UK Economic Prospects October 2014 Peter Spencer

UK Economic Prospects

October 2014

Peter Spencer

Turning cautious… We’ve seen the benefits of a rebound in confidence following

the Euro crisis but now the worry list is lengthening The Scottish Referendum was not decisive and the panic

reaction in Westminster leaves a big constitutional mess This adds to the uncertainty over the outcome of the general

election, which is very hard to predict following the Clacton buy-election

The gap between the two main parties is greater than at any time since 1992, particularly on the key economic issues of fiscal retrenchment and the EU referendum.

Political stability is crucial for international investors, underpinning FDI and financing the current account deficit, which has opened up again this year, moving back to 5% of GDP

…’cause breaking up is hard to do

► As we saw in 2011 and 2015 with the €, these break-up risks are almost unfathomable and can paralyse investment

► We don’t expect paralysis this time, but investment will slow if firms begin to worry about existential risk again

► Mortgage lenders and borrowers have both become more cautious following the Mortgage Market Review and the prospective increase in interest rates

► While export growth is held back by the weakness of European markets and the weaker Euro

Remember how uncertainty about the banks and the € trashed business confidence…

40

45

50

55

60

65

70

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Source: Haver Analytics

% balance

UK: CBI uncertainty about demand

…and the consumer

-50

-40

-30

-20

-10

0

10

20

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014


GfK NOP Index

UK: Consumer confidence

Mortgage lenders and borrowers have become more cautious…

-40

-30

-20

-10

0

10

20

30

40

50

60

70

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

2012 2013 2014

UK: Secured household lending - past 3 mths% balance* tightening (-)/loosening (+) credit

Source : Bank of England Credit Conditions Survey

* supply loosening/demand rising (+) supply tightening/demand falling (-)

Still not worried? Take a look at the incoming threats on the global risk radar…

Should we still be worried by the global search for yield?

And about the tightening of US monetary policy?

Will the ongoing crisis in the ‘fragile 5’ EM’s undermine global growth?

How serious is the continued risk of a Chinese financial crisis?

Last but not least, is Europe headed for deflation?

Here we go again - compression in EM risk premia…

Monetary policy remains a major uncertainty… The low level of US and EZ interest rates compressed

yields and led to an under-pricing of risk similar to the one that led to the crunch

The Fed is nearly done tapering, prior to raising interest rates at some stage next year

But Janet Yellen has said this will be dictated by the US economy and labour market rather than global risk factors

This has given the EMs another headache, following last year’s ‘taper tantrum’

With another test to come in the form of the effect of higher US interest rates on the carry trades

Here we go again - compression in EM risk premia…

The Fed has done tapering, with the first rate hike expected in 2015H2…

0

1

2

3

4

5

6

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

US: Interest rates%

Source : EY ITEM Club

Federal Funds Rate

10-year government bond yields

Forecast

The Fed’s tightening adds to the currency problem in the EMs…

75

80

85

90

95

100

105

110

Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14

India

Indonesia

Brazil

Turkey

Emergers: Exchange rates vs. US$Index (Dec 31, 2012 = 100)

Source : Haver Analytics

Appreciation

…weakening the short-term growth outlook…

7.1

4.5

5.4

1.9

3.22.8

3.5

0.0 0.0

2.9

1.2

5.15.3

7.4

0

1

2

3

4

5

6

7

8

China India Indonesia Brazil S Africa Russia Turkey

Oct-13 Oct-14

Emerging markets: GDP growth in 2014% year


… but the EMs are in a much better place than in 1997…

World: share of disposable household income

Source: Oxford Economics.

…and long-term, the emerging market growth story is inescapable

Global risk radar…

US Monetary policy?

Will the crisis in the ‘fragile 5’ undermine global growth?

How serious is the risk of a Chinese financial crisis?

Will China suffer a banking crisis?

A crisis is not my central expectation China has over $3.6trn in reserves and government

debt is low. The government is focused on financial sector

reform. The authorities still have much greater control over

the economy than we have in the West.

However: High levels of corporate debt Excess supply of real estate. Serious questions over the ability of the Peoples’

Bank to control the growth in shadow banking. These risks may be related in ways we can’t see yet.

