GDP growth to remain weak as the UK economy rebalances

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1 Bloomberg: DAVY<GO> Research: Institutional Equity Sales: Davy Research October 18, 211 Conall Mac Coille, Chief economist conall.maccoille@davy.ie / Research Report: UK economy update UK economic forecasts GDP growth to remain weak as the UK economy rebalances Davy forecasts for the UK economy Consumer spending Government consumption Investment Exports Imports GDP.7 1 Employment growth.1 Labour force growth.3.4 Unemployment rate Wages and salaries per head Source: Davy forecasts UK GDP to grow by just.7% in 211 In our first formal forecast for the UK economy, we expect UK GDP growth to be.7% in 211 and 1.% in 212. Our forecasts are well below the current consensus average of 1.% for 211 and 1.5% for 212. Our projections imply that GDP will be close to flat in the second half of 211. There is a very high probability that the UK may see at least one quarter of negative growth in 211. Consumer retrenchment set to continue Consumer spending is likely to contract in H2 211 and remain stagnant in 212. Households remain squeezed between high CPI inflation and weak nominal pay growth. Recent falls in employment will push down on nominal income growth. Investment recovery to stall The modest recovery in investment spending in the year to Q2 211 is now likely to stall given uncertainty about demand prospects. Surveys have indicated that companies' investment intentions have fallen back in recent quarters. Exports set to slow Given the slowdown in global demand, we expect UK export growth to slow sharply in 212 to just 3.4%. This means the rebalancing of the UK economy towards a more balanced trade position will be associated with weak economic growth. Please refer to important disclosures at the end of this report. J&E Davy, trading as Davy is regulated by the Central Bank of Ireland. Davy is a member of the Irish Stock Exchange, the London Stock Exchange and Euronext. For branches in the UK, Davy is authorised by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details about the extent of our regulation by the Financial Services Authority are available from us on request. All prices are as of close of previous trading day unless otherwise indicated. All authors are Research Analysts unless otherwise stated. For the attention of US clients of Davy Securities, this third-party research report has been produced by our affiliate, J & E Davy.

2 UK GDP to grow by.7% in 211 and by 1.% in 212 In this research note, we set out our first formal forecasts for the UK economy. We expect GDP growth of just.7% in 211 and 1.% in 212. In our earlier research note on the UK economy ("Outlook for UK growth in 211", issued February 3rd 211), we argued two key points. First, UK export growth would not be sufficient to offset the impact of the fiscal consolidation. Second, the Bank of England would not raise interest rates in 211 as growth weakened. This broad view has been borne out. Looking forward to 212, we expect that UK exports will begin to slow in line with global demand. Hence, the rebalancing of the UK economy away from government spending and domestic demand towards a more balanced trade position will continue to be associated with weak economic growth. Table 1: Davy forecasts for the UK economy Consumer spending Government consumption Investment Exports Imports GDP Employment growth.6..1 Labour force growth Unemployment rate Wages and salaries per head Source: Davy forecasts Key features of our new forecast Domestic demand has slowed more sharply than expected and consumer confidence has deteriorated. UK households will start to increase their savings in 212, pushing down on consumer spending, which will fall by 1.3% in 211 and by.3% in 212. Business confidence has fallen back as the European debt crisis has intensified. We expect the modest recovery in investment spending to stall in Q4 211 and Q Weaker external demand will hold back UK exports. UK export growth is expected to slow to 5.1% in 211 and to 3.4% in 212. Slowing export growth, a stagnant consumer and fiscal consolidation point to a difficult rebalancing of the UK economy. Our forecasts are for GDP growth to be broadly flat in H2 211, with GDP growth of just 1.% in Davy Research

