EY ITEM Club. Winter forecast. January 2014

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1 EY ITEM Club Winter forecast January 214

2 Contents Contents Highlights The lop-sided recovery 2 Introduction 4 Forecast in detail 16 Fiscal Policy 17 Monetary Policy 18 Prices and Wages 19 Activity 2 Consumer Demand 21 The Housing Market 21 The Company Sector 22 The Labour Market 23 Trade and the Balance of Payments 24 EY is the sole sponsor of the ITEM Club, which is the only non-governmental economic forecasting group to use the HM Treasury model of the UK economy. Its forecasts are independent of any political, economic or business bias. EY i

3 Contents Highlights The lop-sided recovery EY 2

4 Highlights The lop-sided recovery Highlights The lop-sided recovery The economy is strengthening and we expect GDP to grow by 2.7% this year after 1.9% in 213. However, this recovery it is almost entirely based on the housing market and the high street, a momentum will be hard to sustain for much longer given continued pressure on real incomes. The rapid expansion of employment has boosted consumer confidence and families that have been putting money away for a rainy day are now happy to spend this. The saving ratio has already fallen from 7-8% after the crunch to 5%, arresting the fall in the debt/income ratio. But any further fall in the saving rate would mean that this ratio will start to rise again, reversing the gains of recent years. The labour market is being affected by immigration, late retirement and government cuts, making this recovery very unusual. These extra workers have priced themselves into jobs, pushing up employment while depressing real wages and productivity. Remarkably, unemployment has been falling as this huge increase in supply has occurred. Projections for the next two years suggest that employment growth should remain strong. Real wages and productivity should recover slowly as the demand for labour picks up and earnings at last overtake prices. But the effect of these supply shocks on the economy is hard to predict, adding to the uncertainties faced by the MPC. The MPC should not think about raising base rates until real wages start to rise and the recovery broadens out into exports and investment. Business confidence and investment intentions have recovered nicely and world trade is picking up momentum. But we do not see exports and investment kicking in until 215 and have pencilled in the first base rate rise for the autumn of 215, the other side of the election. Last year's economic forecasts were overtaken by the rapid recovery in consumer spending. But with budgets still under pressure, any positive surprises in 214 need to come from the business sector. EY 3

5 Introduction EY 4

6 Introduction Introduction The latest national income data release left the Q3 growth rate unchanged at.8%, but boosted the estimates for earlier quarters and revealed even more starkly how dependent the recovery has been upon the household sector. These revisions were to data that predate the revival in the mortgage and housing markets and underline the importance of the strong growth in employment in boosting job security and consumer confidence. The labour market However, real wages have continued to fall despite the strong demand for labour and the long-awaited fall in inflation. Employment reached a record 3.1 million in the three months August to October, an increase of 485, on the year and nearly a million over two years. Unemployment fell by a quarter of a million over this period, indicating that the UK labour force has increased by three quarters of a million in two years. Over this period, the annual rate of CPI inflation has fallen from 4.7% to 2.%, but the effect of this has been blunted by the fall in earnings inflation, from 3.2% to around 1%. The deceleration in earnings growth has been most evident in the public sector, but has been apparent in the private sector too. is experiencing an unprecedented series of positive supply shocks The continued subsidence in real wages is proving to be the governments Achilles heel and could indeed prove to be the weak spot in the recovery. Consumers cannot continue to drive growth for much longer without a recovery in real wages. So far they have been happy to finance this by reducing the saving rate, which has come down from 7.9% in the first half of 212 to 5.4%, but the scope for further falls is limited. A saving rate of 5% just stabilizes the debt/income ratio, so further falls would mean a rising ratio, reversing the deleveraging drive seen since the financial crisis. pushing up employment It is hard to find another episode in which employment has been rising and wages falling for any significant period of time. Historically, shocks have tended to affect the demand rather than the supply of labour, moving employment and wages in the same direction. In contrast, the current conjuncture seems to be the result of series of positive influences on the supply of labour which have depressed real wages as people priced themselves into jobs. while depressing real wages and productivity It is not hard to identify some of the influences that are at work. Immigration is another thorn in the government s side. Besides its social and political impact, it weakens the bargaining power of native workers and undermines real wages. Globalisation hits workers indirectly as cheap imports put their employer under pressure. Older workers are delaying retirement, swelling the workforce and adding to the downward pressure on remuneration. The coalition s payroll and benefit cuts and the crackdown on benefit fraud have similar effects on employment and wages. EY 5

