The ITEM Club's Leap of Faith
So the UK is creeping out of the doldrums, at least according to the latest Ernst & Young ITEM Club report.
Despite a bumpy start to the recovery process the economic forecasting group suggests that “from 2014 the consumer-led recovery will morph into much more balanced growth, as business investment and exports begin to rise more strongly". As a result, they suggest UK GDP growth will accelerate to 2.6% in 2015, and stay at around that level through to 2017.
These figures are roughly in line with those of the Office for Budget Responsibility from March, which forecasted annual GDP growth of 2.3% in 2015 rising to 2.8% by 2017. There are, however, a couple of important caveats to these forecasts.
Both the OBR and ITEM Club assume a sudden pick-up in corporate investment spurred on by a rise in consumer spending. This is despite the fact that after recent revisions to ONS figures business investment now looks to be at its lowest point since 1998.
The numbers are stark. Peak-to-trough business investment has collapsed some 34% over the crisis. Although sentiment surveys have begun to improve in recent months, both the OBR and ITEM Club forecasts rely on investment rebounding by over 8% next year and remaining around those levels thereafter. That is an assumption that needs careful examination.
The main reasons for companies to invest are either in response to increased domestic demand, increased export demand or a combination of both. That we have seen a slight tick-up in the former is good news but the position of the British consumer in the aftermath of the crisis is far from strong with sluggish wage growth and rising household costs eating into spending power.Indeed earlier this month the Bank of England released some discomforting data on household finances. While consumers appeared to be paying down credit card debt in the first few years of the crisis that trend reversed from August 2012 and unsecured debt has been rising sharply since.
Looked at in isolation rising household debt could be indicative of rising consumer confidence. The ITEM Club report claims that “with the gradual strengthening of the wider economic outlook supporting confidence and the worst of the deleveraging over, consumers should begin to reduce levels of saving from recent high rates”. This is again in keeping with the OBR, which expects over half of all growth to come from private consumption.
However, the report acknowledges that much of the recent pick-up in income growth came from the impact of forestalling by higher rate taxpayers in order to avoid the 50p rate and has now largely subsided. As such rising household debt should be a source of some concern with real wages having fallen by 6% over the past five years – the worst wage slump on record according to the Institute of Fiscal Studies.
Also singled out for special mention is the housing market. The authors predict “a steady acceleration in activity, which should translate into price growth of 2.25% in 2013 and 5.5% in 2014”. Among the factors credited for this rise in activity are the Bank of England’s Funding for Lending scheme and the government’s Help to Buy plan.
They might, however, have benefitted from reading Section 2 of the Bank’s Financial Stability Report. In it the Bank notes that without income growth the UK’s banking system remains vulnerable to any increase in mortgage interest rates (caused by, for example, the ending of a government programme designed to support prices). A rise of just 2 percentage points could force households accounting for 20% of total mortgage debt into urgent action to meet repayments, including cutting spending on essentials or taking on additional work.
Moreover a recent paper from Martin Browning, Mette Gørtz and Soren Leth-Peterson found that the correlation observed between rising house prices and increased consumption does not suggest a causal relationship. The authors conclude that “it is probably not a very good idea to design policies targeting the housing market when trying to stimulate household demand in order to lift the economy out of the crisis”.
It is possible that business investment could respond to the short-term improvement in consumer spending or temporarily rising house prices but this would entail something of a suspension of disbelief. More likely there will be a slight increase in corporate investment in order to prevent the depletion of the capital stock.
A more compelling case, however, can be made for businesses to increase investment due to improving external demand for goods and services. In particular all eyes will be focused on the US where the apparent strength of the recovery has led Federal Reserve Chairman Ben Bernanke to start discussing a gradual withdrawal of central bank asset purchases from the end of this year.
It is notable here that the ITEM Club is significantly more bullish on the impact of net trade on UK growth than the OBR, citing weak sterling as a key benefit. However, recent history of the impact of weak sterling urges caution here too as the impact of exports growth on GDP following the 2007 depreciation proved surprisingly small (although later revisions show they did make a modest contribution to growth).
If the US recovery can shrug off the sequester cuts it is possible that, as they say, a rising tide would float all boats. Yet with growth rates of sub-3% still looking ambitious six years on since the start of the crisis it seems inevitable that the recovery will be a slow grind rather than a bounce. Most worryingly, the latest ONS revisions have reduced non-financial corporation cash surpluses from 40% of GDP to 30% suggesting they have build up less of a war chest than previously thought.All of this suggests to me that predicting a surge of private sector investment in the current environment takes a big leap of faith.