EY ITEM Club Summer forecast

Economic forecast in detail

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GDP growth has not only picked up…

With growth continuing to accelerate and the risks associated with inflation and excessive credit growth appearing to be at bay, the foundations of the UK’s gathering economic recovery are looking increasingly secure. We expect GDP growth of 3.1% this year rising to 2.5% in 2015, with a reasonable chance of even stronger increases as activity gathers pace. With survey data showing that consumers are regaining their confidence in the economy, and businesses voicing rising certainty over demand, the UK looks set fair for steady growth for the foreseeable future.

…but is becoming better balanced

The rosy economic scenario is completed by the fact that the long-awaited rebalancing of the UK economy – away from its historical over-reliance on the consumer, and towards business investment and ultimately exports – is now clearly under way. With the capital and banking markets supporting investment by companies in pursuit of growth, and business confidence having returned, business investment is rebounding at a pace that has caught many by surprise, up by 10.6% year-on-year. Our forecast sees it growing by 12.5% this year followed by 9.7% in 2015. While exports have yet to come to the party, we expect this to start happening from next year.

The UK labour market delivers on all counts

If economists were ever to devise a scenario to demonstrate the benefits of the UK’s flexible labour market, then we’re seeing it in action today. Employment is up by 2.7% on the year, with household incomes being boosted by the growth in employment rather than the UK’s customary drivers of wage inflation and borrowing. Average earnings are up by just 0.9% on the year. And this low wage inflation is helping to rebalance the economy by limiting consumption growth, while also supporting investment and exports by restraining interest and exchange rates. True, growth in average earnings will tick back up above 2% next year. But for now, the labour market is putting the economy in a sweet spot.

Companies are putting their cash piles to good use

The capital intensity of UK plc is very low by international standards, and industrial capital stocks fell back during the recession as companies drew in their horns and hoarded cash. With growth in demand back on the agenda, the rebound in business in investment has kicked in. But even so, business investment is still 12.5% below its historical peak, and housing investment – despite increasing by 13.2% in the year to the first quarter – over 25% below peak. So companies and households have a lot of catching up to do, and business investment needs to accelerate to keep up with output. Going forward, this all points to the growth in these measures being sustained.

The rise in interest rates: later, not sooner

The markets are expecting a base rate rise by the end of this year, following the Governor’s recent warning. However, the outlook for interest rates remains uncertain, with low inflation, the strong pound, and the risk of deflation in the Eurozone pointing to a decision to keep them unchanged. Also, uncertainty about interest rates will tend to make households and companies hold back from borrowing to finance large expenditures. Assuming that wage rises remain subdued, all these factors should help to keep interest rates on hold until the first quarter of 2015.

Exports: services’ star is rising again

While the UK’s domestic market is very buoyant, export growth – a key part of economic rebalancing – remains elusive, held back by the continued weakness of European markets. However, compared to our underperforming exports of goods, the UK’s service exports are much more diverse internationally, and are set to recover from their crisis-induced dip to return as the UK’s star export performer on the international stage. Our forecast sees the trade surplus on services increasing from £60 billion in 2012 to £113 billion in 2018, equivalent to some 6% of GDP.