The Q2 2017 ICAEW Economic Forecast, is based on the views of those running UK plc: ICAEW Chartered Accountants working in businesses of all types, across every economic sector and in all regions of the UK, surveyed through the quarterly ICAEW Business Confidence Monitor (BCM).
Following an inflation-induced slowdown in the first three months of 2017, economic activity has strengthened a little in Q2. The business confidence index looks positive for the first time since before the EU referendum and there has been strong output data reported for the manufacturing sector. That said, consumers will face challenges for the remainder of 2017 thanks to falling real wages, while business investment remains constrained by domestic political uncertainty and upcoming Brexit negotiations.
The UK economy slowed sharply in the first quarter of 2017 as consumers finally succumbed to the impact of faster inflation. However data for April and May suggests that the second quarter might be stronger, with GDP growth for the year at 1.7%. Following the election result, we should see relatively little change in the fiscal stance, while monetary policy will remain on hold through what is likely to be a temporary period of higher inflation.
The economy slowed in the first three months of the year, from quarterly GDP growth of 0.7% in Q4 2016 to 0.2% in Q1 2017. The consumer lost momentum, with quarterly spending growth of 0.3%, the weakest since Q4 2014. Latest retail sales data suggest a tentative recovery - sales rose 2.3% month-on-month in April. But this could be partly due to the Easter holiday and the good weather. We therefore remain cautious about consumer prospects, especially since inflation accelerated to 2.9% in May.
Elsewhere, the gradual rebalancing of activity continues. The manufacturing PMI rose to a 3-year high in April, and with Eurozone and wider global trade rebounding in the first half of this year, this is unlikely to be solely down to a weaker pound. The pickup in business confidence in the latest BCM suggests better GDP growth in Q2, possibly as strong as 0.5%. This is unlikely to be sustained in full in the second half of 2017, given that inflation will remain high. Our forecast for GDP growth of 1.7% for the year seems a reasonable expectation given the positive signs in the export sector, and the likelihood that investment will stabilise later in the year.
From a policy perspective, the election result means a change in fiscal stance is unlikely. The Monetary Policy Committee is likely to tolerate a period of above-target inflation, keeping rates on hold to help support economic activity.
Please note that 2017 data in this report is forecast.
Business investment rebounded a little in Q1 2017, but the breakdown of spending showed that businesses cut back in some key areas. We still expect a modest fall for 2017 overall, but the environment for investment spending looks a little brighter than in recent quarters. A resolution of Brexit-related uncertainties could spur faster investment spending in the year ahead.
After a 1% contraction in Q4 2016, business investment partly recovered in Q1 2017, growing 0.6%. Investment in buildings was the main motor of growth, while investment in IT and other non-transport equipment fell. Capital spending data is notoriously volatile and prone to revisions, and so too much should not be read into the first release of data for one quarter. However, if sustained, this pattern of investment could suggest firms in service sectors are starting to adjust to slower consumer spending.
Nevertheless, evidence from the BCM suggests a slightly better outlook for investment spending for the year than expected during our last Economic Forecast. Consequently, we forecast a 0.6% fall in business investment in 2017, compared to a 1.9% in our last edition. According to the latest BCM, firms plans to gradually increase their capital expenditure over the coming twelve months but they also report substantial spare capacity. It seems likely they will wait until later in the year or early next before loosening the purse strings.
Meanwhile business expectations for other financial metrics remain supportive of capital spending. BCM evidence suggests firms believe margins will be sustained as they increase selling prices in response to rising input costs. Also, with world trade looking stronger and the pound still weak by historical standards, firms anticipate that export markets will be a key source of growth. And firms’ own financial balances remain historically strong, and financing cheap and abundant. Given the uncertain domestic political environment and the difficult and complex Brexit negotiations to come, it seems likely firms will invest cautiously in the months ahead.
2017 represents forecast data
The UK labour market continues to display mixed signals; with strong job creation in the first quarter of 2017, and employment and unemployment rates at historic highs and lows respectively. However, wage growth remains suppressed by weaker bargaining power on the part of workers, and policy measures that will increase the cost of employment in the months ahead.
