The UK Chancellor of the Exchequer may have turned down an invitation to perform a duet with Jeffrey, the R&B-singer with whom he shares a surname, after President Obama got his Osbornes mixed up in June. But in the last few weeks, George Osborne may have been tempted to sing chirpily in his bath, as one of his predecessors was famously reported to have done following the UK’s exit from the Exchange Rate Mechanism in 1992.
In an unguarded moment, Chancellor Osborne may even have been tempted to echo the same predecessor and point to the emergence of some green shoots of recovery. He has, after all, had almost an embarrassment of good news to digest recently, which began in June when the IMF revised its growth forecast for 2013 from 0.7% to 0.9%.
The flow of good news accelerated in August, when the Office of National Statistics (ONS), announced that second quarter growth came in at 0.7% rather than the 0.6% it estimated in July. In the same period, employment rose by 80,000, with the private sector creating three times as many jobs as were lost in the public sector, according to the Confederation of British Industry (CBI). Construction orders jumped by 20% between April and June. Activity and orders in the manufacturing sector are rising at their fastest clip for 19 years. Retail sales are up. So are exports.
It amounts to a cocktail of good news that seems to have caught most forecasters on the hop. “I’m not aware of anyone who foresaw the speed with which the economy seems to be recovering,” says Jamie Dannhauser, director in the research group at Lombard Street Research in London.
Others agree. “The main theme has been the surprising strength of the incoming data,” says Melanie Baker, UK economist at Morgan Stanley. That data, she adds, has recently led Morgan Stanley to revise its forecast for GDP growth in 2014 from 1.4% to 2.4%, leapfrogging the CBI’s forecast for next year, which has recently been lifted from 2.1% to 2.3%.
RBC is also forecasting growth of 2.4% in 2014. “The economy has turned the corner, and I expect the recovery to be sustainable,” says Jens Larsen, chief European economist at RBC Capital Markets in London. “But the growth rate will still not reach the levels we would have regarded as sustainable before the crisis, which would have been in the range of 2.5%-3%.”
Stanley’s Baker foresees sustainable growth underpinned by rising productivity without stoking much in the way of inflationary pressures. “We see a virtuous circle developing in the economy with a simultaneous pick-up in demand, supply and credit conditions,” she says, arguing that as it is largely a cyclical rather than a structural phenomenon, productivity growth should accelerate as the economic recovery gathers pace.
“This suggests that there is less need to worry about the risks of underlying inflationary pressures building in a recovery, compared with our previous concerns,” says a recent Morgan Stanley analysis of productivity in the UK. If the Morgan Stanley prognosis is correct, it should have significant implications for the sustainability of the UK’s equity market, given that will support rising corporate profits. Tellingly, Morgan Stanley has recently lifted its year-end target for the FTSE 100 from 7,000 to 7,170 — suggesting there is scope for a rise of almost 10% over the next three months.
Productivity problem
Baker’s qualification about the productivity outlook is an important point, because Bank of England governor, Mark Carney gave a muted assessment of the outlook for productivity growth in August, forecasting annual growth of 1.8% for the next three years, which is still below its pre-crisis trend of 2.2%. “While even that modest productivity is not assured, it is hardly an aggressive forecast,” said Carney. “It implies that productivity reaches its 2008 level only in 2015. And it means that productivity doesn’t catch up any of its current 15% shortfall relative to its pre-crisis trend.”
“Our outlook is certainly not without risks,” says Baker at Morgan Stanley. “If we’re wrong on the productivity story, it changes the whole complexion of the UK recovery.”
For the time being, however, the consensus among economists is more upbeat than it has been for many years. Indeed, the marked turnaround in the fortunes of the UK economy has given the Bank of England sufficient confidence to stick at £375bn of quantitative easing (QE), rather than to twist for an additional £25bn.
The revival of the economy, however, has also given rise to increasingly vocal misgivings about some of the policies that were originally designed for a patient in intensive care.
Some of these stimulants, it is argued, are looking less and less appropriate now that the patient is out of bed and threatening to start cart-wheeling down the corridor.
The fiercest criticism has been reserved for the government’s Help to Buy scheme announced in the March 2013 budget. Designed to kick-start demand in the housing market, this three year scheme is divided into two parts: an equity loan component and a rather more controversial initiative that will provide some £130bn of guarantees for up to 15% of loans for purchases of homes worth a maximum of £600,000.
One of the reasons the scheme is regarded by many as hare-brained is because it doesn’t appear to take into account wild differences in affordability across the UK’s wonky property market. Most residents in the posh parts of London like Kensington and Chelsea don’t need help to buy property or anything else. But if they did, the government’s scheme wouldn’t get them very far, given a median house price in the borough of £965,000, according to the This is Money website. In the northern towns of Burnley and Stoke, by contrast, it is a little under £64,000.
More broadly, however, the Help to Buy idea has been lambasted by those — even within the UK’s governing coalition — who argue that it is likely to engender an unsustainable house price boom and even a miniature US-style sub-prime crisis.
Housing help
But Baker says that Morgan Stanley is positive on the Help to Buy scheme. “We think there will be a supply response that will be bigger than the market expects, and we also believe it could ultimately act as a powerful macro-prudential defence against future bubbles,” she says.
Morgan Stanley has estimated that, encouraged by the initiative, the UK could see a 30%-40% increase in new housing starts by 2015 on 2012’s levels.
Trevor Williams, chief economist, Lloyds Bank Commercial Banking, is also relaxed about the impact that the scheme may have on house prices. “House price inflation in real terms is still significantly below its peak, and in some parts of the country it is even declining,” he says. “The national average is distorted by the high prices in London, but the picture is more mixed than the headlines suggest.”