Forecast is for smooth rebalancing…but…

34

36

38

40

42

44

46

48

50

2003 2005 2007 2009 2011 2013 2015 2017 2019

China: Expenditure structure of GDP%


Investment

Private consumption

Forecast

…construction is still adding to the excess supply of real estate…

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2006 2008 2010 2012 2014

100

200

300

400

500

600


China: Excess supply in the real estate sectoryears of supply

Average 2006 - 2010

Average from 2011

Vacant floor space (rhs)

mn m²

Ratio of property under construction to sales (lhs)

…and could trigger a crisis

0

10

20

30

40

50

60

70

80

2011 2012 2013 2014

Existing

Newly constructed


China: Cities experiencing house price fallsout of 70 cities

Number of cities experiencing m/m declines in residential house prices

Trade with PRC is not a serious problem for the UK…

0 20 40 60 80 100

IndiaEurozone

RussiaUKUS

ThailandJapan

MalaysiaIndonesiaSingaporePhilippines

TaiwanBrazilKorea

Australia

China share in export growth2009-13

China share in exports, 2013

World: Trade exposure to China

Source : Haver Analytics %

…and lower commodity prices have a silver lining for the UK…

0

20

40

60

80

100

120

1992-2002 2002-2012 2012-2017 (f)

Gas

Oil

Steel

Coal

China: Commodity demand% share of additional global demand for commodity


... helping to subdue input costs…

65

70

75

80

85

90

95

100

105

110

115

70

75

80

85

90

95

100

105

110

115

120

125

1998 2000 2002 2004 2006 2008 2010 2012 2014


2010=100

Core producer input prices(RHS)

Import prices(LHS)

UK: Import and producer input prices2010=100

…and output prices

-15

-10

-5

0

5

10

15

20

25

30

35

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014


% yearUK: Headline producer prices

Output

Input

Global risk radar…

US Monetary policy?

Will the crisis in the ‘fragile 5’ undermine global growth?

How serious is the risk of a Chinese financial crisis?

Europe – headed for deflation?

There’s no silver lining for he UK in the clouds hanging over the Eurozone…

The € recovery has stalled in Q2, with the Ukraine having a surprisingly large effect on confidence…

But Mario Draghi has successfully devalued the €

This has fallen back from $1.43 to $ 1.26

This helps fight deflation by raising import costs

And boosting € zone exports

But at the expense of US and UK exporters!

Recovery stalls in Q2…

-8

-6

-4

-2

0

2

4

6

1999 2001 2003 2005 2007 2009 2011 2013


Eurozone: GDP% year

FranceSpain Germany

Italy

Ukraine has damaged sentiment…

0

2

4

6

8

10

12

14

16

18

Lat Est Fin Sla Aus Ger Ita SlRep

EZ Fra Net Bel Spa Gre Ire Por

Percent of total exports

Percent of GDP


Eurozone: Exports to Russia in 2013%

0

1

2

3

4

5

6

7

Aus Ita Fra Net Ger Bel Gre Spa Por

Percent of total foreign exposure

Percent of GDP


Eurozone: Banks' exposure to Russia%

Low inflation and the large output gap means deflation risk…

-5

-4

-3

-2

-1

0

1

2

3

4

5

2005 2007 2009 2011 2013 2015 2017

Eurozone: Output gap% of potential output


Forecast

But Draghi has successfully deflated the €, which helps stave off deflation and bodes well for European exporters…

98

99

100

101

102

103

104

105

106

Jan 13 Apr 13 Jul 13 Oct 13 Jan 14 Apr 14 Jul 14

1.25

1.27

1.29

1.31

1.33

1.35

1.37

1.39

1.41

1.43

1.45


Eurozone: Exchange ratesIndex - Q1 1999 = 100 $/€

$/€ (RHS )

Nominal effective exchange rate (LHS )

This points to steady but unspectacular growth

-3

-2

-1

0

1

2

3

4

5

6

2010 2011 2012 2013 2014 2015 2016

Eurozone: GDP% year


Germany

France

Italy

Spain

Forecast

..but with no support from fiscal policy

-0.5

0.0

0.5

1.0

1.5

2.0

2011 2012 2013 2014 2015 2016 2017 2018

Source : IMF

Eurozone: Fiscal stancePercentage point

Annual change in the structural budget deficit

Forecast

Global forecast summary

2.72.1

0.8 0.9

7.4

2.62.0

0.8 0.9

7.2

0

1

2

3

4

5

6

7

8

World US Eurozone Japan China

Baseline Risk-weighted

Global GDP forecasts - 2014% year


3.0 3.2

1.51.0

6.9

2.62.9

0.9 0.7

6.1

0

1

2

3

4

5

6

7

8

World US Eurozone Japan China

Baseline Risk-weighted

Global GDP forecasts - 2015% year


Global risk roundup

The US monetary policy tightening has been problematic for EMs

But Asia is less risky than in 1997 and the long run growth story is inescapable

The stronger US economy and dollar now helps the Eurozone And of course UK exporters

.

