GDP in First-Quarter 2012

Perhaps the main focus of a very busy week of important economic releases will be Thursday’s second estimate of GDP in the first quarter of 2012. The preliminary estimate from the Office for National Statistics (ONS) showed GDP contracting 0.2% quarter-on-quarter (q/q) in the first quarter, which meant that the UK was officially back in recession, given that GDP had earlier contracted by 0.3% q/q in the fourth quarter of 2011. It also meant that GDP was only flat year-on-year (y/y) in the first quarter of 2012.

Albeit without a huge degree of confidence and with a lot of hope, we are forecasting that the second estimate of GDP in the first quarter will trim the rate of contraction from 0.2% q/q to 0.1% q/q. This would lift y/y growth from 0.0% to 0.1%. We still think ultimately that the first-quarter contraction will eventually be revised away as construction output, in particular, is revised up.

There has been considerable scepticism—which we share—over whether or not the UK economy really did contract in the first quarter. There is no denying that the UK economy is struggling markedly in the face of major domestic and international (mainly Eurozone) headwinds, but a number of reasonably decent business surveys during the first quarter, a 0.8% q/q rise in retail sales volumes, and improved news on the labor market seemed to point to an economy seeing modest underlying growth.

The preliminary estimate of GDP in the first quarter was based purely on the output side of the economy, using hard data for January and February and estimates for March. According to this, construction output plunged by 3.0% q/q, which was particularly at odds with survey evidence from the purchasing managers and anecdotal evidence from companies. This contributed 0.2 percentage point to q/q GDP contraction. In addition, industrial production fell by 0.4% q/q as it was held back by a sharp drop in extraction activity while manufacturing output was essentially flat. Finally, output in the dominant services sector edged up by just 0.1% q/q.

Hopes and expectations that the first-quarter GDP performance would be revised up—perhaps even to show flat activity—have been hit by a latest estimate from the ONS that showed construction output was even deeper than first reported at 4.8% q/q. While this is even more at odds with the relatively healthy survey, in itself it would mean that the overall GDP decline would be increased to 0.3% q/q, from 0.2% q/q. Meanwhile, March data confirmed that industrial production contracted 0.4% q/q in the first quarter. So hopes that first-quarter GDP will be revised up, or at the very least not revised down further, currently rest on service sector output growth being revised up from the preliminary estimate of just 0.1% q/q. Given the survey evidence, particularly from the purchasing managers, we hope that this will be the case.

The new estimate of GDP in the first quarter will contain details of the expenditure side of the economy. On the positive side, consumer spending probably expanded given the 0.8% q/q increase in retail sales volumes and a likely modest rise in spending on services. It is also possible that there was a limited rebound in business investment after it contracted by 3.3% q/q in the fourth quarter of 2011. It seems likely net trade was a modest drag on GDP, given the reported trade data for January–March, while inventories may have increased at a reduced rate or even been run down thereby weighing down on GDP. Meanwhile, government spending and investment could well have been pared as fiscal tightening measures increasingly kicked in.

Whether or not the economy really did contract in the first quarter, it undeniably still faces serious domestic and international headwinds so it is likely to see only limited activity overall and be vulnerable to relapses over the next few months at least. These headwinds notably include still markedly squeezed consumer purchasing power, elevated unemployment, a reluctance of business to invest in worrying and uncertain circumstances, relatively tight credit conditions, reduced public spending and investment, and muted global economic activity (particularly the weakness in the Eurozone). Recent elevated oil prices have reinforced the headwinds facing the UK economy as they have caused inflation to be sticky thereby maintaining an appreciable squeeze on consumers’ purchasing power. Elevated oil prices have also squeezed companies’ margins, thereby threatening to hold back their investment and, possibly, employment plans.

There is also the likelihood that growth in the second quarter will be held back by the extra day’s public holiday for the Queen’s Diamond Jubilee.

We expect sustainable modest growth to finally develop from the second half of 2012, supported by the reduced squeeze on consumers’ purchasing power coming from lower inflation (assuming that oil prices stay appreciably below their March highs), ongoing ultra-accommodative monetary policy and, hopefully, gradually improving global economic activity. This backdrop should increasingly encourage business to invest, hopefully helped by an easing of credit conditions.

Nevertheless, GDP growth is likely to be limited to 0.4% in 2012. We see GDP growth improving to 1.6% in 2013.

Serious downside risks to these GDP growth forecasts stem from the very real possibility of a Greek exit from the Eurozone, which would have significant adverse repercussions for the UK. This would undoubtedly cause the Eurozone overall to suffer longer and deeper contraction and adversely affect the UK in a number of ways, notably through the impact on banks, credit conditions, exports, UK companies’ operations in the Eurozone, market volatility, and business and consumer confidence. Businesses could well hold back on investment because of the heightened uncertainty. There is also the risk that sterling could rise strongly against the euro and hurt UK competitiveness.