3 Overview: the rebalancing of the UK economy is being achieved by weak domestic demand Hopes that the export sector would compensate for the fiscal adjustment have been disappointed as the weakness of domestic demand has become apparent The deterioration in euro area demand prospects is bad news for the UK export sector Just one year ago, many envisaged a benign rebalancing of the UK economy. As the fiscal position was consolidated, export growth, benefitting from the past depreciation of sterling, was expected to be sufficiently strong to compensate for any weakness in domestic demand. Our view was that such a benign scenario was always unlikely, as we outlined in our previous research notes on the UK economy. Since January, the weakness of domestic demand has become apparent. Consumption has contracted for four consecutive quarters, disappointing expectations that consumer spending would remain relatively robust. Prospects for exports have now also deteriorated as demand in the UK's main trading partners has weakened. The European debt crisis has led the average consensus forecast for euro area GDP growth to be revised down to just.6% for 212 in October. Figure 1: Modal projections for calendar year growth in 211 over time Figure 2: UK current account of the Balance of Payments 1 oya % 4 m Feb-1 May-1 Aug-1 Nov-1 Feb-11 May-11 Aug-11 GDP Consumer Spending Exports -16 Q Q Q Q1 2 Q1 21 Q1 22 Q1 23 Q1 24 Q1 25 Q1 26 Q1 27 Q1 28 Q1 29 Q1 21 Q1 211 Trade Balance Current Account Balance Source: Treasury Forecasts for the UK economy Source: Office for National Statistics We expect the UK current account deficit to narrow as weak consumer spending and investment depress imports GDP growth is now expected to be just.7% in 211 and 1.% in 212 We expect domestic demand to remain weak in 211 and 212 so that there is an improvement in the current account deficit. Consumer spending is expected to contract by 1.3% in 211. The modest recovery in investment spending is expected to stall in H2 211 and then only pick up gradually in 212. To summarise, our projections envisage little private sector crowding in as the fiscal consolidation continues. Households are constrained by low savings and weak balance sheets. Companies' investment plans are held back by credit constraints and uncertainty. Exports are expected to slow sharply in 212. This means that UK GDP will remain weak, expanding by.7% in 211 and by 1.% in Davy Research

4 Short-term outlook: Q3 GDP growth will remain weak UK GDP has been flat over the last three quarters to Q2 211 The monthly output data suggest that GDP growth will be close to zero in Q3 211 Consumer spending indicators suggest weakness continuing in Q3 GDP growth in the UK has been broadly flat over the last three quarters. Following a.5% fall in Q4 21, GDP rose by.4% in Q1 211 and by just.1% in Q Monthly data suggest that growth is likely to remain close to zero in Q3. Purchasing manager indices for the manufacturing and services sectors fell back further, although both ticked up slightly in September. Retail sales values were up 4.7% on the year in August, but this increase reflected rising prices; retail sales volumes were up just.1%. In September, the Confederation of British Industry measure of reported sales fell to -15, its lowest level in 16 months. Given the squeeze in real incomes, consumer spending looks set to contract further. Figure 3: UK Purchasing Manager Indices Figure 4: UK goods trade 65 5 = no change 6 %, 3mnth Services Manufacturing Goods Exports Goods Imports Source: Markit Economics Source: Office for National Statistics Goods export volume growth has fallen back in recent months One surprise in the Q2 GDP data was that net trade detracted from growth following a.4% fall in export volumes on the quarter. Monthly data suggest that the decline was in part temporary as goods export volumes rose by 3.8% in July following a 4.4% fall in June. Nonetheless, goods exports growth is likely to be close to zero in Q3. The key question for the Q4 outlook is how households and companies will react to any adverse effects on confidence from the European debt crisis. Figure 5 illustrates that both the GfK and Nationwide measures of consumer confidence fell back sharply in recent months to similar levels as those that prevailed during the depth of the financial crisis in 28 and 29. Consumer and business confidence measures have fallen back through the third quarter A range of business confidence and investment intentions surveys also ticked down in the third quarter. That said, the declines have yet to match those seen in 28 and 29. For example, the British Chambers of Confidence (BCC) survey, illustrated in Figure 6, shows that business 4 Davy Research