The labour market goes from strength to strength as far as job creation is concerned. The number of people in work rose 122,000 during Q1, while the employment rate ticked up to 74.8% - a new record. The unemployment rate edged down to 4.6%, the lowest since 1975, and the number of unemployed people per vacancy fell below two for the first time since records began.
We continue to expect job creation to slow, as consumer-facing sectors scale back hiring in light of slower spending growth. But at 0.7% for 2017, our forecast for growth in private sector employment is marginally faster than in our last report, reflecting the strong start to 2017 but still lower than growth achieved in 2016 (1.4%). With stable growth in the supply of labour, we anticipate the unemployment rate to rise very modestly through the remainder of the year, averaging 4.8% for 2017 overall. But in the context of the jobless rate having fallen by 3 percentage points since 2013, the UK labour market will remain very tight by the standard of the last few decades.
In spite of this, wage growth has remained very subdued. Annual earnings growth slowed to an eight-month low in the three months to March, and evidence from BCM also suggests stable wage growth for the year ahead. BCM also reveals that a fewer number of firms see skills shortages as a growing challenge, while policy-related labour costs such as the apprenticeship levy and continued pension auto-enrolment will also drag on employers’ bidding power. We forecast average wage growth of 2% this year, indicating further real income falls for households.2017 represents forecast data
Fiscal policy was one of the key election battlegrounds. In reality, the speed at which the deficit is closed is probably of limited importance given the current low cost of government borrowing. More important is a vision on how to address age-related public spending liabilities. Given the sensitivity around these areas of spending, a gradual approach seems likely to persist. As it stands, the new government will largely be sticking to the broad outlines for fiscal policy set out in the March 2017 budget, albeit scaling back promises on protecting the value of some welfare payments, and with greater flexibility to raise income tax.
This flexibility may be important if the government is to hit its fiscal targets in the years ahead. The deficit for 2016-2017 has been revised down, and so the deficit starts the new fiscal year lower than the Office of Budget Responsibility (OBR) March forecast assumed. But more recent data is less encouraging. In April this year, the deficit increased compared to a year earlier for the first time since November 2015, largely due to the slowest rate of tax revenue growth in a year. Income tax receipts grew by just 1.4% on the level in April 2016, demonstrating that the tight labour market is not delivering on wage growth, and therefore doing little to help narrow the deficit.
With the economic outlook relatively weak by the standards of recent years, the chances are that the deficit will widen further through the year. With the government only having committed to lowering the structural deficit (i.e. excluding the effect of the economic cycle) below 2% of GDP by 2020-2021, and the deficit eliminated entirely by 2025, there is little immediate need for further fiscal tightening in the Autumn budget. Indeed, the changes to the fiscal rule made since the last parliament indicate the government is giving itself a buffer against weaker economic growth in the future. The direction of travel for now seems to be further fiscal slippage, while eliminating the deficit is at least a four-parliament challenge.
As the election debate over long-term social care demonstrates, decisions about how to balance the budget in the coming few years is only one aspect of fiscal policy that needs to be settled. The OBR published revised estimates for the anticipated future cost of health spending in January 2017, projecting that this would rise from 7.3% of GDP in 2016-17 to 12.6% by 2066-67. The same report found that state pension costs would rise from 5.2% of GDP in 2016-17 to over 7.6% of GDP over the same period – even assuming the currently legislated rises in the state pension age. In this scenario, sharp cuts to other areas of public spending or rises in taxation would be necessary to keep public debt to projected numbers.
Given the sensitivities around changing pension, health and care entitlements, these issues will continue to be tackled incrementally rather than with more decisive policy action. Dealing with the cost of an aging population will be a challenge that stretches decades into the future.
ICAEW’s forecasts for economic growth, business investment and the outlook for the labour market are based on the correlation between ICAEW Business Confidence Monitor (BCM) indicators and official economic data. The BCM contains data – from a survey of 1,000 UK businesses – on business confidence, financial performance, challenges and expectations for the year ahead to provide a unique analysis of future developments in the UK economy.