| The glory days are behind
us, but are things quite as gloomy as some attest? The
coming year will be one of adjustment for the British
economy, as the slide in the housing market undermines
mortgage equity withdrawal, consumer sentiment, and
therefore household spending. The slide in domestic
economic activity will further weigh on an already-depressed
industrial sector, while slackening growth in the euro-zone
constricts the market for British exporters.
Meanwhile, both government spending and business investment
will contribute less dynamically to growth; the former
as the Treasury makes a small attempt to rein-in spending
to comply with the Golden Rule, the latter as the capital
replacement cycle draws to an end and lower production
expectations bite. This trend will in part be offset
by the jump in company profitability last year –
a factor giving temporary lift to fixed capital formation
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As the housing market slides .
. .
The headline-grabbing matter of concern is, unsurprisingly,
the housing market. By any available measure, the boom
that helped foster a decade of continuous growth has
come to an end. The number of mortgages approved is
in decline, the seller-to-buyer ratio is rising, and
annual price growth is retreating from its heady rates
of 25% in late-2002/early- 2003 to an average gain of
just under 15% in Q4 2004. The mortgage approvals numbers
are a good forward hint of house price growth and these
hit their lowest in nearly 10 years in November. We
expect the slide to continue through the year –
monthly gyrations aside – and to dip negative
towards the end of 2005.
This shift will erase one of the economy’s supporting
struts – annual house price gains have been above
10% for almost five years and were last negative in
late 1995. The close link between consumer spending
and housing prices, so prevalent in the late 1980s and
early 1990s, has, according to the Bank of England (BoE),
broken down in the last half decade. There is, however,
close correlation between housing turnover – which
is falling – and retail sales (a fraction of total
consumption), where growth is also slowing. As a result,
we expect slower retail activity in the months ahead,
on top of relatively dour Christmas shopping. It is
possible that the close house price/consumption link
was due to other factors – the Monetary Policy
Committee (MPC) posited this in its November Inflation
Report. If that is indeed true, consumption should not
fall as far as in previous housing market downturns.
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The upswing in borrowing costs over the course of 2004
has led to worsening credit quality, as personal insolvencies
rise and write-offs (for both secured and unsecured
debt), while low, are likely to increase further in
the months ahead. Total household debt as a share of
disposable income rose from 90% in 1989 to nearly 130%
towards the end of last year and while mortgage debt
led the charge, both credit card and other unsecured
leverage also rose as a share of post-tax income.
The risk of a debt service crunch, however, is less
acute than in the past. Interest rates are much lower,
leading to less onerous debt service payments, and the
labour market is much stronger, deepening and broadening
the positive impact of the recent boom. Households on
the margin are those most likely to face unemployment
as growth slows; in many cases, these only recently
rejoined the labour force and have not accumulated the
financial assets to counterbalance rising indebtedness.
These are a relatively small percentage of overall borrowers
and do not pose a systemic risk to the economy or the
financial sector.
. . . interest rates to hold tight
The deteriorating housing market, gradually diminishing
producer price growth, and a stabilisation in the labour
market will help keep medium-term inflation on par with
the BoE’s prescribed bounds and therefore put
a lid on interest rates. The February Inflation Report
does forecast price growth exceeding the 2% target two
years out. However, the BoE was quick to emphasise that
the balance of risks is to the downside. Yuletide talk
of a cut in interest rates was wishful thinking, while
the outside chance of a rate hike to combat quickening
inflation is small. Current conditions argue for stability
in interest rates, rather than a near term rate hike
or cut.
The BoE, like its neighbour the European Central Bank
(ECB), is in a holding pattern as the impact of recent
policy, in the BoE’s case tighter interest rates,
winds its way through the economy. The downturn in the
housing market and the consequent dimming of domestic
economic activity will instead translate to an easing
cycle early next year. With pay deals largely linked
to retail price inflation – which will remain
well above headline Consumer Price Index growth for
the coming months – an acceleration in wages will
continue to push inflation upward in the first half
of 2005.
