Britain Appears Recession-Bound
Every week brings ever gloomier news on the British growth outlook, and the "R-word" is now frequently used in discussions about Britain's economy. Falling house prices, tighter credit conditions for both businesses and households, falling global and domestic demand, rising food and commodity prices, and squeezed household disposable incomes all indicate that the brakes are being slammed hard on the economy. Meanwhile, public finances leave little room for the government to offer help, and the maneuvering room by the Bank of England (BoE) is limited by upside inflation risk.
Survey indicators point to a sharp slowdown in gross domestic product growth this year and next. According to Purchasing Managers' Index (PMI) data, both the large service sector and the manufacturing sector are now contracting, and construction activity is at a record low. The risk for recession, in the form of two consecutive quarters of negative growth, is looming.
We forecast second-quarter GDP growth of just 0.1% quarter-over-quarter (data due July 25) after a 0.3% quarter-over-quarter increase in the first quarter. If correct, this would be the softest reading since the second quarter of 1992, when growth fell by 0.1% quarter-over-quarter. Meanwhile, we expect the year-over-year rate to have slipped to 1.5% in Q2, versus 2.3% in Q1, which would be the weakest reading since the first quarter of 1993.
In addition, we see risk for negative growth in the third and fourth quarters. For 2008 as a whole we expect a mere 1.2% GDP increase, which would mark a significant slowdown from last year's 3.0% gain. We expect growth of just 1.0% in 2009.
The BoE Q2 credit survey, released July 3, showed that conditions are expected to tighten further in the third quarter. Corporate credit availability fell last quarter and is likely to fall further this quarter, and an increase in corporate defaults is anticipated. Meanwhile, households' demand for secured borrowing fell more than expected, according to banks, and a further decline in both demand and availability for secured borrowing is likely. Household secured lending defaults were higher than anticipated in the second quarter, according to the survey, and are expected to rise further in the third quarter. Overall, the BoE survey does not suggest any letup to the British credit-market turmoil, and falling credit availability will further restrain an already cooling economy.
On the demand side, the outlook for the main growth driver, household spending, is dire. Consumer spending contributed almost 65% of total growth in 2007, and harm to household confidence is likely to have a serious impact on overall GDP in 2008. Consumer spending held up well in the first quarter, rising 1.1% quarter-over-quarter, but we look for significantly softer figures for the second half of the year, with real quarterly growth close to flat.
Retail sales, one indication of overall household demand, turned out surprisingly robust in April and May, although some doubt has been raised over the quality of the data. Either way, we expect consumer spending growth to be subdued in the second half of 2008. Falling house prices, tighter credit conditions, record-low mortgage approvals, and rising food and commodity prices all are likely to make households tighten their purses. Indeed, consumer confidence is currently at an 18-year low, according to the monthly GfK index.
The household savings ratio was merely 1.1% in the first quarter, which marks the weakest reading since 1959 and compares with 3.0% in the fourth quarter of 2007. The drop demonstrates just how far consumer finances were already stretched at the beginning of the year. Meanwhile, real disposable income fell 1.0% quarter-over-quarter, which marks the largest quarterly drop since 1999. On the year, disposable income rose just 0.9%. Together, these data highlight the bleak outlook for consumer spending for the rest of the year.
Housing's Ripple Effect
The link between house-price growth and consumer spending is debatable, but it is clear the previous high level of activity within the housing market, fueled by Britons' obsession with climbing the housing ladder, has underpinned spending on household goods and furniture associated with purchases of new homes. As the property turnover rate now slows, with real estate agents reporting that both sellers and buyers have withdrawn from the market, spending on such items will decrease.
The cooling of the property market, both residential and commercial, will pull residential and business investment lower. Total investment growth fell 1.5% quarter-over-quarter in the first quarter and is likely to remain very weak throughout 2008 as credit is becoming dearer. Previously arranged credit lines have been fully tapped, and prospects for growth in credit are uncertain. Continued stock market turmoil is also likely to dampen the investment appetite of businesses.
