UK Economic Forecast Q BUSINESS WITH CONFIDENCE icaew.com/ukeconomicforecast

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1 UK Economic Forecast Q BUSINESS WITH CONFIDENCE

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3 Introduction Welcome to the Q ICAEW UK Economic Forecast, based on the views of the people running UK plc; ICAEW Chartered Accountants working in businesses of all types, across every economic sector and in all regions of the UK, surveyed through the quarterly ICAEW UK Business Confidence Monitor (BCM). Key findings this quarter. ICAEW s forecast for economic growth in 2016 has been downgraded from 2.0% to 1.8%, and further to 1.1% in The modest growth we can expect in the UK economy in the coming year will be driven by consumer demand, which seems likely to be dampened by the aftershocks of Brexit. More positively, there should be some boost to net exports from a weaker pound. Business investment is forecast to fall 2.9% in 2016, and 3.7% in 2017 (following a rise of 5% in 2015). The BCM survey demonstrates that business confidence has taken a major knock following the decision to leave the EU. Capital spending is likely to remain on hold pending clarity on the UK s relationship with Europe. The labour market will lose momentum, with a modest upturn in unemployment. ICAEW expects private-sector employment growth to slow from 1.8% in 2015 to 1.1% in 2016, with headcount broadly flat over the year in The unemployment rate will tick up from 5.1% in 2016 to 5.3% in Wage growth will be spurred by legislative changes rather than labour market strength. ICAEW s forecast for wage growth is 1.7% in 2017, modestly higher than 2016, but largely as a result of the new National Living Wage. Higher inflation, arising from a weaker pound, will mean this delivers real gains for households. Further policy support seems a done deal. August s rate cut took interest rates to 0.25%, but the Monetary Policy Committee s (MPC) statement made clear there could be more to come. Meanwhile the Chancellor has emphasised that supporting the economy trumps pre-brexit fiscal targets, meaning we may see some easing of public spending in his Autumn Statement. Little evidence is available for the strength of the economy in the post-brexit period, but the official data surprised on the upside in Q2 GDP grew 0.6% on the quarter. A strong labour market and very low inflation underpinned household spending growth, in spite of the failure of wages to pick up. But 2016 will be a year of two halves. Monthly indicators suggest the pace of growth slowed through Q2, meaning a weak start for Q3, even before Brexit impacts are considered. Consumer and business confidence have deteriorated across the board, and the BCM (typically a good predictor of next-quarter GDP growth) suggests growth of just 0.1% in Q3. Assuming a modest recovery in Q4, the strong first half should mean the economy expands by 1.8% in 2016 as a whole. But growth will ease in 2017, to just 1.1%. 3

4 Economic outlook FIG. 1 REAL GDP ANNUAL GROWTH FIG. 2 REAL GDP INDEX (2007 = 100) % Source: ONS, ICAEW forecasts Source: ONS, ICAEW forecasts Our forecast for GDP growth in 2016 has been nudged down to 1.8%, from 2.0% in our last report. This reflects the net effect of outperformance in Q2 2016, more than offset by the likelihood of a serious slowdown in growth in the second half of the year, as businesses and households alike assess the impact of Brexit. A modest 1.1% rise in GDP is likely in 2017, as uncertainty is lifted gradually. More positively, a weaker pound should provide a boost to exports, meaning the UK s current account narrows more swiftly than expected a few months ago. Economic growth picked up from 0.4% in Q to 0.6% in Q2, according to data from the Office for National Statistics. This was a positive surprise, as most forecasts were for a more modest pace of expansion. Consumer spending continued to be the main driver of growth. Households continued to spend at a robust pace retail sales in Q2 were up 4.6% on a year earlier, the fastest rate of annual growth for two years. But faced with the possible impact of Brexit on job creation, and the likelihood inflation will rise in the coming months thanks to the plunge in sterling, consumer spending is likely to slow markedly in the second half of the year. An alternative perspective is to look at the monthly pattern of output. Activity in production sectors and construction slowed sharply in May and June, meaning a soft launch pad for growth in Q3. Having said that, service sector PMI data for July were firmer than expected. The latest BCM revealed a sharp fall in confidence before the referendum, to levels consistent with the peak of the eurozone crisis in Our estimate suggests GDP growth of just 0.1% in Q3 2016, but as the dust settles it should gather a little pace in the final three months of the year. Moving into 2017 though, slower consumer spending growth, combined with falling business investment (see next section), will mean growth will struggle to get above 1% even with the Bank of England and HM Treasury s best efforts to support growth. More positively though, a weaker pound should help exporters. 4

