This report was produced on 22 May 2020 with ICAEW's partner Oxford Economics, one of the world’s foremost advisory firms. Their analytical tools provide an unparalleled ability to forecast economic trends.
- Hopes at the start of this year for steady economic growth have been upended by the coronavirus pandemic. GDP fell by 2% in Q1, the biggest drop since 2009. And with a chunk of the economy in hibernation, output is forecast to shrink a further 14% in Q2, an unprecedented post-war contraction.
- Output is falling because of a planned, partial shutdown of the economy, which offers hope that activity can rebound once restrictions are eased. And policy support by the government and the Bank of England to preserve employment, incomes and liquidity will support a recovery.
- Nevertheless, the economy is forecast to shrink by 8.3% in 2020, the largest decline since 1921. Although output is expected to rebound by 7.8% next year, the forecast does not see the economy returning to its pre-crisis size until the end of 2021.
- The risks are high. Coronavirus could become more virulent and the lockdown extended. A second wave of the virus could trigger another lockdown later in the year. Long-term economic damage could be worse than expected, or policy support could be withdrawn prematurely.
- The response to coronavirus has caused government borrowing to balloon. But with gilt yields at historic lows and demand for debt high, financing the deficit should be straightforward. Furthermore, the greater political appetite for higher government borrowing and spending, already evident before coronavirus struck, is likely to be magnified by the pandemic.
2020 began with the economy enjoying several positives …
A steady progression in living standards has been so long entrenched in UK and other western societies as to have almost become a fact of life. The financial crisis of 2007-08 had interrupted this trend, triggering a recession deep by post-war standards. But at the start of 2020, the scars had largely faded. The economy had avoided a recession for 42 successive quarters, the proportion of people in work had reached a record high and the unemployment rate was at its lowest since the early-1970s. In real terms, average wages had finally exceeded the previous peak reached in early 2008. And last December’s decisive general election result and the UK’s orderly exit from the EU on 31 January had promoted an uptick in consumer and business confidence.
… but the spread of coronavirus saw the economy take a dive in March …
But hopes of a better year for the economy have been upended by the consequences of the coronavirus pandemic. The first diagnosed cases of the virus in the UK occurred in January, while the following month saw the first confirmed case of transmission within the UK. During March, efforts to contain the spread of coronavirus were intensified. People were initially advised by the government to avoid non-essential travel and contact with others. Social distancing requirements were then ramped up on 20 March, including the closure of all pubs, restaurants, bars and gyms, and a nationwide lockdown was announced three days later.
At the time of writing, official economic data is sparse for the lockdown period. But GDP and retail sales numbers for March make clear the early effects of voluntary and enforced social distancing. GDP fell by 5.8% in March, the largest decline since monthly data began in 1997.
Figure 1: UK Quarterly GDP growth
… contributing to GDP dropping 2% in Q1, a decline which has intensified in the second quarter.
With March’s drop following stagnation over the previous two months, output was down 2% in Q1 on the previous quarter, the biggest fall since the depths of the financial crisis in Q4 2008. On another grim note, retail sales volumes in March contracted by a record 5.1% on the month. This was despite a boost to sales in food stores from shoppers stockpiling – in contrast, non-food store sales plunged 19.4%.
More timely measures suggest that activity has declined even more steeply since March. The headline activity balance of April’s Chartered Institute of Procurement and Supply (CIPS) services survey plummeted to 13.4 from 34.5 in the previous month, the weakest in the survey’s 24-year history. The manufacturing PMI declined to 32.6 from 47.8 in March, a record low, and a construction PMI of 8.2 was also unprecedented in the survey’s history. Car registrations in April fell 97.3% year-on-year to just 4,321 vehicles, the lowest since February 1946. In those areas of ‘social consumption’ most affected by the lockdown, such as tourism and restaurants, high-frequency indicators including aircraft departures and restaurant bookings suggest that spending has dwindled to almost zero. And business closures and more homeworking have reduced the number of journeys by car and public transport.
Although official data is sparse, the labour market impact has been profound
A full picture of the impact of the lockdown on the labour market will not be available until June, when a complete set of numbers covering the February-April period are released. However, the available evidence has been grim. The number of people claiming unemployment benefit increased by 857,000 between March and April, from 1.24m to 2.10m (a rise of 69%). Job vacancies in April were down 400,000, or 50%, on March’s level.
And the take up of Universal Credit (UC) and the government’s Coronavirus Job Retention Scheme (CJRS), which pays 80% of salaries up to £2,500 a month if employees are furloughed rather than laid off, have offered more signs of a profound shock. In total, 2.5m new claims for UC were made between 16 March and early May, six times the normal claimant rate. And as at 19 May, companies had used the CJRS to furlough 8m jobs, over a third of all private sector employees. The latest ONS business survey, which found that 67% of respondents were planning to use the scheme, suggests take-up could climb further.