Public spending growth is also likely to be tame given that tax revenue should be meager as economic activity cools, further deteriorating public finances. Continued elevated oil prices should offer some extra income from the fuel duties, however. The abolishment of the lower 10% income tax band was met with so much criticism that the government had to announce a slew of initiatives targeted at low-income families to compensate for the tax increase. Meanwhile the reduction of the basic income tax rate to 20% from 22%, as announced in last year's budget, was implemented in April this year.
The 2008 budget included public spending increases of 2.2% per year in real terms over the next three years, which is then set to slow to 1.9%. These estimates were based on highly optimistic growth forecasts of 1.75% to 2.25% for 2008 and 2.25% to 2.75% for 2009. Maintaining such spending levels would thus mean taking on higher public debt.
British trade is set for a gradual rebalancing as a weaker pound sterling should support export growth and dampen import demand. However, a global growth slowdown is likely to hurt the export industry, and so far this year the trade deficit has shown little improvement. Net export growth is unlikely to contribute much to overall growth this year or next.
A Service-Sector Contraction
As for the output side, PMI data suggest that the service sector, accounting for more than 74% of GDP (according to 2003 data from the Office for National Statistics, the latest available), contracted in both May and June. Production data showed that industrial production fell in May, and June PMI data showed a contraction.
Service-sector growth was 0.3% quarter-over-quarter in the first quarter, which marked the weakest gain recorded since 1995. Growth within the business-services and finance sector was just 0.2% quarter-over-quarter, which marks the weakest in six years. This rate is likely to have remained equally tame, or even softer, in the second quarter.
The finance and business-service industry accounts for about 28% of GDP, compared with 15% for manufacturing (according to 2003 ONS data). The impact from the credit crises, equity market slump, and subdued investor appetite on this industry will have implications for overall British growth. This subindustry also includes services such as insurance, accounting, law, advertising, real estate agencies, call centers, and job agencies, all of which are feeling the pain from the sharp cooldown in the property market and an uncertain labor market outlook.
Almost 50% of total consumer expenditure is directed toward services, and the service sector is likely to display continued weak growth as household spending deteriorates. This view was confirmed by the Q2 Confederation of British Industry (CBI) survey, which showed consumer-service firms with negative attitudes about business expansion over the next 12 months, with an above-average proportion citing the level of demand as a limiting factor (73%).
The industrial sector has gradually lost significance over the past few decades. And the long-term trend for domestic oil production is set for a decline as North Sea deposits dry up. Tighter credit conditions, increased competition from abroad, falling global demand, and squeezed profit margins from rising commodity prices will accentuate the slowdown in industrial production.
Producer price data indicate that businesses are feeling pessimistic about the strength of demand for their products. Unable to pass on recent commodity price increases fully, companies are now internalizing input price increases to the largest extent seen in at least 33 years, which is squeezing their profit margins. Industrial production fell 0.2% quarter-over-quarter in the first quarter, and we look for flat-to-negative quarterly growth figures for the remainder of the year.
The Q2 British Chamber of Commerce survey suggests that if the current trend continues, the British business sector is just one quarter away from a technical recession. The survey, released July 8, showed both services and manufacturing domestic sale indexes negative for the first time since the early 1990s, with the service home-sales index at its lowest since the third quarter of 1992 and the manufacturing index at its lowest since the fourth quarter of 2001.
Meanwhile, prices within the manufacturing sector were the highest since comparable records began in 1997, while prices in the service industry slipped marginally, though remained elevated. Profitability confidence within the service sector was the weakest since 1990, and for manufacturers this measure was its weakest since 1998.
Meanwhile, the National Institute of Economic & Social Research (NIESR), a British think tank, estimated GDP growth of 0.2% quarter-over-quarter in June, versus 0.1% in May. NIESR noted that "although quarterly falls in output are possible in the near future, it remains most unlikely that output in 2008 will be lower than in 2007."
It looks as if the British economy was still expanding in the second quarter, with consumer spending possibly having held up well enough to ensure overall positive quarterly growth. However, we expect negative quarterly GDP growth in the third quarter and the outlook for the fourth is bleak. Recession is a clear risk for the second half of 2008.
Despite this dire outlook, we expect the BoE to keep the repo rate steady at 5.0% well into 2009, as upside risk to inflation remains a serious threat. The inflation threat is thus limiting the central bank's ability to loosen monetary policy to boost growth, suggesting a tough couple of years for Britain.