Economic Update: UK
The ICAEW Economic Update: UK, 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).
Q1 2019 Key findings:
A weak end to 2018 offers a poor launchpad for growth this year
With momentum in the global economy softening and Brexit uncertainties in play domestically, a slowdown in GDP growth in Q4 2018 was predictable. But a quarterly increase of 0.2% was worse than many expected and a sizeable drop from Q3’s 0.6%. This was the slowest quarterly rise since Q1 of last year, when the economy was hit by severe weather, and left annual growth in 2018 at only 1.4%, the weakest since 2009.
Admittedly it was not all bad news, at least by the standards of the previous quarter. The dominant services sector expanded 0.4% in Q4, only marginally down on Q3’s pace, although still weak by historical standards. And consumer spending rose 0.4%, matching Q3’s rate (albeit also historically soft). However, it was a different story for industry which shrank 1.1% and construction output which dropped 0.3%.
The weak end to 2018 presents a poor starting point for this year and it will drag down GDP growth in 2019. And if January’s CIPS activity surveys are anything to go by, this year began on an even more subdued economic note than 2018 ended. The composite PMI fell to the lowest level since July 2016. And our ICAEW Business Confidence Monitor (BCM) forecast suggests growth in Q1 will struggle to beat the previous quarter’s already soft pace.
On a brighter note, inflation began 2019 at a two-year low and should head down further, boosting households’ spending power. Unemployment is forecast to remain low and the extra government spending announced in last October’s Budget will support demand. And if, as we expect, a Brexit deal is finally decided, this should spur pent-up investment. But notwithstanding the likelihood of a Brexit resolution and other upsides, we think that the economy this year is unlikely to better 2018’s rise in GDP, growing by 1.3%, a downgrade from our forecast of 1.6% three months ago. In a ‘no-deal’ world, the effect of new trade barriers and heightened uncertainty would probably see growth closer to zero, with the economy flirting with recession.
Real GDP, annual growth
Companies’ willingness to invest continues to drop
A 1.4% fall in business investment in the last three months of 2018 was the fourth consecutive quarterly decline and left the level of annual investment in 2018 0.9% down on the previous year, the biggest annual drop since the global financial crisis.
Survey evidence from the Bank of England suggests that a lack of clarity over the final Brexit outcome, along with slower global growth, has played a role in this weakness. Reflecting this, business sentiment weakened through 2018, with the latest BCM survey’s Confidence Index falling further into negative territory at the start of 2019, and touching the lowest level in nearly a decade.
If the UK and EU are able to sign a withdrawal deal, conditions are supportive for a revival in business investment. Rates of return enjoyed by companies are above long-run averages, particularly for manufacturers, and corporate borrowing costs remain low.
But at the same time, a withdrawal deal will not eliminate uncertainty around the UK’s longer-run relationship with the EU. And even with a positive Brexit outcome, the extent of the drop in companies’ spending on investment in the latter part of 2018 will make it difficult for 2019 to deliver a year-on-year rise. We forecast another fall in investment, albeit at 0.3%, less poor than 2018’s contraction.
Business Investment, annual growth
Low unemployment to persist, supporting current momentum in pay growth
Despite a subdued rate of GDP growth in Q4 2018, the economy’s capacity to create jobs impressed. The number in work increased by 443,000 or 1.4% on a year earlier, the biggest gain in absolute and percentage terms since Q3 2016. Moreover, the unemployment rate dipped to 4%, the joint lowest since Q1 1975. And the quarter saw a sizeable fall in inactivity, with the proportion of the 16-64 population not in work or looking for work falling to the lowest since records began in 1971.
On another positive note, the strength of demand for workers appears to be increasingly translating into bigger pay rises. Annual pay growth hit a 10-year high of 3.4% in Q4, up from 3.2% in the third quarter and 2.5% a year earlier. This left the annual rise in 2018 at 2.9%, the biggest since 2008, compared to 2.4% the previous year.
However, the stronger wage growth in the last quarter of 2018 was partly due to new employment disproportionately created in higher-paying jobs. This effect is likely to prove transitory. Employer contributions to auto-enrolment pension schemes are set to rise in April, reducing the resources to fund pay rises. And sluggish economic growth should eventually feed into a slower rise in employment, as the BCM predicts. 2019 is forecast to see the number in work climb 0.5%, a step-down on last year’s 1.2%. These factors suggest that significant further advances in pay growth are unlikely this year. Average earnings are forecast to rise by 2.8% in 2019, very close to 2018’s 10-year high.
Employment growth on year ago
Average earnings, annual growth
Until the latter part of last year, the message from central banks globally had been a relatively hawkish one. The US Federal Reserve was steadily raising interest rates, the European Central Bank had brought its programme of asset purchases to an end and the Bank of England signalled (a ‘smooth’ Brexit permitting) the likelihood of rate rises in the near future, citing faster pay growth and an economy exceeding capacity constraints. But the mood-music both abroad and at home has seen a marked shift recently.
Partly this reflects an economic slowdown in most major economies (with the US a qualified exception). The eurozone economy grew by a modest 0.2% in Q4 2018, repeating Q3’s pace, with the German economy stagnating and Italy falling into recession. Further afield, China’s rate of GDP growth in 2018 slowed to a 28-year low of 6.6%. As a relatively open economy, the UK is not immune from global troubles, which will inevitably caution the Bank of England in pursuing higher rates.
The second, more domestic, factor is falling inflation. 2018 was a year of consumer prices rising consistently faster than the Bank’s 2% inflation target. But the annual CPI measure of inflation dropped to 1.8% in January, the first below-target reading for two years. This largely reflected consumer-friendly developments in energy prices. The imposition of a cap on energy bills by the regulator Ofgem resulted in the biggest monthly drop in energy prices since records began in 1988. And the sharp fall in the price of oil (down almost 10% in sterling terms between the third and fourth quarters of 2018) has increasingly fed through to lower petrol prices.
Although inflation is expected to tread water over the next few months, the middle of the year should deliver a further decline if, as we expect, the UK and EU arrive at an agreed withdrawal deal. A more certain economic environment flowing from that development should propel a rise in the value of sterling against other currencies, pushing down import prices. As a result, CPI inflation is forecast to drop to around 1.5% in the second half of 2019, boosting households’ spending power and supporting the economy. In theory, this will not necessarily stop a forward-looking Bank of England, which typically ‘looks through’ temporary influences on inflation, from raising interest rates. But the presentational difficulty of tightening monetary policy with inflation so low suggests that with an ‘orderly’ Brexit, the year could pass with the Bank Rate remaining at the current 0.75%.
In a ‘no-deal’ outcome, the additional trade barriers and fall in the pound which would likely follow would push up inflation and present the Bank with a quandary. But pressure to support the economy makes it highly likely that monetary policymakers would repeat their action after the 2016 referendum and prioritise economic growth, cutting rates down to 0.25%.
Contributions to CPI inflation
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.