Berenberg Macro Views Economics. The power of money: UK forecast update. Key macro reports

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1 The power of money: UK forecast update Monetary policy is gaining traction and Mark Carney has shown his dovish credentials. A fledging consumer led recovery seems to be taking hold and should pick up pace next year. We raise our growth forecast to 1.% in 13, from.7%, and to 1.8% in 1, from 1.3%. Big risks remain. If consumers give in to falling real wages or if recent rises in market rates are not reversed, consumption will contract. Bank lending is still falling. With these risks and with growth still underwhelming, interest rates will remain at.5% until 1 and further stimulus cannot be ruled out. Earlier recovery as monetary policy gains traction: Consumers have opened the purse strings sooner than we had expected in response to ultra-low interest rates and the resulting house price rises. Reduced worries about the Eurozone are helping too. Firmer surveys: They look too good to be true and may fall back. The strength is evident across several surveys, though. Given that broad-based message, we forecast.% qoq in Q and Q3 13. Austerity weighs: Growth remains unspectacular for two reasons: first, austerity of about 1% of GDP in 13 and 1; second, dire income growth holds back consumption. Consumption growth will stall later this year before picking up again as income growth returns. Three big risks o Weak wages: Inflation-adjusted wages are falling fast and benefit payments are being cut. Our forecast assumes households will continue consuming by cutting their savings. However, there is a decent chance they will wilt under the pressure. That would matter a lot. If households returned their savings rate to its 1 average, it would knock.5% off consumption. o Rate expectations: Low rates are the reason why savings are falling. So any rise in rates would be bad news. Bank of England (BoE) multipliers suggest that if the recent rise in yields is not reversed, it could knock.5-.75% off GDP over a couple of years. o Eurozone/world: World growth and Eurozone recovery mean we expect trade to contribute.% to 1 growth. Any serious trouble in the Eurozone would heavily dent the UK s prospects. Growth needs to be stronger: UK output is still % lower than it was in 7, one of the worse performances of the major economies. Even on our more optimistic forecast, UK GDP would still be below its 8 peak at end-1. That is unlikely to be anywhere near strong enough to make a dent in spare capacity. We expect unemployment to remain close to 8% and inflation to fall to the % target. Interest rates are unlikely to go up for a long time. From Canada with love: One reason we are more optimistic is the new Governor of the Bank of England. The key for monetary policy right now is to dampen the recent rise in market rate expectations and cement the recovery, ie reduce the first and second risks above. The BoE introduced forward guidance at Carney s first policy meeting this week and will likely follow up with more formal guidance next month. Key macro reports Understanding Germany a last golden decade ahead 13 October 1 Tough love: the true nature of the euro crisis 13 October 1 Groundhog day: the tough fiscal choices ahead for the UK 1 October 1 Would a nominal GDP target help in the UK? 17 December 1 Tomorrow never dies: do not underestimate UK productivity growth 1 December 1 Carney puts the flexible into flexible inflation targeting 8 February 13 Diamonds are forever: windfalls and benefits are not 1 April 13 Die another day: housing shows British paradox 15 May 13 Euro crisis: progress report May 13 Britain needs help 9 May 13 To receive these and other reports, please contact your Berenberg sales representative 8 July 13 Rob Wood Chief UK Economist rob.wood@berenberg.com 1