7 Introduction Figure 1: UK: Average earnings & inflation Source: ITEM Club % year Average earnings CPI Forecast Source : ITEM Club Figure 2: UK: Unemployment Source: ITEM Club % ILO Claimant count 1 Forecast However, economic data are notoriously difficult to interpret and often allow rival explanations. The recent fall in real wages has coincided with a fall in productivity and some commentators have argued that this explains the fall in real wages. On this thesis, the UK has been hit not by a series of positive labour supply shocks that have driven down the real wage and hence productivity, but by a series of negative output supply shocks that have hit productivity and hence the real wage. Unlike the US, which saw a brutal adjustment in property, credit and labour markets which allowed them to clear away the debris of previous mistakes and move on, the UK cushioned these markets and delayed these adjustments. Consequently, the UK is supposedly locked into a low-productivity low-wage equilibrium, haunted by zombie banks, firms and households. Historically, there is a very tight relationship between real wages and productivity, so this coincidence should not come as a surprise. But has the fall in productivity caused the fall in the real wage or does the causality run the other way? EY 6

8 Introduction Figure 3: UK: Productivity and real wages Source: ITEM Club 2 = Output per head.9.8 Real wage Productivity is classically explained in terms of a trend and cycle model. The secular uptrend in real wages and productivity is seen as the result of technical progress, which boosts factor productivity on a permanent and arguably irreversible basis. It is obviously hard to explain a systematic decline in productivity using this model. A shortage of finance and working capital could reduce efficiency within a single firm, but you would be hard pushed to think of other factors that could have this effect. Compositional effects, like the decline of high productivity and high wage sectors like the North Sea, can account for part of the fall in productivity but this still leaves most of the recent fall to be explained. While we would accept that these factors have contributed to the recent decline in UK productivity - and indeed drew attention to the contrast with the US experience this time last year - we are inclined to view the labour supply theory as the more relevant. It provides a straightforward explanation of the decline in real wages and the growth in employment. The fall in the real wage also helps to explain the weakness of business investment. On the other hand, adverse output supply shocks tend to push up inflation and unemployment as they did in the 197s, but inflation and unemployment are now thankfully falling. Immigration is boosting the labour force Let s take a look at the way these labour supply influences are evolving. EU immigration is the first on the list, with Bulgaria and Romania in the headlines at the moment. The chart shows the wave of immigration from Poland and the other 7 countries that joined the EU in 24. The financial crisis broke this wave in 27, but it has since picked up momentum, adding nearly 4, to the workforce since the end of 29. So far, immigration from Bulgaria and Romania has been relatively small, but this is likely to increase now that restrictions are removed. It is significant that immigration from the core EU 14 states has picked up since the Euro crisis, increasing the UK labour force by 13, over the last two years. The total number of EU-born workers in the UK increased by 18, over this period. The number of non-uk residents work in in the UK increased by 32,. EY 7

9 Introduction Figure 4: EU-born workers in the UK Source: ONS Millions EU14 EU8 Romania & Bulgaria but late retirement and benefit cuts are more important Youth unemployment is also on the political agenda. Actually, it was increasing well before the recession struck. However, the strength of the demand for labour is at last making inroads to this. At the other end of the age range, workers faced by a collapse in annuity rates due to longevity and falling bond yields are remaining in the workforce for much longer. The move towards early retirement, which reduced participation by the 5-64 year age group during the 199s, has now been reversed. Despite the burgeoning numbers of older workers, the number of 5-64 year olds that are economically inactive due to retirement has fallen by 232, over the last two years. Meanwhile, the numbers of over 64s in work have increased by 28,. Figure 5: UK: Status of year olds Source: ITEM Club UK: Status of year olds Millions 5 4 Employed 3 2 Inactive (including education) 1 Unemployed Source : ITEM Club EY 8

