Forecast for the United Kingdom  The economy unexpectedly contracted in the second quarter, driven by destocking following...

Economics Forecast: UK, Brexit & Britain

Forecast for the United Kingdom 

The economy unexpectedly contracted in the second quarter, driven by destocking following a surge in inventories in the first quarter, and suppressed fixed investment. More positively, private consumption was upbeat, on decade-high wage growth and solid job gains, while strong public spending also cushioned the fall. Although the external sector contributed to growth, this was driven by plunging imports, as exports contracted amid a tougher global trading environment. Looking to the third quarter, momentum is likely muted. While the services PMI rose in July, it signaled only modest growth, and the manufacturing PMI remained in contractionary territory. That said, robust retail sales in the same month suggest consumer spending is supporting activity in Q3, and an inventory build-up towards the end of the quarter in preparation for a no-deal Brexit could temporarily boost headline GDP.

Underlying momentum is likely to be meek in H2, held back by soft business investment and weaker growth in key trading partners. However, higher wages and a more expansionary fiscal stance should prop up activity, while inventory changes as firms prepare for a no-deal will likely distort GDP figures. The highly uncertain outcome of Brexit remains the key risk to the outlook. FocusEconomics panelists expect GDP growth of 1.2% in 2019, which is down 0.1 percentage points from last month’s forecast. For 2020, panelists also see the economy expanding 1.2%.

Economy contracts in Q2 for first time in nearly seven years amid destocking and tumbling fixed investment

The UK economy shrank 0.2% in quarter-on-quarter seasonally-adjusted terms in Q2, contrasting Q1’s 0.5% quarter-on-quarter expansion. The figure marked the worst reading since Q4 2012 and significantly undershot market expectations of a flat reading. While several FocusEconomics panelists had been banking on a contraction, it caught the majority of panelists by surprise. In annual terms, growth slumped to 1.2%, down from Q1’s 1.8% year-on-year expansion. The decline was driven by a sharp fall in fixed investment (Q2: -1.0% qoq; Q1: +1.2% qoq), as the uptick in business investment seen in the first quarter proved fleeting, while government investment was also down sharply. Destocking following a surge in inventories in Q1 was another key piece of the picture, subtracting 2.2 percentage points from the headline GDP reading. In contrast, private consumption (Q2: +0.5% qoq; Q1: +0.6% qoq) and government consumption (Q2: +0.7% qoq; Q1: +0.8% qoq) cushioned the fall, bolstered by above-inflation wage growth and a laxer fiscal stance respectively.

Exports were also down sharply (Q2: -3.3% qoq; Q1: +1.5% qoq), amid a more adverse global trading environment and weaker momentum in the Euro area. However, this was more than offset by a huge slide in imports linked to falling inventories (Q2: -12.9% qoq; Q1: +10.8% qoq). As a result, the net contribution from the external sector swung from minus 3.0 percentage points in Q1 to plus 3.5 percentage points in Q2. Looking ahead, a second inventory build-up ahead of the new Brexit deadline of 31 October could provide a temporary boost to the economy in the coming months; that said, as seen in the H1 figures, this effect would be offset by a subsequent drawdown of stocks. Underlying momentum will likely remain limp due to suppressed business investment, despite solid private and public consumption. Overshadowing all this is the outcome of Brexit: A no-deal exit would severely dent activity in the near-term, while an expedient solution to the current impasse could unleash pent up investment.

Housing: According to the Nationwide Building Society (NBS), house prices in the United Kingdom rose 0.3% in July, up from June’s 0.1% increase. On an annual basis, house prices also rose 0.3% in July, down from June’s 0.5% uptick. The average house price in July was GBP 217,663 (July 2018: GBP 217,010). The broad picture is unchanged; the property market is in a soft patch, weighed on by weak consumer sentiment and Brexit uncertainty. The market is likely to stay sluggish in coming months in the runup to the new Brexit deadline of end-October. However, assuming a no-deal Brexit is avoided, house price growth should pick up somewhat, supported by favorable demographics and a strong labor market.

Interview With Oxford Economics

How will victory for Boris Johnson affect fiscal policy?
Johnson’s campaign gave the clear impression that he plans to loosen fiscal policy, but it remains to be seen whether he follows through on his promises. We’ve modelled the impact of his four main pledges – increasing the income tax higher rate threshold, raising the starting point for paying National Insurance Contributions, increasing the education budget and employing more police officers – and we estimate that the package would raise GDP growth by around 0.2 ppt a year for the next three years, if delivered alongside an orderly Brexit. The boost is fairly limited because the policies – particularly the increase in the income tax threshold – are poorly targeted.

What does victory for Boris Johnson mean for the pound?
From our perspective, Brexit is going to be the key driver of movements in the pound. The recent weakening came because markets perceive that no-deal risk has increased with Johnson’s victory, which is something we agree with. If Johnson can ensure an orderly Brexit then we would expect sterling to strengthen, given that it is currently heavily undervalued. But a no-deal Brexit would likely trigger a further depreciation, probably to $1.10 or perhaps lower.

Will victory for Boris Johnson have any bearing on inflation and monetary policy?
Brexit will also be pivotal to prospects for inflation and monetary policy. An orderly Brexit should see sterling strengthen and inflation slow. With the MPC preoccupied with the risk that a tight labour market could drive up inflation, they would probably continue to keep policy unchanged, rather than follow other central banks in cutting interest rates. But in a no-deal scenario, the sterling depreciation would drive up inflation, probably to around 3% in 2020. And it is likely that the MPC would ignore the prospect of temporarily higher inflation and cut interest rates in order to cushion the blow to demand.

In your view, how does Boris Johnson becoming PM affect the likelihood of different Brexit scenarios?
We see Johnson’s victory as raising the chances of the UK leaving the EU in October, with both the deal and no-deal options looking likelier than before. But we still see an extension as marginally the most likely outcome. Even if there was the will, there is not sufficient time to renegotiate the withdrawal agreement, while parliamentary opposition to the deal and no-deal options is firmly entrenched. Ultimately an extension looks like being the path of least resistance and we think that the EU would agree to one more extension to March 2020, particularly if it was to give time to hold an election.

Cartoon by Patrick Chappatte, Le Temps, Switzerland

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