5 confidence fell back in the third quarter but remains relatively high compared with recent years. Surveys suggest that companies are now postponing investment because of uncertainty about the strength of demand Surveys of investment intentions (for example, the Bank of England agent scores, British Chambers of Commerce surveys and Confederation of British Industry surveys) show that investment intentions fell back a little in the third quarter. However, these surveys may not yet have fully captured the adverse impact on confidence from the intensification of the European debt crisis and associated asset price falls. Our view is that the loss of confidence has been sufficient to lead companies to postpone decisions. Figure 5: Consumer confidence measures Figure 6: BCC business confidence turnover Index Balance 8 % Q1 199 Q Q Q Q Q1 2 Q1 22 Q1 24 Q1 26 Q1 28 Q1 21 GfK Nationwide Manufacturing Services Source: Datastream Source: Datastream Perhaps the most striking sign of a slowdown in the third quarter came from the labour market data for August Labour market data suggest that private sector employment growth has slowed sharply Perhaps the most striking sign of a slowdown in the third quarter came from the labour market data for August. The unemployment rate rose to 8.1%, and the Labour Force Survey indicated that employment had fallen by 178, (or by -.6%) in the three months to August. The 178, decline in overall employment in the three months to August suggests that private sector employment has slowed sharply in Q3 The slowdown in overall employment growth reflects the pace of public sector job cuts. Public sector employment fell by 111, in Q2, with private sector employment up by 41,. But the pace of cuts in the public sector is unlikely to have been sustained into Q3. The Office for Budgetary Responsibility estimates that public sector jobs will have to fall by 5, by 215 to meet the government's targets. So the 178, decline in overall employment in the three months to August suggests that private sector employment has slowed sharply in Q3. Spare capacity in the labour market is also evident in the nominal wage data. Average weekly earnings growth (excluding bonuses) fell to 1.8% in August. Together, weak employment and earnings growth will contain consumer spending going into the second half of 211 and into Davy Research

6 Domestic demand: Could UK households begin to increase their saving in 212? Consumer spending has been hit by falling real incomes Will households begin to increase their savings? Consumer spending contracted for a fourth consecutive quarter in Q The retrenchment by the UK consumer has reflected the squeeze in real incomes brought out about by persistently high CPI inflation and weak nominal pay growth. Higher rates of value added tax, increases in energy prices and the lagged effects of the low level of sterling on import prices have pushed up on CPI inflation. We expect CPI inflation to peak at 4.9% in September 211 and then to fall gradually to just above 2.% in 212. As CPI inflation falls back, the adverse impact on real incomes will dissipate slowly. But real incomes will remain weak as nominal pay growth is constrained by spare capacity in the labour market and as employment slows. We expect average weekly earnings growth to remain close to 2.% and employment to be broadly flat through 211 and 212. Figure 7: CPI inflation and nominal pay growth Figure 8: UK household savings ratio 7 %, oya 14 % CPI Average Weekly Earnings Source: Office for National Statistics Source: Office for National Statistics Households have reduced their saving to offset the squeeze on consumer spending from lower real incomes But household savings rates are likely to rise given concerns about the economy and employment prospects The economic accounts for Q1 211 indicate that the household savings ratio was just 4.6%, down from levels exceeding 7.% in 29. UK households have reduced their savings to offset the impact of higher inflation on their real incomes. However, the key risk for the UK consumer is that weak confidence and fears about employment prospects lead them to increase their precautionary saving. Indeed, Figure 8 illustrates that the household savings rate rose sharply as the UK entered the last two recessions in 1992 and 28. Sharp falls in consumer confidence could suggest that an increase in the savings ratio is now likely. Furthermore, the double dip in property prices will increase the incentive for some households to repair their balance sheets. 6 Davy Research