10 Introduction Figure 6: UK: Status of 5-65 year olds Source: ITEM Club UK: Status of 5-65 year olds Millions Employed Inactive (including retirement) 2 1 Unemployed Source : ITEM Club Later retirement has quietly added more to the labour force than immigration has over the last two years. Moreover, unlike immigration, which tends to hurt native workers at the bottom end of the earnings scale, its effects are felt right across the board, with prospects for responsibility and remuneration held back across a wide range of occupations and age groups. The government s benefit cuts are having a similar impact and are likely to continue well into the next Parliament if the Conservatives win the election. They come hot on the heels of the Labour government s push to get people off welfare and back into work. This package included a concerted and remarkably successful campaign to get teenage pregnancy rates down. Single parents have all been encouraged to find employment. The number of lone parent households has practically halved, from close to a million in 1997 to just over half a million currently. The numbers on Incapacity Benefit rose under the first Labour administration, but had stabilized by 23. In October 28 Incapacity Benefit and Severe Disablement Allowance was replaced by Employment and Support Allowance and subject to more stringent medical assessments. The numbers receiving these benefits have since fallen by 15,, with 13, coming off this benefit over the last two years. The total number of working age people receiving out of work benefits has fallen by 287, over the last two years, with most of these being deemed fit rather than unfit for work. Figure 7: Out of work benefits Source: DWP UK: Out of work benefits Millions 6 Lone parent Employment & Incapacity 5 Other income related Jobseekers These trends are likely to persist All in all, these calculations would suggest that EU immigration; delayed retirement and benefit reforms increased the potential UK workforce by over a million in two years. Adding in the 325, redundancies seen in the public sector over the last two years, suggests an increase of well over a million in the EY 9

11 Introduction numbers available for employment in the private sector. The impact of these additional workers is likely to have persuaded others to leave the labour force. These estimates are gross of any such displacement effects and overestimate the net impact. However, as we have seen the labour force has increased by three quarters of a million. Source: ONS, Item Club Inflows to the private labour pool (thousands) Estimate Forecast Basis of estimate Immigration 32 3 Increase in non-uk residents in work Late retirement: 5-64s Increase in active numbers Over 65s Increase in numbers in work Benefit cuts Fall in recipients of out of work benefits Govt. redundancies Fall in payroll Total (gross of any displacement effects) It is remarkable that the labour market has accommodated this increase without a rise in unemployment. Some of these individuals will have lacked skills and motivation initially, but others will be highly skilled and enthusiastic. Indeed, the biggest area of recruitment has been seen in the Professional, Scientific and Technical industries, which added 136, to payroll in the last year and 191, over the last two years. This sector has superseded financial services as the biggest growth area in the economy not just for jobs, but also for output and exports. Figure 8: UK: Public sector share of total employment Source: Haver Analytics % EY 1

12 Introduction Figure 9: UK: Change in workforce jobs, year to 213/Q3 Source: Haver Analytics s Wholesale & retail Real estate Prof & science Admin & Education Health Other jobs support but their effect on the economy is hard to predict Not all of these people will have found jobs yet. However, these factors have probably increased private sector employment by around 3% over the last two years. The standard model of output and employment would suggest that with investment fixed, this would increase private sector output by 2% and depress the marginal product of labour and hence the real wage by 1%. It would thus go a long way to explaining the developments we have witnessed in output and labour markets over the last couple of years. Moreover, the implications for the long run growth of productive potential would be very significant were these trends to persist for any length of time and it seems unlikely that these trends will level off soon....adding to the uncertainties faced by the MPC The implications for monetary policy are also very significant. Forward guidance has been couched in terms of the unemployment rate, and for good reason. Excess supply in the labour market is also reflected in part time working and temporary jobs, but the unemployment rate it is nevertheless a reasonable indicator of the amount of slack in the economy. Together with indicators of vacancies and skill shortages, it should give an early warning of emerging wage pressures and the need to tighten monetary policy. Unemployment also affects job security, consumer confidence and spending, all of which have improved as the labour market has strengthened. However, real wages are also important in this respect and have not shared in the recovery. If the recent trends continue then it is likely that the unemployment rate will fall below the MPC s 7% very soon, well before real earnings growth picks up. This would leave a fragile recovery, heavily dependent upon the consumer s willingness to dip into savings. This makes it important for the MPC to revise the 7% unemployment threshold as soon as possible. It has been suggested that they could reduce the threshold to the FOMC s 6.5% rate. However in our view it would be important to supplement any new unemployment guideline with a requirement for positive real earnings growth. It will also be important to see a significant contribution from net trade and investment. To raise interest rates before the uncertainties about the labour market begin to resolve themselves and before these supports bed in would be premature in our view, putting the recovery at risk. Fortunately, inflation has come back to the target, vindicating the MPCs refusal to raise rates in the face of the adverse shocks of That gives the committee time to assess the situation and wait for the recovery to move to a more secure footing. The forecast shows the consumer continuing to support growth The forecast sees the recent pace of growth moderating slightly in 214, with quarterly increases of around.6% instead of.8%. However, this will be enough to push the annual growth rate up to 2.7%, from 1.9% in 213. EY 11