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Qualitative surveys point toward further hiring in
the immediate months ahead; however, vacancies have
fallen off in the most recent employment surveys, while
the manufacturing sector, after a year of modest employment
growth, has once again begun to pare back staff levels.
Nevertheless, earnings growth remains a potential upside
risk to inflation, though we expect the labour market
to let out steam come mid-year. Note, however, that
the change in trend will be due to a diminished rate
of job creation that makes finding employment more difficult
for new market entrants, rather than a large increase
in layoffs.
All told, the incentive is for the monetary authorities
to wait and see. Quickening consumer price growth is
not so rapid as to cause concern and the fall-out from
the turn in the housing market thus far appears orderly.
Nevertheless, the BoE has some margin to manoeuvre should
the housing market find itself on the edge of the cliff.
With the benchmark rate at an historic cyclical low
of 4.75%, the comfort zone available for rate cuts is
not large, but short of an outright collapse, it should
be large enough to bring a tottering bust back from
the edge.
An easing pound and higher taxes
Despite what the media may imply, the housing market
and interest rates are not the only factors in the UK
outlook. The long-awaited industrial recovery never
really got going and the fortunes of this much-beleaguered
sector are somewhat ill-omened. Global growth prospects
are easing somewhat, most significantly in the euro-zone,
Britain’s largest trading partner. Runaway growth
in China has slowed, but not so much as to diminish
its voracious appetite for raw materials. As a result,
higher commodity prices are here to stay, hinting that
producer price inflation, while down from its spike
in the autumn, cannot be entirely written-off.
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While the increase in input costs is in no way the principal
cause of the slowdown in the UK, it does not bode well
for the UK’s beleaguered exporters. That said,
we expect sterling to depreciate against both the euro
and dollar in 2005 as growth slows and interest rates
hold at present levels, offering a modest boost to export
price competitiveness. All told, the negative contribution
to overall growth made by the net trade sector is set
to stabilise, as the diminished prospects for export
growth are offset by the impact on imports of a downtick
in consumption growth.
Finally, a few words on the government’s deteriorating
fiscal stance. Thus far in Labour’s tenure, Chancellor
Gordon Brown appears to have broadly stuck to the Golden
Rule, but the prospects for the future are less sanguine.
Labour’s public services improvement programme
really got under way in its second term, while substantial
public surpluses were built up during the boom years
of the first term.
By most measures, unless the Treasury shifts the goalposts
to meet its own story, Mr Brown will struggle to meet
the Golden Rule, particularly as we expect growth to
slow noticeably next year. This will have a winnowing
impact on the tax intake, both in respect of personal
income and corporate tax. As we face a period of slower
growth, Labour is loathe to curtail spending aggressively
and thereby deepen the slowdown.
The last spending review prepared by the Treasury outlined
a 2.8% real increase in government spending in average
terms, in 2006 to 2008. In order to fund the anticipated
rise in spending for hospitals and schools, however,
roughly £20bn of savings need to be found. Mr
Brown intends to do so through efficiency savings.
However, we are sceptical given that this government
has promised again and again to cut public sector administration
costs and civil service jobs, and yet both have risen
year after year. In the next economic cycle, an adjustment
on either the revenue or spending side, if not both,
will be necessary.
If Labour is re-elected and intends to continue its
public services improvement programme, and given our
belief that “efficiency savings” are more
talk than practice, the burden of adjustment will fall
on the revenue side.
That said, this Treasury has been adept at raising
hidden, or so-called stealth taxes rather than directly
boosting the income tax rate. We expect this to continue,
with an increase burden also falling on council tax,
social security contributions and other indirect taxes.
Source:
Economy.com (UK) Ltd
For more information, contact:
Tel: +44 (0) 20 8785 5617
E-mail pguest@economy.com
Website: www.economy.com
Paul Guest is European Editor at The Dismal Scientist
Website: www.dismal.com
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