EY ITEM Club UK Autumn forecast

Tougher years ahead for UK economy as consumers' 'sugar rush' begins to fade.

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Forecast in summary

by Peter Spencer, Chief Economic Advisor, EY ITEM Club

The forecast shows GDP growing by 2.5% this year after 2.9% in 2014. We expect growth to slow to 2.4% next year and 2.3% in 2017, with CPI inflation remaining below target until 2018.

Export prospects remain poor and consumption will be restrained by the effect of rising inflation and a tightening fiscal policy next spring. Further progress will depend upon hard-won productivity gains rather than the easy gains from energy and other commodity price falls that are supporting demand this year. Businesses will have to chase overseas markets hard rather than relying on consumer-led domestic markets.

Exports to the emerging markets have been the one hot spot in the UK’s trade performance this decade but are now cooling off rapidly. Investors may have lost faith in the ability of the Chinese authorities to manage the rebalancing of the economy away from investment towards consumption, but household spending and consumer-led service industries have held up well in China. They provide excellent growth opportunities for UK firms, especially since they will need to grow even faster to offset the slowdown in manufacturing and investment.

The commodity markets, which are usually a good leading indicator of world output growth, have been in steep decline for two years now. However the recent price falls reflect the strength of supply as much as the weakness of demand and they boost demand in the key export markets of North America and Europe. UK exports to the US have been particularly strong following the harsh US winter.

The UK consumer is a major beneficiary of these weak price trends, as well as the recent pick-up in wage inflation. This decade has seen a strong increase in the supply of labour associated with immigration and late retirement, which has depressed real wages and arguably productivity. But we are now seeing a more normal recovery, characterised by an increase in the demand for labour, which boosts real wages and productivity.

Wage inflation is strong enough to support households but we think it is unlikely prove too strong for the MPC. The usual hotspots of manufacturing and mineral extraction have been restrained by the weakness of world demand and energy prices, leaving construction and services in the lead. Wages will be further boosted by the National Living Wage next April. Some of the sectoral and regional effects could be very significant but the macro effects are relatively small.

We expect employers to respond to the rise in wage costs by employing more capital to help meet new demand. They are in good financial shape to expand capacity in this way. Profitability and balance sheets of large PLC are strong and the availability of finance to SMEs from both bank and new non-bank lenders is improving. Providing that labour costs are restrained by rising productivity, we expect the MPC to keep base rates on hold until next autumn.

Business implications

by Mark Gregory, EY Chief Economist

The UK economy is rebalancing: is your business?

A domestic growth story...

It is encouraging that the EY ITEM Club Autumn forecast projects GDP growth of 2.5% for the UK for 2015 – a figure only slightly changed from the Summer forecast, despite the recent turmoil in the global economy. EY ITEM Club also expects steady – albeit slightly slowing – economic growth for the UK over the next few years, based primarily on rising domestic demand.

This largely domestic growth story reflects the continuing challenges in the global economy. China is at the epicentre of the problems, as the authorities there try to rebalance the economy from an investment and export-led model to a consumption-driven one. Although this plan and the related slowdown in headline GDP growth have been known for some time, it seems that developments over the summer caught the markets off guard. The combination of devaluation in the renminbi, sharp falls in the Chinese stock market and disappointing growth data has undermined the previous benign narrative for China’s economy.

The slowdown in China will have consequences for both commodity producers and goods exporters, with the greatest impacts falling on emerging markets. The pressure on these countries will be further intensified by the expected rise in interest rates in the US – a move that is likely to reduce capital flows to emerging markets.

...led by the consumer

With the Government reining in spending to reduce the deficit, it will be the consumer driving UK economic growth this year. The labour market remains strong and wage growth is increasing. With low inflation and no rise in interest rates as yet, consumer spending is continuing to rise. However, the UK consumer still faces headwinds: inflation will tick up as the oil price decline from about a year ago drops out of the calculation of the annual rate; and fiscal policy – notably the tax rises and welfare cuts announced in the Summer Budget – will start to affect incomes from next spring. The impact from these factors projected by EY ITEM Club is gradual but significant, with consumer spending growth decelerating from 3% a year currently to just under 2% over the next three years.

Time for UK businesses to step up…

While the consumer has led the UK recovery to date, recovering domestic demand has recently seen businesses start to increase capital investment. EY ITEM Club expects this trend to continue as the main conditions for investment – profitability, availability of funding and the cost of capital – all remain attractive. The introduction of the National Living Wage and accelerating wage growth in several sectors will further boost the relative attractiveness of capital investment compared to employing people. Already, the combination of increased business investment and higher real wages appears to be stimulating improvements in productivity. Maintaining this improvement will be key to the UK continuing to grow in line with the EY ITEM Club’s forecast.

…and take steps to adjust for the changing economy…

The UK economy is rebalancing – albeit not in the way the Government had planned. The hoped-for export-led growth has not materialised, and the UK’s current expansion remains largely domestic in nature. However, the economic situation continues to evolve – and EY ITEM Club expects rising business investment to continue to drive growth over the next few years. While the global economic outlook is challenging, many UK exporters will benefit from the ongoing recovery in developed markets such as the US and Western Europe.

It’s not just capital investment that is on the rise. M&A values are increasing in the UK, and were up by 44% year-on-year at the end of the third quarter. And let’s not forget that 2014 was a record year for Foreign Direct Investment into the UK. All these developments underline that the global and UK economies are changing. It is clear that some businesses have started to adjust their plans for this new environment. But, going forward, all UK businesses must take steps to benefit from the changing economy.

…by reviewing their geographic focus…

First, for businesses operating internationally, now is the time to review their geographic focus. While recent events in China have surprised the financial markets, corporates appear to have been more aware of the risks. In the year to September 2015, research by EY and Dealogic suggests that M&A volumes in North America and Western Europe are up over 30% – compared to about half this rate in China, and flat in the rest of the world. This is consistent with the findings from other EY research: both our European Attractiveness Report 2015 and our Global Capital Confidence Barometer have found that corporates are investing, but with a strong focus on rebalancing their portfolios back towards developed markets.

…and revisiting their investment plans

The second area to focus is investment plans. The UK has launched an effort to rebalance its domestic economy by devolving more economic decision-making to local bodies. The Northern Powerhouse is the flagship for this drive – but the nationwide momentum was underlined when the recent round of Growth funding attracted over 30 bids from regions across the UK. This advancing regionalisation represents a potentially dramatic change to the UK economy, and businesses should take full advantage of the opportunities it creates. Against this background, and with labour likely to become more expensive relative to capital going forward, businesses need to look again at their capital expenditure plans – and ensure they are optimising their mix of resources in the light of the changing economy.


EY - Mark Gregory

Mark Gregory

EY Chief Economist