13 Introduction This growth is driven largely by the high street and the housing market, helped by the continued expansion of employment and the fall in inflation. Energy prices went up in December, but are being pared back by the recent relaxation of the government s drive for energy conservation. Price increases for food and clothing have moderated considerably as world commodity prices have fallen. They will remain low in 214, helped by the recovery in the exchange rate. Factory gate inflation is negligibly low, held back by import prices and the subdued rate of wage inflation. Assuming that oil prices remain at $11 a barrel or below, CPI inflation should fall well below the 2% target this year. Unemployment falls below 6.5% by the final quarter of this year, but we think the MPC will wait for the recovery to strengthen before increasing base rates. We have pencilled in the first base rate increase for the third quarter of 215. but this push cannot continue for much longer As we saw in 213, falling inflation can help to keep earnings growth low. Nevertheless, we expect average earnings growth to overtake price inflation over the next few months. With the labour force and employment continuing to grow strongly, real disposable incomes increase by 2.7% in 214, after standing still in 213. The forecast shows that this will allow consumption to grow by 2.6%, while keeping the saving rate stable. The saving rate fell back to 5.2% in 213 from 7.2% in 212, as consumer confidence bounced back and the pace of retrenchment slacked. The growth in disposable income and consumption eases slightly in subsequent years as inflation picks up and the growth in the labour force and employment growth moderates. With employment and hours broadly keeping pace with output, this forecast implies that productivity will pick up very slowly. Figure 1: UK: Savings ratio Source: ITEM Club % of disposable income 9 8 Forecast As ever, rising real incomes and consumer confidence go hand in hand with a stronger housing market, supported by the recovery in the mortgage market and Help to Buy. Our forecasts for housing transactions and house price inflation remain very bullish. Our optimistic housing investment projections are fully supported by recent developments, with the ONS reporting that new orders for housing increased by 41% in the year to the third quarter. The forecast sees housing investment overtaking its 26 peak by 217. EY 12

14 Introduction Figure 11: UK: Construction orders new housing Source: Haver Analytics bn, 25 prices Figure 12: UK: House prices & transactions Source: ITEM Club Prices, % year 3 The ITEM Club forecast for the UK Economy, Winter Source : ITEM Club Transactions (RHS) Prices (LHS) Transactions, s 5 Forecast 45 % changes on previous year except borrowing, current account and interest & exchange rates GDP Domestic Demand Consumer spending Fixed investment Exports Imports Net Govt Borrowing(*) Current account (% of GDP) Average earnings CPI 3-month interest rate Effective exchange rate EY 13

15 Introduction The ITEM Club forecast for the UK Economy, Winter % changes on previous year except borrowing, current account and interest & exchange rates (*) Fiscal years, as % of GDP Source: ITEM Club without help from investment and exports As we have argued, consumers are not in a position to lead this recovery much further. This has to be driven by exports and investment, which remain very disappointing. Net trade made a modest contribution to GDP in the first half of last year, but then subtracted 1.2% from GDP in the third quarter. Business investment increased by a meagre 2% in the third quarter, after falling by 5.2% over the previous year. There is still plenty of spare capacity and slack in the labour market and it would be unrealistic to expect a strong bounce in investment until growth makes serious inroads into this. Nevertheless, business confidence has recovered nicely and we are now seeing this work through to investment intentions. Business to business activity is very strong, as are lead items like spending on advertising and vehicles. Transactions flow and dividend payments are also recovering from the punishment they suffered during the panic over the Euro. We are forecasting investment increases of 5.% in 214 and 9.3% in 215, but these are modest by the standards of previous recoveries and when set against the very strong cash balances enjoyed by UK plc. Figure 13: UK: Confidence in profitability Source: BCC % balance Service sector Manufacturing sector Figure 14: UK: Investment intentions Source: BCC % balance 4 3 Service sector Manufacturing sector Prospects for North American markets have brightened considerably over the last year and the major European market now appears to be in recovery. Growth in the emerging markets has subsided, but EY 14