2 Becoming more optimistic Monetary policy can be powerful: that is our conclusion from recent firmer UK data. A fledgling consumer-led recovery seems to be taking hold. Low rates are pushing up house prices and prising open households purse strings. The household savings rate fell to a four-year low in Q1. Business surveys have turned up sharply (Chart 1). We have raised our growth forecasts to 1.% in 13, from.7%. For 1, we now have 1.8%, up from 1.3%. The recovery we had expected towards the end of 13 appears to be coming through sooner than we expected. We have revised up consumption growth in Q and Q3 this year. That stronger base pushes up 1 growth mechanically, but we have also raised business investment growth a little, reflecting building confidence. The UK can and will recover. But make no mistake, it is not out of the woods just yet. The recovery almost entirely depends on the consumer ignoring weak real income. We have our doubts (see Diamonds are forever; windfalls and benefits are not, dated 1 April 13), but now see that as a risk rather than a most likely outcome. If consumers do wilt under the pressure, the UK could return to recession. The stakes are high for Mark Carney in his battle to talk down the curve. We are optimistic about his powers of persuasion. If he fails and higher rate expectations feed through to mortgages, consumption will falter. Any return to serious turmoil in the Eurozone, or a slowdown in world growth, would also put the brakes on this UK recovery. The UK can and will grow faster. The economy has been flat on its back for 18 months and is still % smaller than in 7. That is weak even compared to the weak recoveries that normally follow financial crisis; however, austerity will keep growth below trend for the next couple of years at least. Recoveries normally see growth rise above trend rates. But even with the step-change in momentum that we now expect (Chart ), growth reaches only.-.5% qoq. That will not make a dent in spare capacity, and we expect the unemployment rate to change little. To achieve escape velocity, interest rates are likely to remain low for the foreseeable future, and more stimulus from the super-dovish Mark Carney cannot be ruled out. A fledgling consumer recovery seems to be taking hold We have raised our growth forecasts The UK is not out of the woods yet If Carney fails to talk down the curve, consumption will falter Austerity will keep growth below trend for the next couple of years Interest rates will remain low for a long time to achieve escape velocity Chart 1: Surveys point to growth Chart : The UK has a lot of ground to make up PMI BCC CBI Surveys mean-variance adjusted to quarterly GDP growth. Source: Markit, British Chambers of Commerce, Confederation of British Industry Source: ONS, Berenberg Forecast Growth, qoq % Real GDP, level

3 Can the consumer face down falling income? Consumption has kept the economy ticking along in recent quarters. However, to achieve that in the face of weak income, households have had to cut their savings rate to a four-year low (Chart ). The fall in the savings rate probably exaggerates the reality. Early data is often revised. Some of the fall will probably unwind in Q as bonuses that were delayed to take advantage of tax changes are paid. It seems unlikely that households really cut their savings rate that much. Households will have to continue dealing with very weak real income this year. Chart 5 shows the challenge and the risks. Income is likely to be weaker than last year as austerity means benefit payments are cut (Chart ). To keep growth going, households will have to save less and less. We have our doubts about consumers (see Diamonds are forever; windfalls and benefits are not). However, business surveys suggest the strength spilled over into Q3. Car registrations remain elevated. Consumers seem to be throwing caution to the wind and leading the recovery. We assume households can continue to be encouraged to save less and less by Mark Carney talking down rates. After an income-related soft patch in Q this year, consumption will pick up strongly. This judgement is a huge risk to our forecast. If households wilt under the pressure, it is no exaggeration to say that a recession is quite likely. Households saving less has kept the economy going Households will have to save less and less We expect consumption to pick up strongly next year after a soft patch in Q Chart 3: Consumption supporting growth GDP growth, qoq % Source: ONS, Berenberg calculations Consumption, contribution to qoq growth the rest, contribution Chart : Saving rate fell sharply Source: ONS, Berenberg calculations Chart 5: Consumption could sag Chart : Benefit payments helped in 1 8 Real total household income, % m oya, lagged m Household consumption, % m oya Real wages, % yoy Household saving rate, % Other Taxes&benefits Employment Real wages Real income, %oya Ends in Source: ONS Source: Berenberg 3

4 Risks from consumption The extremely low interest rates facing households have been driven by market expectations for official interest rates. So the -5bp rise in gilt yields since May could easily deal a blow to the recovery later this year. There are two useful ready reckoners to quantify this risk. 1. If a sizeable reversal of low interest rates meant the saving rate returned to its average level in 1 of.75% by this time next year, it would knock.5% off consumption growth. With weak income as well, that would mean another recession in the UK.. The BoE estimates that the first bn of asset purchases lowered gilt yields by 1bp and boosted GDP by 1.5-%. Reverse engineering, a bp rise in yields could detract.-.8% from GDP over the next couple of years. We do not think either scenario is the most likely outcome. As argued above, the savings rate fall in Q1 will probably be revised away to some degree, ameliorating that risk, and policy action from Carney should reduce the second risk. But the scenarios show the significance of the risks. If the consumer falters, the UK is in trouble. bp in gilt yields could dent recovery If the consumer falters, the UK is in trouble

