Winter forecast 2014-15

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Forecast in summary

by Peter Spencer, Chief Economic Adviser, EY ITEM Club

EY ITEM Club Winter 2014-14 forecast table
Figures are % changes on previous year except borrowing, current account and interest & exchange rates
Source: EY ITEM Club

The recent collapse in the global oil price is creating winners and losers worldwide – and the UK is decisively a winner. Cheaper energy will have large and wide-ranging effects on the UK economy, giving the consumer a major shot in the arm and driving inflation as measured by the Consumer Prices Index (CPI) down to an average of zero this year.

As a result we’ve revised up our forecast for UK GDP growth in 2015 to 2.9% from 2.4% in October, meaning we’re projecting acceleration from last year’s estimated growth of 2.6%, and growth is also revised up to 2.9% for next year.

Video: Peter Spencer, Chief Economic Adviser, EY ITEM Club, EY
Video: Peter Spencer, Chief Economic Adviser, EY ITEM Club

And with inflation averaging zero in 2015, this will effectively put any rise in base rates on hold until next Spring. This, together with stronger real income growth will also help to boost housing activity. It’s clear that what were silver linings in a generally cloudy outlook have turned to gold.

The negatives in this apparently glowing scenario are largely risks that might arise, rather than existing factors holding back the economy. The plunging oil price itself partly reflects a lack of demand in the global economy, and worries over the Eurozone are intensifying. Also, this year’s consumer-led growth will leave the UK economy even more unbalanced and dependent on domestic consumption – at a time when political uncertainty is mounting ahead of the general election and a possible EU referendum.

Forecast in detail

EY ITEM Club Winter 2014-15 - Contributions to GDP growth
UK: contributions to GDP growth
Source: EY ITEM Club

Cheaper oil turns the UK’s silver lining to gold

The collapse in the global oil price is likely to have large and wide-ranging effects on the economies of the UK and its major trading partners, with the consumer being a major beneficiary. In view of this, we have revised up our forecast of 2015 GDP growth to 2.9%, from 2.4% in October, and compared with a likely outturn of 2.6% for 2014. Inflation as measured by CPI is likely to average out to zero this year and remain below the 2% target until 2017.

EY ITEM Club Winter 2014-15 - CPI Inflation
UK: CPI inflation
Source: EY ITEM Club

Bringing renewed momentum to the recovery

This boost was particularly opportune since it came at a time when the economy was losing momentum. Business surveys remain firm but are not as strong as they were last summer. The housing market has also slowed, with mortgage and housing transactions and house price inflation well down on the high rates seen six months ago.

The big question: how far will energy prices fall?

Much now depends upon how low energy prices go – and for how long. This could be a flash in the pan like 2009, when prices fell briefly to $40 a barrel, but we believe that this fall will last longer. Saudi Arabia has regained control of the market, and will want to remind investors in alternatives that oil prices can go down as well as up – and stay down for a worryingly long time. However, we are not expecting another prolonged era of cheap energy like the late 1980s and 1990s, and we’re assuming that Brent will be back at US$75 a barrel by 2018.

EY ITEM Club Winter forecast 2014-15 - Real household income and spending
UK: Real household income and spending
Source: EY ITEM Club

The inflationary genie stays in its bottle…

CPI inflation will actually turn negative for a few months during the first half of 2015, before moving back up in the final quarter to average about zero per cent over the year as a whole. Unemployment will continue to fall, though more slowly than in the past two years. With wages already picking up on the back of the strong labour market we think that real household disposable incomes will increase by 3.7%, and consumption by 2.9%, this year. The saving ratio will move back up above 7%, keeping household debt/income ratios stable.

EY ITEM Club Winter forecast 2014-15 - Household demand for Credit
UK: Household demand for credit
Source: Bank of England Credit Conditions Survey

Pushing back higher interest rates to 2016

With low inflation boosting disposable incomes and spending, there’s an argument for looking through the low inflation numbers and raising interest rates as the recovery picks up steam again and the labour market strengthens further. However, it will be difficult for the MPC to raise base rates this year with inflation well below 1%, requiring a succession of letters of explanation from the Bank of England Governor to the Chancellor. So we do not expect an increase in base rates until the first quarter of 2016.

Housing transactions pick up as price rises moderate

The slowdown in the mortgage and housing markets last year was partly due to expectations of rising interest rates, which are now likely to be less of a worry. Real incomes are a major driver of the housing market and will provide renewed momentum this year, and scrapping the annuity requirement for defined contribution pension schemes could free up funds for retirees to invest in buy-to-let. We expect transactions to pick up again but house price inflation to remain close to 5%.