16 Introduction these nevertheless remain the major target for future export growth. In the forecast, export volumes grow by 3.3% in 214, followed by increases of 5% or more in subsequent years, just ahead of import growth. The current account returns to surplus in 217, helped by a modest improvement in the terms of trade, underpinned by the weakness of non-oil commodity prices and the recent recovery in sterling. We expect the strength in the exchange rate to fade in 214 as other economies pick up steam, without seriously impeding UK exports. while the prospects for business spending remains a major uncertainty Companies are already contributing to the recovery in terms of employment but we really need to see wage rates picking up and investment and dividends moving up sharply. However, there is a good chance that the company sector could surprise us on the upside. Business spending has been held back by risk aversion on the part of managers and investors and the revival in in business confidence could push acquisitions and investment up strongly. EY 15

17 Introduction Forecast in detail EY 16

18 Forecast in detail Forecast in detail Fiscal Policy The stronger than expected acceleration in economic growth through 213 has started to generate an encouraging improvement in the public finances. This strength has been mainly observed in its impact on tax receipts, in particular VAT and stamp duty, which have been boosted by the strong recoveries in consumer spending and the housing market. This has led to central government receipts running just over 3% ahead of last year s level over the first eight months of the financial year, once the distortions caused by the transfers from the Asset Purchase Facility and the Swiss capital tax are excluded. Stronger activity has also had a modest impact on central government spending, which has risen by 1.8% over the first eight months of the financial year, a little lower than the OBR s full-year forecast of 1.9%. The impact has mainly come through lower levels of unemployment, which has reduced spending on social benefits. Figure 15: UK: Public sector net borrowing Source: Haver Analytics UK: Public sector net borrowing bn 12 Cumulative position bn Fiscal year 12/13 OBR forecast 13/ Fiscal year 13/14 2 Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Source: Haver Analytics The improved outlook led the OBR to make substantial revisions to their forecasts for the public finances, when they were published alongside December s Autumn Statement. They now expect Public Sector Net Borrowing (PSNB) excluding APF transfers and the Royal Mail to total 111.2bn in , down from their March 213 forecast of 119.8bn. There is scope for borrowing to come in even lower, given the recent history of departmental spending coming in below budget and the likelihood that the OBR s rather conservative short-term forecasts for economic growth will be exceeded. Beyond the current financial year, we expect borrowing to continue to steadily decline, as a strengthening recovery underpins a pickup in revenue growth and reduces spending on the automatic stabilisers, such as unemployment benefits. Our forecast assumes that the government will broadly keep to its announced departmental spending plans and, given that these plans involve substantial cuts in real terms, this will also help to rein in the deficit. We expect PSNB to have fallen to just 25bn by This is similar to the OBR s forecast and is consistent with the Chancellor balancing the cyclically-adjusted current budget, based upon the OBR s forecast for the output gap. EY 17

19 Forecast in detail Monetary Policy We are fast approaching the point at which the Monetary Policy Committee (MPC) will have to make a decision about the future of its forward guidance policy. The policy had been intended to reassure households, firms and markets that Bank Rate would remain at.5% for a prolonged period. However, the economy and, in particular the labour market, have improved so quickly that we expect that unemployment will reach the 7% threshold for forward guidance in early-214, more than two years earlier than the Bank had forecast when it introduced forward guidance. Recent soundings from the MPC have given the impression that they would like to keep rates on hold for as long as possible, so we expect Bank Rate to remain at.5% throughout this year, even if the 7% threshold is reached. The Bank is likely to lower the threshold, to 6.5% or even 6%, and could supplement it by linking it to other variables, such as real wages. Since the Federal Reserve announced that it was starting to taper its asset purchases, long-term interest rates have risen, albeit to a much lesser extent than last summer. With the UK economy also having continued to perform strongly, 1-year gilt yields have edged upwards, moving from an average of 2.79% in Q4 213 to in excess of 3% in January. We expect yields to continue to nudge upwards over the coming year as the recovery gains momentum. Figure 16: UK: Long-term interest rates Source: Haver Analytics % UK long-term interest rate German long-term interest rate Source: Haver Analytics Figure 17: UK: Sterling Source: Haver Analytics US$/ Euro/ The pound strengthened significantly over the latter part of 213. In part this reflected the relative weakness of the dollar, but it was also a function of the UK s strong growth performance and market expectations of an earlier tightening of monetary policy. Moving forwards we expect the pound to lose some of its strength against the dollar as US growth prospects improve and the Fed steadily ratchets up EY 18