Public Finances in April

Public finances data for April (Tuesday) are expected to be essentially little changed compared with a year earlier.Specifically, we forecast there to have been a Public Sector Net Borrowing Requirement (PSNBR) excluding financial interventions of GBP8.5 billion in April, which would be down marginally from GBP8.6 billion in March 2011. April is the first month of fiscal year 2012/13 when Chancellor George Osborne is aiming to trim the PSNBR to GBP120 billion from the 2011/12 outturn of GBP126 billion.

April’s public finances should benefit from more of the policy tightening kicking in as the new fiscal year gets under way. Nevertheless, recent weakened economic activity is likely to have taken a toll on tax revenues.

Consumer Price Inflation in April

Data out Tuesday are expected to show that consumer price inflation moderated to 3.2% in April after rising to 3.5% in March from 3.4% in February. While this would be the lowest level since October 2010 and down from a peak of 5.2% in September 2011, the fact remains that consumer price inflation is proving a lot stickier than had been expected and hoped for. Consumer price inflation remains well above the Bank of England’s 2.0% target rate, with the result that the bank’s governor, Sir Mervyn King, will be required to write yet another letter to Chancellor George Osborne explaining why consumer price inflation is more than one percentage point above its target rate and what the central bank is doing about it. In fact, King has been writing a version of this letter every quarter since February 2010.

Inflation is expected to have fallen modestly in April, largely because of the fact oil prices retreated from their March highs. In contrast, oil prices rose markedly in April 2011, which will help the y/y comparison. In addition, it appears that the y/y increase in food prices moderated in April. Specifically, the British Retail Consortium (BRC) shop price deflator showed that annual food price inflation retreated appreciably to 4.3% in April after jumping to 5.4% in March from 4.2% in February and an 18-month low of 3.7% in January. The BRC‘s shop price deflator also showed that non-food prices fell 0.5% y/y in April, which marked the third successive month of deflation in non-food prices. However, it was less than the 0.9% y/y drop seen in March, which was the sharpest fall for 28 months. Overall, the y/y increase in the BRC’s shop price deflator fell to 1.3% in April, after spiking to 1.5% in March from a 23-month low of 1.2% in February. This was down from 1.7% in December and a peak of 2.7% in both September and August 2011.

Future oil price developments will have a key role to play in just how far and how quickly consumer price inflation comes down over the coming months. The good news is that oil prices have recently retreated appreciably (even if it is primarily for very worrying reasons, i.e., heightened concerns over the Greek situation and its potential impact on the global economy) with Brent oil trading at a 2012 low under USD107/barrel on Friday. This is down from a peak of USD126/barrel. Even so, the concern is that oil prices may well remain prone to upward spikes, while core inflation (seen stable at 2.5% in April) has also proved stickier than had been hoped for.

On balance, we expect consumer price inflation to be down to around 2.3% at the end of 2012. We believe that underlying inflationary pressures will gradually ease because of appreciable excess capacity, extended muted economic activity, and ongoing wage moderation amid substantial labor market slack.

Minutes of May Bank of England MPC Meeting

Wednesday sees the release of the minutes of the May meeting of the Bank of England's Monetary Policy Committee (MPC) when the committee held off from extending quantitative easing (QE) and kept interest rates down at 0.50% where they have been since March 2009. With February’s GBP50-billion extension to QE having been utilized by early May, the MPC’s inaction meant that QE has now been brought to at least a temporary halt.

We suspect that the decision to hold off from more QE followed a split vote within the MPC and it will be very interesting to see just how close the vote was. We anticipate that David Miles continued to favor more QE at the May MPC meeting, and we expect that at least one other committee member joined him. Obviously, the closer the vote was in deciding to hold off from more QE, the greater the likelihood that it could eventually be extended. And latest comments by Adam Posen suggest that he is having serious doubts about dropping his call for more QE in April.

The overall impression from the Bank of England’s Quarterly Inflation Report is that the bank is highly mindful of the major uncertainties currently surrounding both the growth and inflation outlooks and is keeping its options fully open on future policy. Events in Greece are magnifying the uncertainties and risks to the outlook. The inflation report contained the all-too-familiar and depressing blend of reduced GDP growth but raised consumer price inflation forecasts in the near term.

Despite the near-term rise in the consumer price inflation forecast, the Bank of England’s central forecast still shows consumer price inflation modestly below its 2.0% target on a two-year horizon, which suggests that further QE is certainly not excluded. While the central forecast shows consumer price inflation modestly below the 2.0% target on a two-year horizon, the Bank of England also considers that “the risks of inflation being above or below the target by the end of the forecast period are judged to be broadly balanced.” Meanwhile, despite lowering the near-term GDP growth forecasts and highlighting the distortions that will affect the quarter-on-quarter growth patterns over the rest of 2012 (extra day’s public holiday from Diamond Jubilee, Olympics), the Bank of England holds to the view that recovery will take hold later on this year. Nevertheless, the Bank of England’s central forecasts show y/y GDP growth picking up less markedly to around 2.5% in two years’ time, partly due to a slower pickup in productivity than previously assumed.

