Overall, the biggest disappointment so far this year has been construction data, which may have contracted by approximately 10% in the first quarter. Construction is roughly 7% of UK GDP, so a contraction of this size could easily dent overall growth figures. Close behind comes industrial and manufacturing data. IP fell at a 2.3% annual rate in February and manufacturing data has declined four months out of the last five. Although the pick-up in PMI data suggests that things may have improved in March, the industrial and manufacturing sectors have been in steady decline since peaking in mid-2010.
The bright spot in the data was retail sales, which increased at a 3.3% annual rate in March. However, retail sales have a fairly weak relationship with the measure of consumption in the national accounts data, so this gain may not be reflected in overall GDP.
We believe that the UK economy will (just about) register growth in the first quarter of this year, thus narrowly avoiding recession. However, the UK is still in a precarious position and faces both internal and external threats. (blog continues below)
The obvious external threat is a deterioration in the sovereign debt crisis. The peripheral sovereign debt market in Europe has stabilised after wobbling earlier this month, but weak growth in the periphery and continued sovereign strains are a major threat to the UK’s export market.
UK financial woes
The internal threat is our own public sector spending. February and March delivered some nasty surprises regarding the public sector debt levels. Public sector borrowing in March was up by £18.2 billion, higher than the £16 billion expected by the market. Although this was the second consecutive disappointment, the government still met its debt forecast for the year of £126 billion, down from £136.8 billion last year. However, the March borrowing figures still put the UK’s public sector debt levels above the £1 trillion mark. Although public sector spending excluding benefits and interest fell slightly, the first fall since 1955, it is still going to be a challenge to meet the government’s borrowing target for this year of £120 billion.
The government is still spending more than £388 billion per year, and the bulk of the spending cuts in the UK economy are actually back-loaded and expected to take place in the last two years of the current parliament. Either the government expects us all to get used to austerity over the next three years or we should expect the fiscal goal posts to be moved in the coming years.
For traders the public sector finances are important for a couple of reasons: one, a weak economy could boost benefit payments and make public sector spending even harder to bring down; and two, any fiscal slippage could cause the UK to lose its triple A credit rating, which it has managed to hold onto even though the US and France recently both lost their top credit rating.
An increasingly less dovish BOE
The market expects Q1 GDP to expand by 0.1%, a fairly lacklustre quarter. But this hasn’t stopped the Bank of England from getting increasingly less dovish in recent weeks. Even former uber-dove Adam Posen changed his stance at the last Bank of England meeting earlier this month and voted to keep rates and asset purchases on hold. This is significant – Posen is no longer talking about more QE and instead sounding worried about inflation.
While official growth figures are likely to skirt along the bottom for at least the next couple of quarters, the Bank of England has said that GDP data is likely to underestimate the underlying strength of the UK economy. The Bank’s justification for its shift in stance from the dovish side to the fence is based on an on-going economic recovery and stubborn inflation pressures. This change in stance has helped to buoy GBP/USD above 1.6060 and EUR/GBP below 0.8200. But if growth surprises to the downside tomorrow or data starts to turn lower in the coming months, this could jeopardise the Bank of England’s more hawkish stance, which could weigh on the pound.
Added to this, we don’t believe there will be higher rates in the UK any time soon. The Bank of England will need to fill in the growth gaps caused by fiscal consolidation, which as we state above remains very incomplete at this stage.
Kathleen Brooks is research director for UK, Europe, Middle East & Africa for Forex.com.