The latest UK data show a much stronger recovery…

This month’s ONS data revisions give a very different perspective on the shape of the recession – and recovery

GDP has been revised up, meaning that we passed the previous peak a year ago and output is well above the 2008 peak

This is more consistent with the strong growth in employment, although productivity has still fallen

The upward revision in investment has been particularly pronounced, meaning the need to catch up for the low levels of the recession is less than previously thought

…and put the UK in an expansion phase

They give a very different picture for investment…

70

75

80

85

90

95

100

105

110

2006 2007 2008 2009 2010 2011 2012 2013 2014

UK: Business investment revisionsRebased, Q1 2008 = 100


New

Old

..but show much smaller revisions for consumption

93

94

95

96

97

98

99

100

101

2006 2007 2008 2009 2010 2011 2012 2013 2014

UK: Consumer spending revisionsRebased, Q1 2008 = 100


New

Old

But where is next year’s growth coming from?

The labour market remains strong and flexible and we expect consumer incomes to be buoyed up by rising employment

Employment growth should slow but wages should pick up a bit as unemployment falls and the labour market tightens

Financial conditions favour investment and firms are still catching up with the effect of the recession on the capital stock

We expect GDP to growth to ease back to 2.4% next year after 3.1% this year, with interest rates on hold until next spring

Consumption is constrained by weak wages and the need to save…

The recovery in real incomes and consumption has been founded on employment rather than wage growth

This has been reinforced an improvement in job security and consumer confidence, encouraging people to reduce rates of precautionary saving and to go out and spend

However, savings ratio has now fallen back to around 6%, just about consistent with a stable debt to income ratio of around 1.4

Pension pressures and the prospect of higher interest rates likely next year should stop the saving ratio from falling further

And the FPC will also be keen to prevent rising debt ratios Meaning that the growth in consumption must move back

towards the growth in household disposable incomes

The FPC will be watching these ratios…

4

5

6

7

8

9

10

11

12

2002 2004 2006 2008 2010 2012 2014 2016 2018

UK: Savings ratio% of disposable income


Forecast

…and especially this one this one…

110

120

130

140

150

160

170

2002 2004 2006 2008 2010 2012 2014 2016 2018

UK: Household debt-to-income ratio% of household disposable income


Forecast

…very closely

20

40

60

80

100

120

140

160

180

200

1990 1993 1996 1999 2002 2005 2008 2011 2014 2017

Source: Oxford Economics

Forecast

1995=100

Mortgage interest payments/income

Houseprices/incomes

UK: Housing ratios

This is where the growth is coming from…

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

1997-2007

2012 2013 2014 2015 2016 2017 2018

Consumer spending Investment

Govt. consumption Inventories

Net trade

UK: Contributions to GDP growth%pts


ITEM Club UK Autumn forecast 2014

The EY ITEM Club forecast for the UK economy, Autumn 2014

% changes on previous year except borrowing, current account and interest & exchange rates

GDPDomestic Demand

Consumer spending

Fixed investmen

t Exports Imports2012 0.7 1.4 1.1 0.7 0.7 3.12013 1.7 1.9 1.6 3.2 0.5 0.52014 3.1 3.1 2.1 9.3 -0.3 -0.42015 2.4 2.8 2.3 7.5 5.1 5.42016 2.3 2.5 2.2 7.8 5.2 5.52017 2.5 2.3 2.0 7.3 5.1 4.22018 2.5 2.1 1.8 6.2 5.1 3.7

Net Govt Borrowing

(*)

Current account

(% of GDP)

Average earnings CPI Bank Rate

Effective exchange

rate2012 7.2 -3.7 2.4 2.8 0.5 83.02013 5.6 -4.2 1.4 2.6 0.5 81.52014 5 -4.6 1.1 1.6 0.5 87.22015 3.9 -3 2.1 1.3 1.1 87.42016 2.4 -2 2.8 1.5 2.1 86.42017 1.0 -1.6 3.3 2.0 3.1 85.52018 0.1 -1.2 3.8 2.2 3.5 84.7

Summary

Uncertainty is now likely to slow UK investment The weakness of wages constrains the consumer, but employment

growth remains strong The export outlook remains poor, particularly in Europe, given the fall in

the €. But falling commodity prices should give the advanced economies a significant boost, especially large oil importers like the Eurozone and Japan.

In the UK, they have sharply reversed the inflationary pressures of recent years, taking CPI inflation down to 1.2%

I expect GDP to grow by 3.1% this year and 2.4% in 2015, with interest rates on hold until next spring at the earliest, depending on how these risks play out

Documents

UK Economic Prospects October 2014 Peter Spencer