UK economy ... stuck in the middle lane?

A good start to the year …

It is always good to start the year with positive news, so receiving two encouraging stories in quick succession was particularly pleasing. First came the preliminary estimate of 1.8% for UK economic growth in 2017 — certainly better than many forecasters expected at the start of the year. This was closely followed by an increase in EY ITEM Club’s 2018 forecast for GDP growth, up from 1.4% to 1.7% since their last outlook. EY ITEM Club’s forecast reflects their expectation of a slight slowing of the inflationary squeeze on consumers in 2018 and a continuing improvement in trade as the strong global economy and a competitive pound combine to support UK exporters. This is consistent with the positive mood I found among UK manufacturers in my recent trips around the country, with higher export growth being the main driver of this sentiment.

… but hints that we are missing out …

Nevertheless, 1.8% growth in 2017 was the weakest UK expansion since 2012 and marked a relatively lacklustre performance, with the annualised rate of growth slowing through the year. It is also the case that UK GDP growth in 2017 looks weak when viewed in the context of improving global growth, which is estimated to have improved from 2.4% in 2016 to 3.0% in 2017, strengthening expansion in the Eurozone from 1.8% to 2.5%, and US GDP growth likely improved from 1.5% to 2.3%.

… and future concerns …

The further out we look, the less sign there is of an acceleration back to historic norms for UK growth. The EY ITEM Club’s GDP growth projections beyond 2018 and 2019 (forecast growth of 1.7%) have been slightly reduced since their last forecast for 2020 (from 2.0% down to 1.9%), 2021 (from 2.2% down to 2.0%) and 2022 (from 2.3% down to 2.1%). The expectation is that the UK will remain below its trend rate of growth and also struggle to match the growth rates of our better-performing developed-country peers.

This concern about the future reflects the fact that the downgrades are mainly due to a lowering of expectations of the UK’s productivity performance, on which much attention was focused in 2017. The Bank of England cited — as a contributory factor in its decision to raise interest rates in November — its belief that the economy’s potential growth rate had lessened. Even more notably, the Office for Budget Responsibility (OBR) substantially reduced its expectations for UK productivity growth over the next five years when providing its forecasts for Chancellor Philip Hammond’s November 2017 Budget.

… and the added challenge of uncertainty for investment …

This relatively flat outlook should be seen as subject to significant uncertainty, especially over how negotiations on the future relationship between the UK and EU will develop. The EY ITEM Club forecast assumes the UK and the EU will agree a transition agreement and that this will reduce uncertainty and underpin business investment. There is little scope for upside on this assumption, with risks of slower or worse progress being the downside.

Business investment in 2017 was — a bit like the economy as a whole — reasonable, but below the levels we would hope for and that the economy needs if we are going to be able to drive productivity improvements, prepare for Brexit and adapt to technological change. The fundamentals for business investment, such as corporate net rates of return, balance sheets and finances are largely healthy, the cost of capital currently remains low, and the availability of credit is at a healthy level. Last, and by no means least is the incentive to invest — for UK exporters and domestic firms competing with imports — provided by sterling’s recent weakness. The EY ITEM Club expects business investment to rise 1.9% in 2018 after an estimated increase of 2.3% in 2017. Investment growth is seen picking up to 2.7% in 2019, helped by improved economic activity. A welcome improvement, but not at a level to drive the economy forward significantly faster.

… and in the labour market …

As EY ITEM Club points out, the unemployment rate came down to 4.3% in 2017, which is the lowest rate since 1975 and is below the 4.5% rate that the Bank of England currently considers to be the ‘equilibrium’ level. I hear the same message up and down the country from employers, that is, with the labour market now extremely tight, it is becoming increasingly difficult for companies to find suitable candidates in several sectors. There were some signs towards the end of 2017 that underlying pay growth was starting to creep up but pay rises remain below the level we would expect, given the low level of unemployment. The EY ITEM Club is forecasting that average earnings will rise by 2.7% in 2018, with a further increase to 3.1% expected in 2019, but the labour market remains a source of much uncertainty. Will the UK be able to attract the labour it needs? Will wage inflation suddenly accelerate?

… create a worry over the UK’s future performance …

A significant risk is that prolonged uncertainty, concerns over the UK’s economic outlook, and skills shortages end up weighing down markedly on business investment, thereby damaging the UK’s economic potential. This could be compounded if foreign companies ended up markedly reducing their investment in the UK and this diluted any beneficial spillover of skills and knowledge. The result is that there is a real risk that the UK will find its ability to grow faster than it is currently, severely constrained. The UK Government must do all it can to create an environment that encourages UK-based businesses to invest in skills, capital and intellectual property, creating the conditions for strong growth in the future.

… and business must remain proactive.

With uncertainty and slow domestic growth, it would be easy for businesses to default to a defensive mode. This would be a mistake, and would mean a risk of missing out on global growth and failing to position for the future in the UK. Now is the time to review the global portfolio while ensuring risks are identified and managed in the UK, in addition to developing a strategy for the business post-Brexit.

Read the EY ITEM Club Winter Forecast

@MarkGregoryEY

EY ITEM Club is part of our Economics for Business programme which provides knowledge, analysis and insight to help businesses understand the economic environments in which they operate.