EY ITEM Club Summer forecast
Will we see a more business friendly Brexit?
by Peter Spencer, Chief Economic Advisor, EY ITEM Club
Despite a silver lining from the election…
Last month’s general election result has increased political uncertainty and thrown a spanner into the works of the Article 50 EU exit negotiations. However, the silver lining is that it could lead to a more business-friendly Brexit, resulting in agreement on transition arrangements that eventually lead to a comprehensive free trade agreement.
…the immediate outlook has darkened
Meanwhile, the surge in inflation has finally slowed the consumer – and with investment and exports failing to offset this effect, GDP growth fell back to 0.2% quarter-on-quarter in the first three months of 2017. The outlook for the rest of the year remains poor, and we’ve revised our April forecast of 1.8% for GDP growth in 2017 down to 1.5%. Growth of 1.2% for next year has been revised up marginally to 1.3%.
Households are under pressure…
With household savings already very stretched, wage growth remaining in the doldrums and inflation picking up faster than expected, consumer spending grew by just 0.4% quarter-on-quarter in Q1 of 2017, down from 0.7% in Q4 of 2016 and 0.8% in each of the previous quarters. Meanwhile, the household saving ratio fell to another record low of 1.7% in Q1, from 3.3% in Q4 of last year.
When wages fail to keep pace with price rises, inflation saps the strength of consumption and pushes down demand, as we saw in the early years of this decade. With the economy slowing it seems unlikely that falling unemployment could now trigger a significant increase in wage inflation. We expect Consumer Prices Index (CPI) inflation to move above 3% by July and reach 3.2 to 3.3% in the autumn, maintaining the pressure on households.
…but a recovering pound may help
That said, sterling has rallied in the last three months, partly on hopes of a softer Brexit. Oil and some other commodity prices have also slipped back from the peaks seen in Q1. These developments have already eased the pressure on industrial costs, and – if sustained – will reduce the pressure on the CPI this winter. Domestic cost pressures remain subdued, and we expect CPI inflation to be back in line with the Bank of England’s 2% target by the end of 2018.
However the pickup in inflation has increased tensions within the Monetary Policy Committee (MPC). Several members have said their vote will depend upon whether investment and overseas trade can offset the slowdown in consumer spending. The Financial Policy Committee (FPC) is reversing the stimulus it injected post-referendum, notably the cut in the banks’ countercyclical capital buffer. This is arguably the best way to rein in household borrowing, and eases the pressure on the MPC to reverse the cut in base rates.
Base rates should stay on hold…
All of this leaves the outlook for base rates uncertain. But with the economy slowing and inflation coming back down to the target, we think the Bank of England will keep rates on hold until the autumn of next year. By then we should also have greater clarity on the outcome of the Article 50 talks, since any deal would need to be near to agreement to leave time for ratification by national parliaments.
The general election is also likely to result in a modestly looser fiscal stance. Ministers are now openly debating the future of the cap on public sector pay and the Chancellor will surely have to respond. The surge in inflation is making the cap harsher than envisaged, and provides leeway for a token relaxation by pushing up nominal tax revenues.
…with a possibility of investment picking up
Assuming we see a transition agreement, with talks on a free trade agreement under way, this should stimulate investment – especially in sectors like the motor industry where it has been held back by Brexit uncertainty. We’ve revised up our medium-term forecasts accordingly. April’s GDP growth forecast of 1.5% for 2019 is raised to 1.8%, while expected growth rates of 1.8% for 2020 and 2021 have moved up to 2.0% and 2.2% respectively.
Looking behind the headlines: shades of a softer Brexit?
by Mark Gregory, EY Chief Economist
The EY ITEM Club Summer 2017 forecast is the last to be overseen by Peter Spencer, as the Professor is retiring after almost two decades as our Chief Economic Advisor. We’re delighted that Howard Archer has agreed to accept the considerable challenge of replacing Peter – and I would like to take this opportunity to thank Peter for all his wisdom, humour and advice over many years. He will be sorely missed.
However, the changes at the EY ITEM Club pale into insignificance when compared to the recent shifts in the political and economic landscape. If a week is a long time in politics, a quarter is a lifetime in economic policy. Since the last forecast, we have seen the Conservative Party lose its majority in the House of Commons, the negotiations around Article 50 commence, Bank of England Monetary Policy Committee members hint at earlier rate rises than previously assumed, and challenges to austerity emerge from across the political spectrum.
…leading to a shift in the outlook…
These changes are reflected in the latest forecast, with revisions to the headline forecasts for GDP. While the projection for 2017 has worsened from growth of 1.8% to 1.5%, 2018 is expected to be slightly better than was forecast in April. However, the biggest changes are in the medium term, as the prospect of a softer Brexit than EY ITEM Club previously assumed leads to an upward revision in the growth forecasts for 2020 and 2021.
Behind the headline figures, the outlook for consumer spending and business investment remains challenging, with an apparent weakening of confidence since the spring expected to lead to lower growth in both areas. However, trade is expected to provide support to growth, even though the pound is now forecast to strengthen relative to the spring forecast.
…especially around Brexit…
As EY ITEM Club notes, the election has made the shape of Brexit a matter for debate — for the first time. Clearly, many voters were worried about the prospect of a hard Brexit. It does appear that to get any deal through Parliament, support from other political parties — almost all of whom have advocated maintaining closer EU ties than the Conservative Party — will be required.
EY ITEM Club is assuming that this makes a transition arrangement more likely, during which the UK’s relationship with the EU would continue much as it does at present. At least the new electoral timetable allows time for that. The latest forecast is based on the assumption of a transition arrangement that leads to the stronger growth forecast for 2020 and 2021.
…and possibly around austerity
The election also underlined that the public are becoming weary of austerity, and are receptive of the view that enough is enough. The Prime Minister’s former chief of staff and his replacement both agree that this has been a major factor in Labour’s surging popularity. EY ITEM Club now believes that any future attempts to curb spending growth will need to be handled very deftly.
Nevertheless, the outlook is highly uncertain as there is no sign of the Chancellor changing tack. In his Mansion House speech, Philip Hammond stuck to the familiar line that higher borrowing to finance current spending would be “asking the next generation to pay”. However, EY ITEM Club wonders if Mr Hammond’s emphasis on current spending leaves open the possibility that he may be open in the autumn Budget to borrowing more for investment.
The short term remains challenging for business…
Despite the changes, and the potential for a softer Brexit and reduced austerity to support growth, the core message for business remains similar to the last forecast: the UK economy is slowing, with the consumer sector most exposed, and companies must ensure their plans are realistic in this environment. Beyond the slowdown in the consumer sector, other challenges could include:
- Changes to the UK labour market, as uncertainty over the post-Brexit arrangements for freedom of movement potentially reduces immigration and creates skill shortages. I have come across a significant amount of anecdotal evidence that this is already an issue.
- Uncertainty over the level and rate of change in interest rates. Businesses need to be sure their financing is in place and that they can cope with a faster rate-rise scenario.
- Exchange rate uncertainty. The prospect of a softer Brexit has provided some support to sterling, but there could be bumps in the road ahead as the Article 50 negotiations develop.
…and the future cannot be ignored
Businesses face a difficult balancing act between managing through the short term and creating the basis for growth if the medium-term outlook does improve as forecast. Business investment has been weak in recent quarters and productivity continues to disappoint. Businesses that want to capture the benefits of improving export markets and a more competitive pound need to invest ahead of the recovery in the economy after 2018. This requires careful and detailed analysis of the likely scenarios and options, to enable investments to be made in a sensible and carefully-managed way.