5 Growth needs to be stronger On government plans, austerity will drag by about 1% a year on growth in 13 and 1 (Chart 7). That is one reason why our growth forecasts remain a little underwhelming. In 13, consumers are taking a hit through restricted benefit payments. They surged in 1 but working age benefits are now being cut by 1% in real terms. It is already showing up in government spending growth (Chart 8). Much of the rest of austerity comes through holding spending growth down to 1-% per year, in nominal terms (Chart 8). Within that picture, spending by government departments on staff and procurement is set to fall, while spending on pensions rises. The UK can and will grow faster. UK output is still % lower than it was in 7 (Chart ). That is weak even relative to the poor recoveries that normally follow financial crises. Strong growth is needed for several years for the UK to return to something approaching a normal position. With austerity weighing on the economy, that is unlikely to happen in the next two years. With stronger growth needed, we expect interest rates to remain at rockbottom levels until at least 1. Eventually, as the Eurozone and world growth recovers, that will allow private-sector demand to pick up further and drive demand growth above trend. We are optimistic that the recovery will gain momentum over the next couple of years. This strategy will mean rapidly rising house prices which we expect to increase by 15% in the two years to end-1 and a slowdown in the pace of deleveraging though. Growth is underwhelming because austerity drags on the recovery UK output is still % lower than it was in 7 So interest rates are likely to remain at rock bottom levels until at least 1 Chart 7: Austerity drags on growth UK, % GDP, change Euro-area, % GDP, change Change in cyclically adjusted primary balance, % GDP Source: OBR, IMF, EC Chart 8: Benefit payments cut this year 1 Total current spending 1 1 Net social benefits Source: ONS, Berenberg 5

6 Q1 Q1 3Q1 Q1 1Q13 Q13 3Q13 Q13 1Q1 Q1 3Q1 Q1 GDP % y /y % q/q %q/q ann Private Consumption % y /y % q/q Government Consumption % y /y % q/q Investment % y /y % q/q Final Dom Dd 1 % y /y % q/q Net exports 1 % y /y % q/q Stockbuilding 1 % y /y % q/q Current Account Balance GBP bn % of GDP Industrial production % y /y % q/q Unemployment rate 3 % CPI % y /y General govt balance % of GDP General govt debt % of GDP BoE main rate Contribution to GDP grow th incl. mining, energy, sa, quarterly avg. 3 ILO measure, period averages, sa Period averages 5 Maastricht basis

7 Disclaimer This document was compiled by the above mentioned authors of the economics department of Joh. Berenberg, Gossler & Co. KG (hereinafter referred to as the Bank ),. The Bank has made any effort to carefully research and process all information. The information has been obtained from sources which we believe to be reliable such as, for example, Thomson Reuters, Bloomberg and the relevant specialised press. However, we do not assume liability for the correctness and completeness of all information given. The provided information has not been checked by a third party, especially an independent auditing firm. We explicitly point to the stated date of preparation. The information given can become incorrect due to passage of time and/or as a result of legal, political, economic or other changes. We do not assume responsibility to indicate such changes and/or to publish an updated document. The forecasts contained in this document or other statements on rates of return, capital gains or other accession are the personal opinion of the author and we do not assume liability for the realisation of these. This document is only for information purposes. It does not constitute a financial analysis within the meaning of 3b or 31 Subs. of the German Securities Trading Act (Wertpapierhandelsgesetz), no investment advice or recommendation to buy financial instruments. It does not replace consulting regarding legal, tax or financial matters. Remarks regarding foreign investors The preparation of this document is subject to regulation by German law. The distribution of this document in other jurisdictions may be restricted by law, and persons, into whose possession this document comes, should inform themselves about, and observe, any such restrictions. United Kingdom This document is meant exclusively for institutional investors and market professionals, but not for private customers. It is not for distribution to or the use of private investors or private customers. United States of America This document has been prepared exclusively by Joh. Berenberg, Gossler & Co. KG. Although Berenberg Capital Markets LLC, an affiliate of the Bank and registered US broker-dealer, distributes this document to certain customers, Berenberg Capital Markets LLC does not provide input into its contents, nor does this document constitute research of Berenberg Capital Markets LLC. In addition, this document is meant exclusively for institutional investors and market professionals, but not for private customers. It is not for distribution to or the use of private investors or private customers. This document is classified as objective for the purposes of FINRA rules. Please contact Berenberg Capital Markets LLC ( ), if you require additional information. Copyright The Bank reserves all the rights in this document. No part of the document or its content may be rewritten, copied, photocopied or duplicated in any form by any means or redistributed without the Bank s prior written consent. May 13 Joh. Berenberg, Gossler & Co. KG 7

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