7 With interest rates at.5%, the Bank of England has little scope to counter a renewed retrenchment by the consumer There has been a very slow recovery in investment spending since the trough of the recession Surveys indicate that investment intentions are now falling back In 29, upward pressure on household savings was offset by cuts in the Bank of England rate. However, with interest rates close to their effective floor, the Bank of England now has less room to influence consumer behaviour if precautionary savings begin to rise. In our forecast, we assume that the household savings rate rises slowly in 212, depressing consumer spending. Sustained recovery in business investment remains elusive with renewed uncertainty holding back spending The pattern of business investment growth has been erratic in recent quarters, rising by 11.6% in Q2 211 following a 1% fall in the first quarter. Annual business investment growth was 3.8% in Q2 211, indicative of the weak recovery since the recession. In Q2, the level of business investment was 29.6% below its pre-recession peak. Planned cuts to government expenditure have been concentrated in capital expenditure which will also hold back investment. Similarly, residential construction is likely to remain muted, with activity remaining well down on pre-recession levels. Surveys of investment intentions indicate that companies are now postponing their spending plans. The Confederation of British Industry surveys of the distribution and manufacturing sectors show investment intentions falling back in Q3, albeit to levels remaining well above those in 28 and 29. This pattern is reinforced by surveys from the British Chamber of Commerce, the Bank of England's regional agents and the Deloitte survey of chief financial officers. Figure 9: Deloitte survey of chief financial officers Figure 1: UK PNFCs' net external finance raised 8 Balance 5 Three-month rolling sum, bns) Q3 27 Q1 28 Q3 28 Q1 29 Q3 29 Q1 21 Q3 21 Q1 211 Q3 211 Loans Attractive Bond Issuance Attractive Bond Issuance Next 12 Months Loans Next Months Bank Bank 12 Source: Datastream Net Capital Market Issuance Borrowing from MFIs Net External Finance Raised Source: Bank of England; Davy calculations The weakness in investment intentions is apparent in companies reducing their external finance A striking feature of these surveys is that uncertainty about demand prospects is cited as a key factor limiting investment. In contrast, credit availability, balance sheet restructuring and the cost of credit appeared to be less of a concern for companies in Q3. For example, in Q3 the Deloitte Survey of CFOs indicates that they see both bank loans and bond issuance as attractively priced but did not plan to increase external finance through these channels (Figure 9). Respondents also indicated that they planned to reduce capital expenditure over the next 12 months. 7 Davy Research

8 Softening investment intentions in Q3 did not appear to reflect tightening credit availability The weak recovery in business investment spending will slow in H2 211 This trend is also borne out by capital issuance data (Figure 1). A modest recovery in capital market issuance in the beginning of the year tailed off in Q3, and this decline in capital market issuance appears to have preceded recent stresses in bank funding markets. The Bank of England's Credit Conditions Survey indicated that lenders expected to curtail credit availability sharply to private non-financial corporations (PNFCs) in response to the increases in their funding costs. So both uncertainty and a renewed credit squeeze are converging to limit companies' investment spending. It may be that the recently announced expansion of quantitative easing is successful in limiting the impact of stresses in bank funding markets on the cost of borrowing for PNFCs. However, we still expect only a very gradual recovery in investment with weak credit demand limiting companies' spending. Investment is forecast to decline by 1.4% in 211 and to rise by 1.6% in 212. External demand: UK exports likely to slow given poor demand conditions in the UK's key trading partners Prospects for UK export demand have clearly deteriorated, particularly for the euro area, a key trading partner for the UK There is some evidence that sterling depreciation has arrested the decline in the UK's export market share But since the recession, UK exports have been held back by the poor performance of the traded financial services sector Downward revisions to global growth forecasts have led to a deterioration in the prospects for UK export demand. The IMF now expects that world trade will slow from growth of 7.5% in 211 to 5.8% in 212. Expectations for GDP growth have been revised down particularly sharply for the euro area, one of the UK's key trading partners (accounts for around 5% of UK exports). The IMF now expects euro area import growth to slow from 5.6% in 211 to 3.3% in 212. So the UK is exposed to those parts of the global economy where demand prospects are most gloomy. Figure 11 illustrates how UK exports have performed relative to global demand over the past two decades. In recent years, UK goods exports appear to have benefitted from the depreciation of the sterling exchange rate. The trend decline in the UK's export market share has been arrested since 27. But the positive impact of the sterling depreciation has been offset by the poor performance of the UK traded services sector. The UK is particularly specialised in the provision of financial services exports, and this sector has performed relatively poorly. We have assumed the UK broadly maintains its share of export markets. Hence, UK export growth is likely to slow given weakening global demand. 8 Davy Research

9 Figure 11: Developments in the UK export market share Table 2: IMF projections for GDP and imports Index World trade April WEO Sept WEO World Advanced economies Euro area Source: IMF World Economic Outlook Services Goods Source: Bank of England, August Inflation Report Exports are forecast to grow by 5.1% and 3.4% in 211 and 212 respectively. Net trade is still expected to contribute to UK GDP growth but largely because imports will be depressed by domestic demand. Imports are expected to decline by.2% in 211 and to rise by.4% in 212. Public finances: a crisis of confidence in the austerity strategy? The coalition government has set out ambitious targets for the fiscal consolidation UK exports will slow in line with external demand to growth of 3.4% in 212 The coalition government's March budget set out ambitious targets for the public finances, with government borrowing targeted to fall from 9.9% of GDP in 21 to just 1.5% in 215. Table 3 illustrates that interest costs are expected to rise to 3.4% of GDP in 215 so that the improvement in public sector borrowing will be achieved by running a primary budget surplus. The government expects UK general government debt to peak at 87.2% of nominal GDP in 213. Table 3: Projections for the public finances, Office for Budgetary Responsibility, March Current receipts ( bn) Current expenditure ( bn) Gross capital expenditure Public sector borrowing (PSNB) % GDP PSNB Primary balance Interest costs General government gross debt % GDP Source: Office for Budgetary Responsibility, Economic and Fiscal Outlook, March Davy Research