5 Business investment FIG. 3 REAL BUSINESS INVESTMENT ANNUAL GROWTH % Source: ONS, ICAEW forecasts According to the BCM survey, business investment is set for a more pronounced slowdown in the second half of 2016 and into Our forecast is for business investment to fall to 2.9% in 2016 and 3.7% in Firms remain in a healthy financial position, and in principle have the financial resources to invest. A swift resolution of the UK s relationship with Europe could provide the certainty firms need to resume capital expenditure, but this seems a relatively distant prospect. Business investment surprised in the second quarter of the year, with a modest increase in capital spending the first since Q But evidence from business surveys conducted around the time of the referendum and in its immediate aftermath, including the BCM, clearly suggests that firms are more cautious over capital spending. Our forecast is for a fall in investment of 2.9% in 2016, and a further 3.7% in Fundamentally though, businesses remain in relatively good financial shape for investment. The Bank of England is clearly aiming to boost credit supply (and do what it can to push down borrowing costs) in the months ahead, firms retain historically high cash balances, and rates of return in several service sectors are high. Swift resolution of the UK s trade and investment relationship with Europe, or indeed early progress on trade deals with other parts of the world, could offset some of this decline in investment as could ambitious infrastructure investment or further policy measures to incentivise business investment. However, all these possible upside risks remain for now very much hypothetical. 5

6 Labour market FIG. 4 AVERAGE EARNINGS ANNUAL GROWTH FIG. 5 UNEMPLOYMENT RATE % % Source: ONS, ICAEW forecasts Source: ONS, ICAEW forecasts Job creation is set to slow markedly in the months ahead, as businesses take stock of the possible implications of Brexit. Employment is forecast to grow by 1.1% through 2016 as a whole, but as with investment and GDP growth this is likely to be a story of H1 strength and H2 weakness. Hiring will remain tentative well into 2017, and as a result we expect unemployment to tick up a little. Wage growth is expected to be relatively stable in 2017 (easing from 1.9% in 2016 to 1.7% in 2017), but for households this will be largely offset by higher inflation. A solid pace of job creation through the first half of the year helped bring the unemployment rate down from 5.1% in Q to 4.9% in Q2. However, an easing in the level of vacancies towards the end of Q2 suggests labour market momentum was already beginning to cool, even pre-brexit. Evidence from the BCM survey also suggests appetite for hiring has ebbed, with the indicator for future workforce growth falling to its lowest level in over three years. Our forecast is for employment to grow by 1.1% for 2016 as a whole, and fall by 0.1% in In turn this will increase the unemployment rate, albeit modestly, from 5.1% for 2016 to 5.3% in Wage growth is likely to slow more gradually, from 1.9% in 2016 (0.2pp lower than in our Q2 forecast) to 1.7% in With the government intending that the National Living Wage rises to 60% of median earnings by 2020 this should continue to put upward pressure on wage growth. There is also likely to be some effect on wage settlements from higher inflation, in light of the post-brexit depreciation of sterling. But these are both transient impacts, and somewhat flatten the ability or willingness of firms to offer real wage increases in the coming few quarters. 6