Near-term prospects for the economy
Output is expected to fall by 14% in Q2 and by over 8% over 2020…
The blizzard of bad economic news since March points to the economy suffering a severe contraction in Q2. Oxford Economics forecasts GDP to shrink by 14% in that period and by 8.3% over 2020.The latter would be the largest decline since 1921. Relative to the plunge in output, a forecast rise in the unemployment rate to 7% in Q3 from 4% at the start of the year is less shocking, reflecting the incentive to retain workers provided by the CJRS.
Figure 2: Annual falls in GDP*
*10 largest declines since 1900. Forecast for 2020.
… but the unusual nature of this recession offers hope of a rapid rebound …
In looking for any silver linings, the unusual nature of the downturn is one. GDP is falling because of a planned, partial shutdown of the economy on public health grounds, not, as is typically the case when the economy shrinks, because of imbalances in the private sector or policy mistakes. So the use of the word ‘recession’ to describe current circumstances is, arguably, a misnomer.
This offers cause for optimism – in theory, activity prevented by the lockdown can restart once restrictions are lifted. And a rebound will be aided by the fact that, while the pandemic has inflicted a terrible human toll, unlike a natural disaster such as an earthquake or flooding, it has not caused any damage to the country’s physical capital, such as buildings and infrastructure.
… helped by the huge amount of support from fiscal and monetary policy …
The potential for a bounce back is boosted by the scale of policy support provided by the government and the Bank of England (BoE). The UK central bank has cut the official interest rate to its effective floor of 0.1%, restarted quantitative easing with £200bn of asset purchases, and implemented various schemes to ease credit conditions for business. Furthermore, the minutes of the May MPC meeting have led us to expect a further £100bn of asset purchases to be authorised in June.
The fiscal response has been of wartime proportions. Oxford Economics estimates that the various policy measures could raise borrowing in 2020-21 by £173bn or 7.5% of GDP. Around two-fifths of this total is accounted for by the CJRS, but the government will also provide support for the self-employed; various schemes to bolster household incomes, including extra welfare spending; grants, tax holidays and subsidised loans for businesses; and extra spending on the NHS.
… and the private sector emerging from the lockdown with money to spend.
Thanks in part to the scale of policy support, the private sector is likely accumulating savings. In aggregate, data from the BoE suggests companies have been building up cash, helped by the deferment of VAT payments in Q2, tax holidays and grants to businesses. And, for the household sector in aggregate, severe restrictions on consumption means spending has probably fallen by more than disposable incomes. It follows that pent-up demand when the lockdown is lifted could be considerable. And that the sharp drop in oil prices earlier this year is set to push inflation close to zero in the summer, which will boost household spending power.
The pace of recovery though will be tempered by several factors …
This optimism is tempered by three reasons for caution:
- Some GDP has been lost permanently. For example, the restaurant meals or haircuts not enjoyed during the lockdown period have been lost for ever. That said, spending on durable goods, such as cars, may have simply been deferred. If so, some of the spending foregone while social distancing measures are in place may be made up for later. Whether consumers adopt a more cautious approach or return to their pre-pandemic mindset will be key here.
- The economy is made up of a complex set of relationships between businesses and customers and employers and employees. Can those relationships can be restored post-lockdown? The answer will depend in part on how long restrictions are in place and the effectiveness of policies to maintain existing companies and jobs.
- The plan for relaxing the lockdown outlined by the Prime Minister on 10 May entails only a gradual return to normality. Non-essential shops will be reopened from 15 June, but pubs, restaurants and other high-contact sectors will remain closed until at least the beginning of July. And while people working in some sectors, including construction and manufacturing, not subject to lockdown restrictions have been encouraged to continue working, the fact that schools will reopen only gradually from the start of June will restrict the ability of some parents to return to the workplace.
… but assuming a relaxation of the lockdown over the summer, the economy should make up much of the ground lost over the second half of 2020 and into 2021.
Assuming we follow this timetable, and with government support schemes (including the CJRS and loans to businesses) seeing a strong take up, the economy should return to growth through the second half of this year and into 2021. Oxford Economics expects GDP to rise by 7.8% next year, although in level terms, output is not expected to regain its end-2019 level until Q4 2021.
Figure 3: UK GDP growth
Risks to the recovery
Economic forecasts at present are highly uncertain and subject to big downside risks
Given the lack of precedent for national, let alone global, economic lockdowns, and the novel nature of the coronavirus, there is a huge degree of uncertainty surrounding any forecasts. This is reflected in the following considerable risks, most of which lie to the downside.
- Coronavirus becomes more virulent and the lockdown period is extended. Oxford Economics has modelled a downside scenario in which the lockdowns become more widespread across the world and persist into Q3. In this scenario, a prolonged lockdown encourages households and businesses to save more and spend less, leading to a weaker recovery, while long-standing structural vulnerabilities, such as overvalued asset prices and high levels of corporate debt, are exacerbated, triggering a financial crisis. By the end of 2024, world GDP levels are 10% below the pre-coronavirus baseline. The UK economy is forecast to suffer a deeper recession in 2020 and a slower subsequent recovery, with GDP growth 2.1 percentage points a year below the baseline forecast over the 2020-22 period.
