotiated in full.

Weak investment activity not only weighs on current growth via spending. It also slows future growth through its impact on capital accumulation, already sub-par in the past, and productivity, which has been extraordinarily weak since the crisis.

Now Is Still Not Yet The Time To Raise Interest Rates

Remarks by Mark Carney, BoE governor, at a European Central Bank (ECB) event in Portugal on June 28, about monetary policy decisions becoming more conventional were interpreted by markets as a signal that the bank could raise its policy rate as early as the end of this year. We believe markets overreacted. Indeed, Mr. Carney during his speech (see "Related Research") also repeated earlier MPC statements that the bank will tolerate temporarily higher-than-target inflation. He also reiterated the now familiar guidance that whether the bank raises rates, and at what pace, will depend on "the extent to which weaker consumption growth is offset by other components of demand …, whether wages … begin to firm, and … how the economy reacts to … the reality of Brexit negotiations".

Therefore, contrary to the market reaction, we do not see any material change in the BoE's stance. Moreover, we think it unlikely that, in the near term, investment and net trade will fill the growth gap that slowing consumption creates, or that pay growth accelerates substantially so that conditions for a hike would be met. We expect the current ultra-accommodative stance to continue over the medium term, and expect a first rate hike to occur only in mid-2019.

Forecast Assumptions And Risks

Our forecast is not driven by any specific assumption regarding the details of the exit deal that the U.K. strikes with the EU, given the early stages of the negotiations and high uncertainty surrounding the outcome. In particular, we have not made any assumptions about net immigration being cut to the "tens of thousands" as the ruling minority Conservative government has repeatedly pledged (although not necessarily immediately after leaving the EU). Had we made such an assumption, our forecast would likely be weaker in the outer years of the horizon, given the skills' needs of the U.K. economy (for example in the National Health Service and the construction sector) that can only be fully met by additional hiring from abroad.

However, we do assume there will be no cliff edge in 2019, a situation where the U.K. leaves the EU without any deal in place at all, resulting in trade being subject to World Trade Organization (WTO) rules, arguably the worst outcome in terms of trade arrangements. Instead, we assume that a largely orderly Brexit will be achieved, with a transitional deal in place after March 2019.

There are some upside risks to our forecast, for example if the U.K. were to obtain a trade deal that comes close to the current full access to the single market, or if it were to remain in the customs union. However, we consider the chances for this outcome rather slim. We see an EU exit, in which the U.K. leaves the single market and the customs union, as the most likely outcome. The June election, which saw the Conservative Party lose its absolute majority and form a government with the support of the Northern-Irish Democratic Unionist Party, is unlikely to change this outcome.

Overall, we believe the risks are heavily skewed to the downside. For example, the staging of the negotiations, with the "divorce" settlement being negotiated before any future relationship with the EU is addressed, means that should the separation negotiations stall, there would be less time left for negotiating the future trade relationship. This would risk a cliff edge. In general, should negotiations stall for an extended period, this could translate into a further significant depreciation of sterling and a consequent rise in inflation.

Whether the BoE raises interest rates in response or not, the impact on growth would be detrimental because both higher interest rates and untamed inflation would depress economic activity. But even if sterling does not depreciate much further from current levels, consumer and--in particular--business sentiment could suffer if negotiations stall. Businesses might then start activating their contingency plans, leading to sizable relocations of operations, workers, and consequently a fall in investment and consumer spending. In all these cases, our forecast would also be lower than we currently expect.

Table 1: U.K. Forecast Summary

  2015 2016 2017f 2018f 2019f 2020f
GCP Growth 2.2 1.8 1.4 0.9 1.3 1.5
Private consumption 2.5 2.8 1.6 0.5 1.0 1.4
Government consumption 1.3 0.8 1.1 0.6 0.4 0.9
Investment 3.4 0.5 0.7 0.6 2.3 3.4
Exports 6.1 1.8 3.1 3.6 3.4 3.2
Imports 5.5 2.8 3.0 2.1 2.2 2.3
CPI Inflation 0.1 0.6 2.7 2.3 1.8 1.9
Unemployment rate 5.4 4.9 4.7 5.0 5.2 5.2
Bank of England policy rate 0.50 0.40 0.25 0.25 0.34 0.81
Exchange rate $ to € 1.53 1.35 1.26 1.29 1.33 1.37

f--S&P Global Global Economics forecasts. Source: S&P Global Economics, ONS, Oxford Economics.