20 Forecast in detail the pace of tapering. However, stronger relative growth prospects should underpin greater resilience against the euro. The MPC will be watching developments closely, having expressed its concern about the potential impact of a stronger pound on growth. Prices and Wages Inflationary pressures cooled over the latter months of 213, with CPI inflation finally moving back to the 2% target for the first time in four years in December. The slowdown in inflation was largely a function of base effects; big rises in food prices in the autumn of 212 were not repeated last year and increases in domestic energy bills, while still very large, were also lower than in the previous year. In addition, the impact of higher university tuition fees was smaller in 213 than in 212, which also helped to slow inflation a little. Figure 18: UK: Inflation Source: Haver Analytics % year CPI 2 2% inflation target Source: Haver Analytics But there has also been a slowdown in underlying or core inflation; December s reading of 1.7% for CPI excluding food, energy, alcohol & tobacco was the lowest for more than four years. We attribute this to the combination of a large output gap, which continues to keep wage growth constrained and profit margins under pressure, and the influence of a stronger pound which has reduced the price of imported commodities. There would appear to be little sign of any pickup in inflationary pressures in the short-term. There is no evidence of any pressures in the supply chain, with producer output price inflation having slowed to less than 1% over the past few months. Similarly oil prices have been trading at a little under $11 per barrel over the past few months, in line with the average for 213 as a whole in dollar terms but, because of the appreciation of sterling, around 4% lower in sterling terms. The benefits are being seen at the pumps, with retail petrol prices currently around 3 pence per litre lower than over 213 as a whole. We expect oil prices to slip back through 214 as supply increases strongly, particularly from North America, and while the pound is likely to weaken against the dollar as the US economy accelerates, we still expect petrol prices to be broadly flat through 214. Underlying inflationary pressures are also likely to remain soft. We estimate that the output gap remains large and will continue to bear down on margins and wages pressures. Such weak underlying pressures should push inflation below the 2% target during the early months of 214; our forecast shows CPI inflation dropping from 2.6% last year to average 1.8% in 214. As the recovery becomes more firmly entrenched and spare capacity is eroded, margins and earnings are likely to recover and generate a steady pickup in underlying inflationary pressures. However, these will be partially offset by the impact of higher university tuition fees falling out of the calculation in late- 215, which will have added around.3-.4ppts a year to inflation rates over the period. We expect CPI inflation to average 2.3% a year from EY 19

21 Forecast in detail Activity As we begin 214 the growth outlook is much improved compared with a year ago. In part this reflects some sizeable upward revisions to previously released data, but it is also a function of the stronger than expected pickup in activity through 213. The economy grew by.8% in both Q2 and Q3 and business survey data point to a similar rate of growth in Q4. This would take GDP growth for 213 as a whole to 1.9%, which would be the strongest since 27. But while the headline figures have been encouraging, the detail has been less positive. Thus far the recovery has been very narrowly focused on the consumer and the housing market, with around 1.6 percentage points of the 1.9% GDP growth in 213 estimated to have come from these two sources. In contrast, business investment detracted from growth in 213, while net exports made barely any contribution. While the housing recovery has continued to gain momentum, supported by government schemes such as Help to Buy, the latter part of 213 saw the first signs that consumer demand was beginning to cool. This was not surprising, given that real incomes had remained sluggish and that the pickup in spending through 213 had largely been a function of stronger confidence and lower saving. However, it does emphasise the importance of the recovery broadening out to investment and exports. Figure 19: UK: Contributions of GDP growth Source: ITEM Club %pts Consumer spending Govt. consumption Net trade Investment Inventories Recent survey evidence provides some encouragement that this is beginning to happen. A wide range of business surveys are now reporting stronger sentiment and investment intentions. With larger firms, in particular, reporting strong financial positions with plenty of cash on their balance sheets, this should lead to an increasingly strong recovery in business investment over the coming years. The surveys have also reported an improvement in export demand, as the recovery in advanced economies has gained momentum, and our global forecasts suggest that this will continue. This transition to more balanced growth is unlikely to be smooth and we expect GDP growth to cool a little in the early part of 214. Our forecast shows growth of 2.7% this year and 2.6% in 215, before cooling to 2.5% a year from EY 2

