UK Economy - A fragile recovery

Economic outlook by Ruth Stroppiana, Chief International Economist, Moody’s Economy.com on the UK Economy

The UK economy has exited recession, but faces a slow and difficult recovery this year.
Households are unlikely to boost spending into the UK economy until they see improvement in employment opportunities.
Banks have started to relax lending criteria, but conditions remain tight.
Tight credit, weak hiring, and muted earnings growth will impede the housing market this year.

Moody’s Economy.com The UK economy has emerged from its longest and deepest recession on record. Real GDP rose 0.4% q/q in the fourth quarter of 2009 after shrinking a cumulative 6.2% in the previous six quarters. However, growth in the UK economy was mainly driven by government spending and a policy-induced rebound in consumer spending. The UK economy will struggle this year to evolve from a recovery based on government stimulus to a self-sustaining expansion. High-frequency data in the opening months of 2010 have been mixed, suggesting the recovery of the UK economy will be fitful in the near term.

Uncertainty about both the UK economy and the general election has dominated the start of the year, and there is growing focus on public finances. Costly fiscal stimulus measures and bank bailouts, combined with lower revenues, have dramatically eroded public finances. Opinion polls suggest the possibility of a hung parliament, which could complicate fiscal reform and further cloud the outlook of the UK economy. Britain’s policymakers face a difficult balancing act in addressing near-term challenges and long-term issues with the UK economy. Withdrawing government support too early risks depressing demand, hindering job creation, and scuppering the recovery. But delaying fiscal tightening measures for too long could sow the seeds of fresh financial market difficulties.

The outlook for the UK economy is for a slow increase in the pace of activity and a gradual transition to sustained growth. Real GDP growth will be weak through 2010, coming in just over 1%, well below the economy’s potential. The UK economy recovery will accelerate in 2011 and 2012 as the global economy picks up steam. Exports are expected to emerge as a key growth driver, garnering support from strengthening external demand and the weak trade-weighted pound, which has shed around 25% since the start of the financial crisis in mid-2007. The weak pound is expected to help reorient local production towards exports and import substitution, strengthen manufacturing, and reduce the trade deficit and the UK economy reliance on financial services.

Jobless recovery

Britain’s job market fared better than expected during the recession. Despite a record 6.2% peak-to-trough fall in output, unemployment has risen less than during previous recessions. However, the smaller-than-anticipated rise in unemployment has been accompanied by a record surge in the number of people of working age who are inactive. Meanwhile, the number of those employed continues to decline, as the only significant job creation has been in the public sector. During the recession, government employment substantially supported Britain’s labor market, adding jobs and raising wages as the private sector cut jobs and hours and froze wages. Looking ahead, public-sector spending cuts and layoffs will keep unemployment elevated in the medium term.

Moody’s Economy.com Whilst business confidence in the UK economy has improved markedly since the depths of the recession, business surveys show many firms still expect a protracted period of weak revenues. Firms also still report restricted access to credit, forcing them to keep a tight rein on costs, with negative implications for hiring. Households are unlikely to boost spending until they see an improvement in employment opportunities.

The combination of high unemployment, muted earnings growth, and rising interest rates will test British household finances through 2010 and keep upward pressure on loan delinquencies and defaults. Despite the pullback in the debt servicing ratio – the share of disposable income that households must devote to debt repayment – since the start of the recession, British households are only in the early stages of balance-sheet repair. UK households remain deeply indebted, with just under one-fifth of gross disposable income going towards debt repayments.

Given British households’ heavy debt burdens, they are not in a position to lead the recovery of the UK economy in the medium term. The bleak hiring and earnings outlook will remain a strong disincentive to borrow and spend through 2010. Any windfall stemming from low interest rates is likely to continue to be used to pay down debt. UK households are particularly vulnerable to a rise in mortgage rates, with mortgage-related debt accounting for over 80% of all UK household debt outstanding.

Rebound in house price will unravel

Moody’s Economy.com The UK housing market will face strong headwinds throughout 2010. Recent housing market data have been mixed. The upward trend in house prices since last summer has weakened substantially, and the housing market remains relatively depressed. Turnover is sluggish, and leading indicators such as mortgage approvals remain well below levels consistent with sustained house price growth.

A shortage of properties for sale underpinned the rise in house prices during the second half of 2009 and early 2010. Record-low mortgage rates last year dramatically reduced the share of household disposable income allocated to mortgage payments, easing pressure towards forced sales and curbing the supply of homes on the market.

Moody’s Economy.com However, the forces curbing the supply of homes are unlikely to persist. Higher mortgage rates will put pressure on distressed homeowners this year, increasing the supply of houses for sale and depressing house prices. Meanwhile, the weak labor market and higher income taxes will continue to weigh on mortgage demand.

Low affordability will also act as a drag on the UK housing market. Residential property prices relative to earnings, especially for first-time buyers, remain well above long-run averages. Restricted access to mortgage funding will also remain an obstacle to first-time buyers through 2010. While the government’s recent decision to double the stamp duty threshold for first-time homebuyers from £125,000 to £250,000 until 2012 will provide some support to buyers, further adjustment in house prices or solid earnings growth is needed to attract new purchasers and ensure a sustained recovery.

Downside risks still predominate

Considering the cooled consumer credit sector and the weak labor market outlook, the risks to consumption-driven sectors and the broader UK economy remain weighted to the downside. The UK economy outlook also remains complicated by concerns about fiscal finances. Regardless of the outcome of the upcoming general election, the party in power will be under pressure to withdraw the stimulus to reduce the deficit. As the UK economy recovery gains momentum next year, public spending will be slashed and taxes will be raised, weighing on growth. While the government and the Bank of England are expected to keep policy supportive until the risks ease and growth is more broadly based, both the government and households will be focused on repairing debt-laden balance sheets, making for a fitful UK economy recovery.

This commentary is produced by Moody’s Economy.com, a division of Moody’s Analytics Inc., which is engaged in economic research and analysis. This commentary is independent and does not reflect the opinions of Moody’s Investors Service Inc., the credit ratings agency. Both Moody’s Analytics and Moody’s Investors Service are subsidiaries of the Moody’s Corporation. If sourcing this article, please quote Moody’s Economy.com.

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