7 Focus The policy reaction to Brexit FIG. 6 UK INTEREST RATES % year gilt yield Bank Rate Source: Oxford Economics Before the EU referendum, Bank of England governor, Mark Carney, described Brexit as the biggest domestic risk to stability in the UK economy, citing his concerns around heightened levels of uncertainty affecting business investment and household spending. In the event of a Leave vote, he vowed that the central bank would do everything in our power to discharge our responsibility to achieve monetary stability and financial stability. True to his word, the MPC took decisive action at its August meeting. The MPC opted for a four-pronged package of monetary stimulus, which was towards the upper end of the range that many anticipated. The four elements of the package were: a cut in the Bank Rate from 0.5% to 0.25%; the introduction of the Term Funding Scheme (TFS) which seeks to reinforce the pass-through of the cut in Bank Rate; the purchase of up to 10bn of UK corporate bonds; and a 60bn expansion of the Asset Purchase Scheme for UK government bonds, taking the total stock of assets purchased to 435bn. While the cut in the Bank Rate had been priced-in by markets, the TFS is an innovation. It will provide up to 100bn of funding from central reserves, with the lowest funding cost Bank Rate available to banks which maintain or expand net lending. This means the impact on banks and building societies margins of a cut in the Bank Rate would be broadly neutral. The MPC expects this to prevent any negative impact on the supply of lending and ensure that the cut in the Bank Rate is fully passed on to borrowers. Additionally, the MPC restarted its programme of asset purchases, seeking to buy 60bn of gilts and 10bn of sterling non-financial investment-grade corporate bonds (i.e, firms working in the real 7

8 Focus The policy reaction to Brexit (continued) economy ) over periods of 6 and 18 months respectively. The Bank s modelling of the impact of the previous rounds of QE implies that 60bn of gilt purchases would boost GDP growth by %. But QE is likely to deliver less bang for the buck in the current environment gilt yields are already very low, and corporate borrowing spreads have fallen back to prereferendum levels. As such, some market observers have speculated that the QE package may have relatively little impact on borrowing costs. The MPC also made clear that there was scope to expand all parts of its package, with most members expecting to vote to reduce the Bank Rate further if the outlook evolves in line with the MPC s forecast (which is not dissimilar to ICAEW s current outlook). As such, we expect the Bank Rate to be cut to 0.1% in November. With investors having anticipated the loosening of monetary policy after the UK referendum, government bond yields have dropped sharply in recent weeks. And with the MPC going further than many expected, yields have continued to drop since the August meeting. With debt so cheap the case for fiscal easing is now very strong and the pressure is on the Chancellor to follow the Bank of England s lead and loosen the purse strings in his Autumn Statement. In particular, there is a strong case for infrastructure investment given that construction is likely to be among the sectors hardest-hit by the Brexit vote, and given the benefits of infrastructure investment for longerterm economic growth. 8

9 Forecasting methodology Headline economic forecasts f 2017f Real GDP annual growth % Real business investment annual growth % Labour market forecasts f 2017f Earnings (total pay) annual growth % Employment annual growth % Unemployment rate % ICAEW s forecasts for economic growth, business investment and the outlook for the labour market are based on the correlation between ICAEW Business Confidence Monitor (BCM) indicators and official economic data. BCM contains data from a survey of 1,000 UK businesses on business confidence, financial performance, challenges and expectations. BCM indicators provide a useful and unique steer on future developments in the UK economy. 9

10 Oxford Economics Oxford Economics is one of the world s foremost advisory firms, providing analysis on 200 countries, 100 industries and 3,000 cities. Their analytical tools provide an unparalleled ability to forecast economic trends and their economic, social and business impact. Headquartered in Oxford, England, with regional centres in London, New York, and Singapore and offices around the world, they employ one of the world s largest teams of macroeconomists and thought leadership specialists. ICAEW is a world leading professional membership organisation that promotes, develops and supports over 145,000 chartered accountants worldwide. We provide qualifications and professional development, share our knowledge, insight and technical expertise, and protect the quality and integrity of the accountancy and finance profession. As leaders in accountancy, finance and business our members have the knowledge, skills and commitment to maintain the highest professional standards and integrity. Together we contribute to the success of individuals, organisations, communities and economies around the world. Because of us, people can do business with confidence. ICAEW is a founder member of Chartered Accountants Worldwide and the Global Accounting Alliance. ICAEW Chartered Accountants Hall Moorgate Place London EC2R 6EA UK T +44 (0) E economicforecast@icaew.com linkedin.com find ICAEW twitter.com/icaew facebook.com/icaew ICAEW 2016 MKTPLN /16