22 Forecast in detail Consumer Demand The consumer was the key driver of the UK recovery during 213; we estimate that consumer spending accounted for 1.4 percentage points of the 1.9% GDP growth achieved last year. Figure 2: UK: Consumer spending Source: Haver Analytics Retail sales Household consumption But this acceleration in consumer spending growth came despite real household incomes barely growing. As such, households financed this additional spending by sharply reducing their rates of saving, with the savings ratio estimated to have fallen from 7.2% in 213 to just 5.2% in 213. This lower level of saving reflects stronger consumer confidence, which lowered precautionary saving, and a steady decline in deposit rates, which reduced incentives to save. Given how low the savings ratio has already fallen, and that households are likely to continue to lower their debt burden in preparation for when interest rates rise, the scope to reduce savings further is limited. So consumer spending growth in 214 and beyond will be more closely tied to real incomes. In this respect the outlook for 214 is brighter. The labour market outlook has improved in line with the wider recovery, generating sustained employment growth and improving workers wage bargaining position. Indeed, some sectors are already reporting skills shortages, which should add to wage pressures in those sectors. Another above-inflation increase in the income tax personal allowance in April will provide further support, although on the flip side the government has either frozen or limited the indexation of many social benefit payments. At the same time we expect inflation to cool to below 2%, reflecting weaker pressures from energy and food prices. These factors will increase household spending power, with real household disposable income forecast to grow by 2.7% in 214 and 2.3% in 215. This should permit consumer spending growth of 2.6% in 214 and 2.2% in 215; a considerable improvement on recent years, but still well down on the 3.7% a year it averaged for the decade prior to the financial crisis. The Housing Market The housing market recovery has continued to gain momentum with activity accelerating and prices continuing to increase strongly on all measures in the latter part of 213. This trend looks set to continue in the short-term, with the latest survey data from RICS reporting strong growth in new buyer enquiries. The initial recovery was driven by the Bank of England s Funding for Lending Scheme (FLS) and supported by the first leg of the Government s Help to Buy (HTB) policy, which provided equity loans for new build properties. Latterly, there has been added momentum from the improvement in the wider economy, in particular the labour market, and by the early introduction of the second phase of HTB, EY 21

23 Forecast in detail which involves the government providing a guarantee for lenders offering mortgages to borrowers with a loan-to-value ratio of 8-95%. The rapid improvement in the housing market has raised concerns that we are once again in the midst of a bubble and the Bank of England has demonstrated its concern by removing the mortgage lending incentive from FLS. Given that lenders had made much less use of the scheme in recent quarters the impact on mortgage availability should be limited, but this does send a clear message that the Bank is willing to intervene should it feel the need to. Figure 21: UK: House prices Source: ITEM Club % year Forecast We think that further intervention will prove unnecessary. There is little evidence of a bubble at present; prices are still marginally short of pre-crisis peaks in nominal terms and still some 25% lower in real terms, while affordability and indebtedness measures are far less stressed than they were during the financial crisis. A bubble could develop if housing supply does not move in line with rising demand. But the early evidence suggests that the stronger market has encouraged a robust pickup in house building and our forecast shows this continuing, with residential investment recovering strongly. As such, though activity is set to accelerate further driven by HTB as well as strengthening incomes and rising employment stronger supply should limit house price growth. Our forecast shows prices rising by 8.4% in 214 and 7.3% in 215, but this keeps the price-to-income ratio well below recent peaks. The Company Sector The latest national accounts data suggest that the corporate sector is still playing very little part in the recovery. Though business investment rose by 2% in Q3 213, it remained more than 5% lower than a year before and is still 24% lower than the early-28 peak. This performance has been particularly disappointing given the relative strength of corporate finances. Non-financial corporations continued to run sizeable surpluses throughout 213 and have now accumulated cash deposits equal to 3% of GDP, some 7 percentage points higher than the average of the decade prior to the financial crisis. Some smaller firms continue to report problems accessing funding, which is likely to be having some effect. However, larger firms tend to dominate investment spending and they have both high levels of cash holdings and good access to bank finance, so a lack of funding would appear not to have been the decisive factor behind low levels of investment. Rather, it appears to have been primarily a reflection of concerns about the likely net return on investment due to weak growth at home and heighted global uncertainty. This uncertainty led firms to use their cash in other ways, rather than to commit it to lengthy investment projects where the future level of returns was particularly uncertain. EY 22

