WHAT’S TO COME

• The slowdown in private consumption growth will only gradually reverse course
• Elevated debt levels, rising unemployment, and slack real income gains all argue in favour of gradual spending growth
• Renewed housing market growth might be good for the economy in the short run, but it creates greater risks for later
• Interest rates will remain on hold until the current risks and rewards facing the economy have been clarified. We have dropped our forecast rate cut in February, but borrowing costs will not rise until late in the year
• The manufacturing sector recession will gradually come to an end, buoyed by strengthening domestic demand and a stronger euro-zone economy

The British economy will slowly recover from the abrupt slowdown in early 2005. However, activity will pick up only slowly in the first half of this year, as consumers continue to work off the hangover of an elevated debt burden and an overvalued housing market.

Although the rate of growth is gradually coming off its nadir, and there are spreading signs of quickening private consumption, slackness in the first half will undermine the figures for the year
as a whole. This implies a 2.2% real GDP gain in 2006, up from about 1.9% in 2005, but below the 3.2% rise achieved in 2004. Thereafter, once some of the imbalances in the economy have eased and an extended period of reasonably accommodative interest rates has had an effect, private spending growth will
get back to its feet, pushing real GDP gains to close to potential (seen as 2.75%) in 2007.

CONSUMERS, SERVICES, AND HOUSING
In the near term, consumer confidence will remain brittle and the labour market will continue to weaken, implying that the uptick in service sector and retail activity in the final stanza of 2005 might not last. We expect unemployment to keep rising over the next half-year: the claimant count and ILO rates will top out in mid-2006 at 3.2% and 5.2%, respectively. These are both below previous cyclical peaks and are illustrative of sluggish growth, rather than outright recession. Real earnings growth, including bonuses, will remain slow but steady. In 2006, we expect an average gain considerably below the 4.1% rise notched over the first 11 months of last year. The combination of higher unemployment and slower wage gains will weigh on retail spending, unsecured credit growth, and debt servicing ability.

With consumer price growth ahead of the level enjoyed in recent years and earnings growth easing, we would expect to see slower inflation-adjusted discretionary income gains. As spending tends to grow in line with disposable income, this also implies a sluggish recovery in consumption. The recent signs of resurgence in the housing market might bode well in the short term, but with the price-to-earnings and debt service ratios out of kilter with historical precedent, the potential for a renewed boom is limited.
On the subject of the housing market, there is only a small chance of a resurrected boom. However, the lingering bubble continues to pose a risk to the economy. Insolvencies and repossession actions are, and will remain, elevated compared to historical norms.

These conditions will not register a notable improvement until 2007, following a long period of historically-low real interest rates and robust, if not elevated, earnings growth. The threat of a housing market crash has lessened, but we are hesitant to applaud the renewed price growth. A boom would be counterproductive for the economy, as Britons already face a huge debt burden and an exaggerated price-to-earnings ratio. In this case, taking on further leverage in rapid fashion is the last thing the average household needs as it would only be storing up a bigger adjustment for later.

That said, we expect a relatively accommodative interest rate environment. Initially, we had forecast a further quarter-point cut in the benchmark rate, to 4.25%, in February. The most recent retail sales and earnings data – figures that the central bank had clearly tagged as its principal short-term determinants – suggest the authorities will sit tight and assess the pace of the recovery over the coming months. Nevertheless, we do not expect borrowing costs to rise until late in the year, when the rebound in private consumption has solidified and the labour market has stabilised. There is as yet little sign of the sort of energy price-induced inflationary wage growth that would prompt early tightening from the Bank of England.

BUSINESSES AND TRADE
Favourable interest rates, equity market gains, and robust profitability point to a gradual reversal of the recent soft patch in business investment. High input costs and limited pricing power are, however, eating into corporate earnings. As long as commodity and energy prices are high, firms, particularly in the industrial sector, are liable to put off hiring and investment.
Looking forward, the impact of high input prices will gradually ease and both domestic and euro-zone demand will continue to strengthen. The manufacturing sector will climb back out of recession early this year and continue on a slow growth footing through the first half. In the fourth quarter 2004, the orders sub-indices of the PMI both pointed toward firming demand. The export orders metric in particular strengthened, while domestic orders continued to seesaw.

Faster growth in the euro zone – Britain’s largest trading partner – will continue to boost foreign orders. In turn, this will feed through to higher export growth and industrial activity. Moreover, short-term volatility aside, we expect the pound to stabilise against the euro and weaken modestly vis-à-vis the US dollar over the next 12 months, buoying the price-competitiveness of exporters. Notably, however, this will also inflate import costs, which could put some upward pressure on the CPI and impinge on corporate profitability for those dependent on imported inputs.

The net trade sector will remain a net drag on real GDP growth, meaning that imports will continue to grow more rapidly than exports. As a result, the current account deficit will come to about £23bn in 2005, within a billion-and-a-half of the 2000 record. The red ink spill will retreat to just over £18bn in the current year, thanks to modestly more vigorous foreign sales growth.
The combination, however, of strengthening exports, principally to the UK’s EU trading partners, and reduced imports, this time from outside the Union, is gradually helping winnow Britain’s trade deficit. With the services surplus generally stable just over the £1.5bn mark, it has been the job of merchandise trade to drive shifts in the overall balance. In this respect, exports have grown steadily over the last half-year and hit a record-high monthly total in October. That said, the distortions caused by fraud identified by HM Revenue and Customs shed some doubt on the EU trade balance data, although the impact is likely relatively small compared to total sales.

Faster growth will boost foreign orders

THE FINAL WORD
The economy’s medium-term prospects are sound. The slowdown of 2005, although it will undermine growth through the first half of 2006, has been relatively short and there are no clear signs of recession outside the manufacturing sector. Moreover, the central bank has some margin in which to lower interest rates in order to boost domestic growth if such a move becomes necessary. The risks to this scenario – that domestic demand will improve more rapidly on account of a stronger housing market, or that it will flounder thanks to fragile household confidence or higher gas prices – are evenly balanced. In addition to the housing market, as highlighted above, the public sector finances are an additional source of medium-term risk.

According to the 2006/2007 Pre-Budget Report, total borrowing over the next half-decade will be almost £20bn higher than previously anticipated. The total tax burden has risen yet again, and with substantial unrealised spending commitments in the government’s public services improvement programme, further tax rises are expected. This will reduce private consumption growth and weigh on the economy’s long-term growth potential.

Paul M Guest is Senior Economist and European Editor at The Dismal Scientist
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