Can the UK consumer hold off the Chinese dragon?

Happy New Year

January started with a flow of bad news from the global economy and especially China. Executives reading the press on their return to work would have been rushing to downgrade their forecasts for the year. In fact the mood was so pessimistic that the positive news on US job growth was missed by many people, buried as it was in the inside columns.

Yet the latest EY ITEM Club forecast expects the UK economy to grow by 2.6% in 2016 and to continue with steady – albeit slightly slowing – economic growth for the next two years, This is a slightly more optimistic view than EY ITEM Club presented in their Autumn forecast, suggesting UK prospects are improving.

How can we reconcile these apparently contradictory views of the economic outlook?

A rebalancing world is a divergent one…

The global outlook in recent times has been driven by China and the US. We now also have to take into account the role being played by Saudi Arabia in oil markets – the oil price is effectively being set by political not economic factors. Global economic conditions remain challenging in aggregate but there are stark differences between countries/regions:

  • The US recovery is strengthening although the rise in wages is weaker than the rate of job growth, suggesting the Fed may have gone slightly early on interest rates. A growing USA economy adds demand to the world economy but the rise in interest rates is squeezing financial flows to emerging markets, contributing to a slowdown in their growth.
  • China is growing more slowly than at any time in the last decade. The exact rate of growth is open to debate but the consequences of China’s slowdown can be seen in the fall of prices in non-oil commodity markets and the decline in world trade growth. Both of these developments impact the emerging markets and are more significant drivers of a slowdown than US interest rate rises.
  • Saudi Arabia’s recent policy announcements on fiscal and public sector reform confirm its intention to remain on its current strategy in respect of oil production. This means oil is now likely to stay below $60 a barrel for an extended period. Overall a lower oil price is usually marginally positive for global growth but the key point is that growth is redistributed from oil producing to oil consuming countries. Europe, the US and India are all winners from this shift.

…that plays to the UK strengths…

The key UK export markets such as the US and Europe have been growing and are forecast to continue to do so. According to the EY ITEM Club, the result has been improved export performance to these two markets, with the value of exports to the US up 34.7% in the three months to November 2015, compared to a year earlier, and while export values to the EU fell, volumes were up 6%. This trend is expected to continue and offset the challenging conditions in other markets to an extent. The UK is in effect now benefiting from its failure to penetrate the emerging markets more deeply in recent years.

…and allows UK consumers to continue to spend.

The UK consumer seems unconcerned by the global outlook and consumer spending has been the largest component of UK economic growth over the last two years. The EY ITEM Club expects this to be the case in 2016.

Chart Contributions to GDP growth

The recent falls in oil and other commodity prices will ensure inflation remains low for even longer than previously forecast and with labour markets still strong, wage growth increasing, the abandonment of the tax credit reforms in the Autumn Statement and interest rates remaining at low levels, The EY ITEM Club expects consumer spending to grow at 2.8% in 2016, very similar to the likely out-turn for 2015.

However, 2016 is likely to be as good as it gets for consumer spending in this decade as increasing inflation, interest rate rises and welfare reform start to bite in later years. The EY ITEM Club expect a significant impact with consumer spending growth decelerating to an average rate of around 2% annually from 2017 to 2020.

The response of UK business is the big unknown.

The UK consumer is likely to continue to spend and help offset the impact of any slowdown in emerging markets. However beyond the short-term, the strategies adopted by UK businesses will be the primary driver of UK economic growth.

Businesses have already begun to react to higher demand with business investment reaching 10% of GDP in Q3 2015 for the first time since 2001 (allowing for changes in data classification). With favourable financial conditions (profitability, availability of funding and the cost of capital), continuing steady domestic growth and expansion in selected export markets, EY ITEM Club expects this trend to continue.

Chart Business investment & GDP

In addition, the introduction of the National Living Wage and accelerating wage growth in several sectors together with falling energy prices will increase the relative attractiveness of capital compared to employing people. This combination of higher demand and changing supply economics, points towards an increase in capital investment which will play a greater role in driving growth from 2016. If this investment drives productivity improvement then the UK economy will be in a good place to continue to grow strongly.

But we have seen before that confidence can be fragile and the coverage of global developments is unlikely to be helpful in encouraging risk-taking. There is also the Brexit issue and the resulting uncertainty could begin to impact confidence and hence investment decisions.

The need is for a balanced approach.

The EY ITEM Club forecast assumes the UK consumer continues to push ahead, UK businesses exploit the growth in the US and Europe and that businesses invest in response to increased demand. A growth rate of 2.6% in 2016 requires all of this to come together and it is clear that the risks are certainly more towards the downside especially on exports and business investment. Businesses need to balance risk and ambition and I will turn to the details of what this means in practice in my next post.

 


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