24 Forecast in detail However, with UK economy looking on a more sustained recovery path, the Bank of England signalling that interest rates are not due to rise in the near future and the Eurozone crisis having passed it critical phase, expectations of future returns should start to improve. Indeed, business surveys suggest that corporate confidence has started to improve and that it is translating into stronger investment intentions. As such, we expect firms to increasingly release their accumulated cash surpluses to fund investment projects. Figure 22: UK: Business investment Source: ITEM Club bn Forecast After falling by an estimated 3.2% in 213, we expect business investment to rebound and grow by 5% this year, before accelerating to 9.3% in 215, as confidence continues to strengthen and firms take advantage of low borrowing costs and strong liquidity. Nevertheless, it will be another four years before business investment returns to its pre-crisis peak. The Labour Market The pace of improvement in the labour market has stepped up in recent months in line with the stronger performance of the wider economy. The latest Labour Force Survey data, for the three months to October, showed that the level of employment increased by 25, on the quarter, the strongest growth since mid-21, while the unemployment rate fell by.3 percentage points over the same period to 7.4%. Almost the entire rise in employment over the past year has come from an increase in the number of full-time workers, while the number of vacancies has risen to a five-year high, so there is an underlying strength in the labour market. But this has meant that the productivity puzzle has deepened, with real GDP per worker now almost 16% lower than it would have been had the pre-recession trend continued. Given the introduction of forward guidance, resolving the productivity puzzle and forecasting labour market developments has taken on added importance. Some of the decline in productivity is likely to be permanent, resulting from the fallout from the financial crisis. Low levels of investment have reduced the pace of innovation and led firms to lengthen replacement cycles. Furthermore, bank forbearance is likely to have caused a misallocation of capital and prevented it from being used for more productive uses. EY 23

25 Forecast in detail Figure 23: Unemployment Source: ITEM Club % ILO Claimant count 1 Forecast But some of the decline in productivity is likely to be a result of both temporary and cyclical factors. Firms which have hoarded labour in recent years will not need to hire as many workers as output recovers. And with a record number of part-time workers wanting to work full-time but having to accept fewer hours, there is plenty of slack that can be utilised. As the wider outlook improves we expect firms to increasingly make use of this slack and to cool the pace of job creation, but not soon enough to stop the ILO unemployment rate falling below the Bank of England s forward guidance threshold of 7% in H At below 1% on an excluding bonuses basis, annual earnings growth is still very weak. Wage bargaining power will increase as unemployment falls back and skills shortages emerge, though the public sector pay squeeze will remain a sizeable drag. We expect earnings to grow by 1.8% this year, before picking up to 2.7% in 215 and 3.5% in 216. Trade and the Balance of Payments After more promising signs in H1 213, the official data for the latter part of the year was very disappointing given the improved economic performance of many of the UK s trading partners. The latest monthly data for the three months to November showed the volume of non-oil goods exports up less than 1% compared with a year earlier, with exports to the European Union up just.6%. This runs contrary to the much more upbeat surveys, which have all reported greater momentum in recent months. Figure 24: UK: World trade* Source: ITEM Club UK: World trade* % year 15 Forecast *weighted by UK export shares But we are optimistic that the stronger survey results will soon be reflected in the official data. The US recovery looks well entrenched and growth in emerging markets is expected to remain robust. EY 24

26 Forecast in detail Meanwhile, the Eurozone has pulled out of recession and should recover over the next few years, albeit slowly. World trade, weighted by UK export shares, is forecast to grow by 4.7% this year, up from 2.1% in 213, before accelerating to 5.7% in 215. With the pound also expected to depreciate modestly on a trade-weighted basis, this should be sufficient to underpin a steady acceleration in export growth. Import growth is likely to be more subdued, given that consumer demand is unlikely to accelerate, so net trade should contribute positively to GDP growth from this year. This should also ensure that the large current account deficit begins to narrow, eventually closing by 217. EY 25

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