Clouds on the horizon

However, it’s not all good news. The global economy has slowed and prospects for the Eurozone appear to be going from bad to worse. The euro has fallen to an all-time low against the dollar, which will help combat deflation and stimulate Eurozone exports at the expense of UK producers. Investors face the uncertainty of the UK General Election, followed by the possibility of a referendum on UK membership of the EU. Overall, the prospects have brightened – but remain very risky.

Business implications

by Mark Gregory, Chief Economist UK&I, EY

The forecast uptick in the UK’s GDP growth – fuelled by cheaper energy – comes against a background of continued political risks at home and economic risks abroad. So companies need to take a balanced approach, based on identifying and exploiting upside opportunities while staying alert and forearmed for further shocks.

Video: Mark Gregory, Chief Economist, EY
Video: Mark Gregory, Chief Economist, EY

This stance demands a dual focus on forecasts and risk scenarios. On the forecasting side, the precipitous decline in the oil price means many companies may have entered 2015 with forecasts in place that were already significantly undercooked. As a result, budgets for this year may not be sufficiently ambitious for the conditions that businesses will be operating in. So these should be reviewed and – if necessary – realigned with the new reality.

However, in making any adjustments it remains important to keep optimism in check. EY’s Analysis of UK Profit Warnings Survey for the third quarter of 2014 found warnings running at their highest levels since 2008. And the top three reasons for issuing warnings were pricing pressures, competition, and currency effects. All these factors remain relevant.

On the risk side, it isn’t hard to see why companies need to remain vigilant. The brighter outlook continues to be overshadowed by several significant discontinuities and ‘what if’ scenarios – ranging from a Greek exit from the Eurozone to a UK election result that sees a Conservative-led coalition move quickly to an EU referendum. Such risks mean businesses should keep a very firm grip on their investment plans – something that EY’s latest Global Capital Confidence Barometer suggests they’re already doing, with confidence running ahead of actual investment. The key is to run scenarios for major risk events and have firm plans in place for how to respond.

EY Consumer Viewpoint

by Ed Hudson, UK Consumer Products Sector Leader, EY

How will consumers spend their windfall?

The collapse in the oil price over the past few weeks has seen EY ITEM Club elevate its forecast for 2015 growth in UK GDP from 2.4% last October to 2.9% today. With inflation predicted to plunge to zero this year and growth in average earnings improving, the indications are that consumers will have more money in their pockets and are likely to be more confident about spending it.

As the impacts of cheaper energy feed through, we now see the increase in real disposable incomes happening both faster and in a more pronounced way than previously anticipated. With consumers feeling increasingly optimistic and anxious to shake off years of austerity, the likelihood is they’ll spend this money rather than saving for a rainy day. EY ITEM Club now projects consumer spending to increase by 2.9% this year and 2.6% in 2016, compared to its forecast last September of 2¼% for both years.

Video: Ed Hudson, UK Consumer Products Sector Leader, EY
Video: Ed Hudson, UK Consumer Products Sector Leader, EY

The big question is exactly where will they spend their newfound cash this time. Here EY ITEM Club’s latest Special Report on Consumer Spending, published last September before oil prices reached their current lows, provides some interesting insights. The expectation in that report was that the prospective winners from the relatively gradual increase in discretionary spending would be hotels, restaurants and consumer technology including smartphones. Post oil-collapse, our view is that the same pattern of spending will apply, but amplified and accelerated – meaning recreation and electronics retailers stand to benefit especially strongly, as will fashion and clothing. At the other end of the scale, there are categories such as food that have been experiencing price deflation for some time, and are less volatile (since people need to eat) – and here the impact will be less pronounced. In these categories premium-priced products should benefit as some consumers trade up. And while there will be variations by category, retail and consumer goods producers should experience an overall uplift that will accelerate progressively the longer oil and energy prices stay low.

Looking more broadly across sectors, businesses in general should see an immediate reduction in input costs, depending on their energy usage profile and the extent to which they have hedged ahead. Just about everything needs to be transported, and oil extracts are ingredients in many wrapping materials such as plastics and many products such as soap. These effects will help to embed lower inflation.

Overall, the latest forecast for the UK economy from EY ITEM Club is encouraging news for consumer, retailers and consumer goods producers. They’ve all had a rough ride in recent years: now it’s time for some payback.


Mark Gregory

Chief Economist
+44 (0) 20 7951 5890