Opinion about another stimulant, the Funding for Lending scheme (FLS) introduced in August 2012 to boost lending to households and companies, is mixed. According to the Bank of England’s latest numbers on the FLS, in the second quarter of this year 18 participants made drawdowns of £2bn, bringing the total of outstanding drawdowns under the scheme to £17.6bn from 28 lenders. That is a far cry from the £70bn that was originally set as the upper limit when the scheme was announced, and perhaps explains why the programme was modified to incentivise banks to increase their lending to SMEs.
In its most recent update on FLS, the Bank reports that “there is evidence that the price and availability of lending to businesses has improved since the scheme began and this trend has continued in recent months.” Lending still has some way to go, however, before it comes close to pre-crisis levels. Having risen by 16.8% in 2007 and 18% in 2008, lending to UK businesses slipped back by 1.8% in 2009, 7.1% in 2010, 3.3% in 2011 and 3.1% in 2012. “Although there are tentative signs that the pace of bank balance sheet restructuring may be lessening, credit flows remain moribund,” Barclays cautioned in a recent note.
It may not have generated the volumes that its most enthusiastic advocates were hoping for at its launch, but economists say the FLS has had a beneficial effect on credit conditions in Britain.
“One of the reasons that bank funding costs are so low is that they have had access to FLS,” says Larsen at RBC. “The reason banks are going through such an extensive period of balance sheet restructuring is not shortage of liquidity. Capital requirements and pressures on profitability have been the main constraints on bank lending.”
The recent rise in Gilt yields is a reflection of a range of influences, led by the global response to tapering in the US. But economists say longer term rates in the UK may also reflect a view that monetary tightening may be required sooner than had been expected earlier this year.
This is why some are even questioning the suitability of the new governor’s signature tune, forward guidance, given the apparent volte-face in the UK’s economic fortunes. Forward guidance, or ‘conditional commitment’, refers to the commitment of the Bank of England’s Monetary Policy Committee (MPC) to holding policy rates at 0.5% until GDP growth accelerates to the point where it brings the UK unemployment rate below 7%.
It’s a knockout
There are, however, three knockout clauses that would trigger a tightening in monetary policy before the 7% target is reached. All bets would be off if the MPC reckons inflation looks like reaching 0.5% above target over a 10-24 month period, or if medium term inflationary expectations become dislodged.
Monetary tightening could also be brought forward if the Bank of England’s Financial Policy judges that low rates pose a threat to financial stability by fuelling asset bubbles or excessive leverage.
For now, none of these knockouts look imminent, but some say that the credibility of forward guidance is already coming into question. “Recently markets haven’t been buying into the guidance story, which is a worry,” says Dannhauser at Lombard Street Research. “My hunch is that over the next few months the MPC will try hard to talk down rates and the pound and contain the upward move in yields.”
Certainly, in his first speech as governor, delivered at the end of August, Carney gave three reasons why he still believes it will be a while before unemployment reaches the 7% threshold which will trigger a rise in rates. The first, he said, is that the Bank’s projections for growth are “solid not stellar”.
The second is that although a fall from the current level of around 7.7% to 7% may look achievably modest, it would mean that well over 750,000 new jobs would need to be created, with the responsibility for doing so falling squarely on the shoulders of the private sector. That will be a tall order.
The third, Carney warned, is that a recovery in growth does not necessarily filter through to faster job creation. That may be a legitimate caution. Witness concerns over what some have called the jobless recovery in the US.
Economists appear to agree with Carney that a rapid decline in unemployment towards the 7% level looks unlikely. “Unemployment has been roughly unchanged for the last four years now,” says Williams at Lloyds Bank. “One of the reasons for believing unemployment is unlikely to fall to 7% is that one of the consequences of having stable or growing employment at a time of falling or stagnant output is that labour productivity plummets. As output picks up, firms will aim to generate more productivity from their existing staff before they start thinking about adding to their labour force.”
One extreme manifestation of this pursuit of productivity gains from companies’ existing labour resources has been the increase in the number of employees working on zero-hour contracts, which the Office of National Statistics (ONS) puts at 250,000.
There are several reasons that Carney is right to be cautious about growth and employment, say economists, particularly when it comes to the UK’s main trading partners. Another dip in European economic performance could be especially damaging.
UK’s ‘lost year’
Another is that although the government has made considerable political capital out of the recent encouraging data, the recovery is a fragile one which comes from a very low base, following what the Institute for Fiscal Studies (IFS) describes as a “lost year” for the UK economy in 2012.
“The marked improvement in recent economic performance is no reason for George Osborne to declare victory,” says Dannhauser at Lombard Street Research. “One or two quarters of strong data does not make a recovery.”
The strong performance of the last few months has only succeeded in clawing back some of the losses of recent years, making for unflattering comparisons between the UK and its main trading partners. “Construction activity is still 16% below its pre-crisis peak and production is 10% below its peak, while services have just got back to where they were in 2008,” says Williams at Lloyds Bank. “As for the economy as a whole, it is still about 3% below its 2008 peak, compared with 5% above the 2008 level in the US and 4% higher in Germany.”
One explanation for the weakness of the UK’s recovery, Williams adds, has been the deleveraging of households in recent years.
“At its peak, UK household debt was approaching 180% of GDP,” he says. “It has now come down to about 140%, which is a sharper fall than in any other industrialised nation. There is now scope for households to start spending again, which is partly why recovery is underway, although some would argue that debt is still uncomfortably high.”
The weakness of the recovery to date comes in spite of the fact that government spending has risen, meaning that the economy would have been weaker without it. That does not bode well for cuts set to take effect in the near future.
“We shouldn’t underestimate how material the public sector cuts that still have to kick in will be,” says Dannhauser. “Putting the debt ratio on a sustainable course is going to require very large fiscal tightening. So the big picture is that the public finances still have years and years of austerity to go through before they are back into shape.”