- The virus strikes again later this year and the lockdown is repeated. A second wave of coronavirus would generate a ‘W-shaped’ path for the economy, as activity initially rebounded before being hit again. In this event, the uncertainty created would inflict even more damage to confidence and encourage people to save more and spend less.
- Long-term damage to the UK economy proves more significant than expected. Studies have shown that individuals who experience sharp recessions are more cautious in making economic decisions over their lifetimes and tend to save more (reflecting what the Bank of England’s Chief Economist, Andrew Haldane, has termed ‘dread risk’). And it is not difficult to see how the experience of the pandemic could make companies warier of expanding or spending money on things like on-the-job training. So the current crisis could have a long-running adverse effect on investment, entrepreneurship and innovation, weighing on the productive capacity of the economy.
- Policy support is withdrawn prematurely. Some have argued that the sluggish pace of recovery after the 2008-09 recession was a consequence, in part, of the then government prematurely choosing a policy of fiscal austerity. Given the scale of public borrowing in response to the current crisis, politicians may seek, post-pandemic, to reduce the deficit too quickly. Or fears of inflation may prompt the BoE to over-hastily tighten monetary policy. These risks could be elevated were the lockdown to be only partially lifted. Then, policymakers may feel justified in withdrawing some support, but demand and sales would remain depressed by the need to maintain social distancing.
With the pandemic dominating attention, it would be easy to ignore longer-standing risks, of which a lack of clarity over the UK’s future relationship with the EU had been the focus of concern. The UK formally left the EU on 31 January and is now in a transition period, due to last until end-2020, during which trading arrangements remain unchanged and the two sides are seeking to negotiate a future relationship. But the disruption caused by the coronavirus outbreak and the resulting switch of political priorities mean the chances of concluding a trade deal by the end of this year appear low. If talks break down, leaving the UK and EU to trade under WTO rules from 2021, the economy’s post-pandemic recovery could prove more muted than hoped.
The fiscal consequences of coronavirus
Government interventions are set to drive up public borrowing to levels unseen outside wartime …
In response to the pandemic, the government has backstopped the income of millions of people and the cash flow of hundreds of thousands of companies. The result has been a huge expansion in the state’s involvement in the economy. Public sector borrowing in April alone was £62bn, comfortably the highest level in any single month on record. The scale of public support and the loss of tax revenues from the shutdown mean that the deficit is likely to expand to around £290bn this year, a sum equivalent to 14% of GDP. This would be the biggest deficit in post-war history, exceeding the previous record of 10.2% of GDP in 2009-10.
Figure 4: Government finances
… but demand for ‘safe’ assets and BoE purchases means that extra borrowing can be financed at a historically low cost.
The good news is that in funding this deficit, the government faces very favourable financing conditions. In part reflecting a ‘flight to safety’ among investors from risky assets like equities to the perceived security of government bonds, interest rates on UK Government gilts are hovering around record lows. The BoE’s decision to buy £200bn of assets, of which at least half will be gilts, using newly-created money has helped keep yields down – in fact, between the end of March and early May, BoE purchases of gilts ran ahead of issuance by the government’s Debt Management Office.
This approach has been met with near-unanimous support from economists. The question is whether, post-pandemic, the state’s role in the economy will revert to what it was before coronavirus, or if the current shift in the private-public balance will, at least in part, persist.
Post-pandemic, the state is likely to play a permanently bigger role in the economy …
There is good reason to think that even when conditions approach normality again, the government will retain some of its enlarged role in the economy, financed by a combination of higher borrowing and increased taxation. One lesson of the crisis is that governments, aided by the support of central banks, have more fiscal space than some previously believed. With borrowing costs likely to stay low as the economy recovers, there should be no urgency to cut the deficit quickly.
The public mood is likely to err in the same direction. Individuals’ greater awareness of their vulnerability to unemployment might increase demands for redistribution. Indeed, support for the creation of the post-war welfare state was founded, in part, upon memories of the economic slump of the 1930s. The crisis has also arguably demonstrated the need for more spare capacity in the NHS and that successive governments have prioritised static ‘efficiency’ in the provision of health care too much at the expense of resilience. So already sizeable pressure to spend more on healthcare will only build.
… building on a shift in the political zeitgeist evident even before coronavirus struck.
Granted, the rise in the ratio of public debt to GDP resulting from the fiscal cost of the pandemic could prompt some people to argue for a repeat of the austerity measures that characterised most of the 2010s. But increased support for higher government spending and borrowing was apparent across the political spectrum even before coronavirus emerged. For example, on the plans set out by the Conservative government in March’s Budget, total public spending was already due to rise to 40.8% of GDP by 2024-25, a bigger share than the Labour administration spent in any year between 1997 and 2008. So voices calling for a rapid reduction in borrowing and the size of the state are unlikely to hold much sway.
In an ideal world, the economy’s current predicament will represent a short-lived shock, with much of the damage quickly made up. But the repercussions for how governments approach economic policy and what the public demands from policymakers could prove long-lasting.