10 With economic growth disappointing, the targets set out in the March budget are now likely to be missed. The Office for Budgetary Responsibility's latest projections are for GDP growth of 1.7% in 211, 2.5% in 212 and 2.9% in 213. These projections now look too optimistic. In the first five months of the budget year 211, current expenditure was broadly on track to meet the growth target of 3.6%. However, government receipts had grown by 4.6% on the corresponding period of 21, below the full year target of 6.9%. The Treasury/Office for Budgetary Responsibility projections for UK GDP growth now look far too optimistic. Further budgetary measures will be required in 212. There is potential for pressure on UK gilt yields to be offset by quantitative easing, but a renewed weakening of the currency could constrain the Bank of England The government has come under increasing pressure to relent on its austerity strategy. Our central view is that the government will broadly stick to its austerity plan, with further budgetary measures implemented next year to ensure that targets are met. Government consumption of goods and services is expected to fall by.2% in volume terms in 212. Reduced capital expenditure will push down on aggregate capital formation in the UK economy. However, with growth disappointing, the peak debt to GDP ratio is now likely to surpass 9%. Any let-up in the pace of the government's fiscal consolidation plan could lead to upward pressure on gilt yields, which could warrant further expansion of the Bank of England's quantitative easing programme. That said, the Bank may be constrained if additional quantitative easing leads to a downward adjustment in the sterling exchange rate. Summary At the beginning of 211, most macroeconomic projections expected that UK export growth would be sufficiently strong to offset the weakness of domestic demand as the coalition government implemented its austerity strategy. Clearly, domestic demand has slowed more sharply than expected. Heading into 212, we expect that nervous UK households will start to increase their savings, pushing down further on the outlook for consumer spending. We now expect UK consumer spending to fall by 1.3% in 211 and by.3% in 212. UK export growth will be constrained by the slowdown in the global economy, particularly the euro area. UK export growth is expected to slow to 5.1% in 211 and to 3.4% in 212. Overall, the combination of slowing export growth, a stagnant consumer and the continuing fiscal consolidation point to slow UK GDP growth in the remainder of 211 and 212 Overall, the combination of slowing export growth, a stagnant consumer and the continuing fiscal consolidation point to slow UK GDP growth in the remainder of 211 and 212. Our forecasts suggest that GDP growth will be broadly flat in the second half of 211, with GDP growth of just 1.% in Davy Research

11 Important disclosures Analyst certification I, Conall Mac Coille, hereby certify that: (1) the views expressed in this research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this report and (2) no part of my compensation was, is or will be, directly or indirectly, related to the specific recommendation or views expressed in this report. Investment ratings definitions Davy ratings are indicators of the expected performance of the stock relative to its sector index (FTSE E3) over the next 12 months. At times, the performance might fall outside the general ranges stated below due to near-term events, market conditions, stock volatility or in some cases company-specific issues. Research reports and ratings should not be relied upon as individual investment advice. As always, an investor's decision to buy or sell a security must depend on individual circumstances, including existing holdings, time horizons and risk tolerance. Our ratings are based on the following parameters: Outperform: Outperforms the relevant E3 sector by 1% or more over the next 12 months. Neutral: Performs in-line with the relevant E3 sector (+/-1%) over the next 12 months. Underperform: Underperforms the relevant E3 sector by 1% or more over the next 12 months. Under Review: Rating is actively under review. Suspended: Rating is suspended until further notice. Restricted: The rating has been removed in accordance with Davy policy and/or applicable law and regulations where Davy is engaged in an investment banking transaction and in certain other circumstances. 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