The impression we get is that the Bank of England is keeping the door fully open to more QE despite bringing it to a halt in May and will continue to closely review its decision over the coming months in light of whether or not the economy shows evidence of underlying improvement and how sticky consumer price inflation proves to be. We suspect that the Bank of England would prefer not to do more QE, but is prepared to act if underlying economic activity fails to improve.

While the outlook for QE seems highly uncertain, the outlook for interest rates appears clearer. Interest rates seem set to remain at their current level of 0.50% until at least late 2013 and very possibly into 2014. Interest rates are clearly not going to be raised for some considerable time to come, given the fragility of the economy and the need to counter extended tight fiscal policy. At the same time, there is clearly little interest within the Bank of England for taking interest rates lower than 0.50%. Indeed, it is significant that even at the height of the 2008/09 recession, the Bank of England did not take interest rates below 0.50%, which reflected doubts within the MPC that even lower interest rates would have a net beneficial impact.

Retail Sales in April

Retail sales volumes (Wednesday) are expected to have fallen 1.0% month-on-month (m/m) in April after spiking 1.8% in March. This would limit y/y growth to just 0.7% in April, although this is limited by the fact sales in April 2011 were inflated by the royal wedding and particularly good weather. Survey evidence from the British Retail Consortium, in particular, indicates that sales were appreciably softer in April.

Clearly, there was always going to be some correction in retail sales in April after the sharp jump in March. It is evident that March’s sales were lifted by people bringing forward purchases of summer clothes and footwear, and outdoor goods due to the good weather that month. In addition, overall sales were lifted in March by panic buying of petrol resulting from fears of a tanker drivers’ strike (although retail sales were still up 1.5% m/m in March excluding fuel sales). In contrast, the very wet weather suffered in April dampened sales of clothing, footwear, and outdoor products—literally!

Looking through the factors weighing down on retail sales in April, it is evident that there are currently a lot of pressures on consumers as they face uncertain and worrying times, so they seem likely to be cautious overall in their spending over the next few months at least. With consumer price inflation proving sticky at 3.5% in March, annual earnings growth limited to just 0.6% in the three months to March (and 0.1% in March itself) and fiscal policy tight, the squeeze on purchasing power is currently appreciable. Meanwhile, unemployment is still high and full-time employment falling modestly, despite the recent better news on the labor market.

There is also the very real worry that already-low and brittle consumer confidence will have taken a significant hit from the news that the UK is back in recession, and this will lead to increased caution in spending. Heightened worries over the situation in Greece and how this could hit the UK economy is also likely to fuel consumer caution.

Hopefully, inflation will eventually fall appreciably further and support consumer spending, but this looks like a gradual process. Even if consumer price inflation does eventually fall back appreciably further, unemployment is likely to remain high and wage growth muted so the overall environment will likely still be pretty tough for consumers.

CBI Industrial Trends Survey for May

We expect the Confederation of British Industry (CBI) industrial trends survey for May (Thursday) to indicate that manufacturing activity is expanding modestly in the second quarter. Latest hard data from the ONS show that manufacturing output rebounded by 0.9% m/m in March after dropping 1.0% in February when it may well have been damaged by the snow early on in the month. Manufacturing output was flat overall in the first quarter of 2012 compared with the fourth quarter of 2011.

Specifically, we forecast the balance of manufacturers reporting their orders are at normal levels to have eased to -10% in May from -8% in both April and March. This would compare with a long-term average of -17% for the balance.

We also expect the May CBI survey to reveal that manufacturers generally expect to raise their production over the next three months. In April, a balance of 24% of companies expected to raise output over the next three months. This matched the March level and was the highest balance for a year.

While we believe that the manufacturing sector is currently growing modestly, it clearly faces serious challenges that are limiting its performance and at least its near-term prospects. Eurozone weakness and soft activity elsewhere are weighing down on foreign demand for UK manufactured goods, and exporters will be worried that sterling’s recent firmer tone (it has hit a 33-month high on a trade-weighted basis in May) will hurt their competitiveness. Meanwhile, domestic demand for manufactured goods is handicapped by a still-appreciable squeeze on consumers’ purchasing power as well as by tighter public spending. In addition, recent higher input costs centered on elevated oil prices has been bad news for manufacturers as it is squeezing their margins and exerting pressure on them to raise prices at a time when demand is still fragile. At least though, oil prices have retreated markedly from their March highs.