An economic multiverse - Capital Economics
UK Economics

An economic multiverse

UK Economic Outlook
Written by Paul Dales
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As Brexit could dramatically alter the near-term outlook for the economy, we are continuing to publish three sets of forecasts based on different Brexit outcomes (deal, no deal and more delays). But there are three common themes to this economic multiverse. First, GDP growth in 2021 may be reasonably good in all scenarios (although growth would slow sharply after a no deal Brexit and a decent rebound would require a swift and strong policy response). Second, fiscal policy will be much looser over the next few years than over the past few years. And third, inflation will spend most of the next two years above the 2% target. Those themes point to higher interest rates in time. If there is a Brexit deal or a delay, then interest rates may rise next year. If there’s a no deal Brexit, rates would be cut first.

  • Overview – As Brexit could dramatically alter the near-term outlook for the economy, we are continuing to publish three sets of forecasts based on different Brexit outcomes (deal, no deal and more delays). But there are three common themes to this economic multiverse. First, GDP growth in 2021 may be reasonably good in all scenarios (although growth would slow sharply after a no deal Brexit and a decent rebound would require a swift and strong policy response). Second, fiscal policy will be much looser over the next few years than over the past few years. And third, inflation will spend most of the next two years above the 2% target. Those themes point to higher interest rates in time. If there is a Brexit deal or a delay, then interest rates may rise next year. If there’s a no deal Brexit, rates would be cut first.
  • Forecasts – Our three sets of forecasts highlight how the political decision on Brexit required by 31st October could send the economy down vastly different paths.
  • External Demand – Regardless of domestic political developments, the global economy will probably remain a drag on the UK economy for the rest of this year and for most of next year.
  • Consumer spending – Despite a softening outlook for income growth, in most Brexit scenarios households will probably remain the strongest part of the economy.
  • Investment – Businesses are clearly most exposed to a no deal Brexit. But if a deal on Brexit is reached, a rebound in business investment would probably underpin faster GDP growth.
  • Labour Market – Employment growth has probably peaked and the unemployment rate may have reached a trough. Even so, wage growth may stay fairly close to its recent decade high.
  • Inflation – In all three of our Brexit scenarios, faster rises in labour costs contribute to CPI inflation rising further above the 2% target than the Bank of England expects.
  • Monetary & Fiscal Policy – All political roads appear to lead to looser fiscal policy, which may mean at some point interest rates will have to rise to compensate (except after a no deal when rates would be cut).
  • Long-term Outlook – Over the next 20 years, the drag on the economy’s potential growth rate from lower migration and an ageing population will probably be offset by faster productivity growth.

Key Forecasts Table

Table 1: Brexit Repeated Delays Scenario*

2019

2020

Annual (% y/y)

Q1

Q2f

Q3f

Q4f

Q1f

Q2f

Q3f

Q4f

Average 2010-17

2018

2019f

2020f

2021f

Demand (% q/q)

GDP

0.5

-0.1

0.5

0.3

0.5

0.3

0.4

0.4

2.0

1.4

1.4

1.5

2.0

Consumer Spending

0.6

0.4

0.4

0.5

0.4

0.5

0.5

0.5

1.7

1.8

1.8

1.8

1.7

Government Consumption

0.8

0.6

0.5

0.5

0.4

0.4

0.4

0.4

0.7

0.4

2.5

1.8

1.6

Fixed Investment

1.2

-1.1

0.6

-0.1

0.5

0.5

0.7

1.0

3.6

0.2

0.5

1.4

3.6

Business Investment

0.4

-1.0

0.5

-0.5

0.5

0.5

1.0

1.5

3.8

-0.4

-1.3

1.4

4.8

Stockbuilding1 (contribution, ppts)

0.3

-0.9

0.5

-0.5

0.1

0.0

0.0

0.0

0.1

0.4

0.3

-0.3

0.0

Domestic Demand2

1.0

-0.8

0.9

-0.1

0.5

0.5

0.5

0.5

2.1

1.6

1.9

1.5

2.0

Exports

1.5

-2.0

0.4

0.4

0.4

0.4

0.4

0.5

3.5

0.1

1.6

1.0

2.3

Imports

10.8

-10.0

1.7

-0.9

0.8

0.8

0.8

0.8

3.9

0.7

5.2

-0.6

2.3

Net Trade2 (contribution, ppts)

-0.5

0.6

-0.4

0.4

0.0

-0.2

-0.1

-0.1

-0.1

-0.1

-0.6

-0.1

-0.1

Labour Market (% y/y)

 

 

Unemployment (ILO measure, %)

3.8

3.9

3.9

4.0

4.0

4.0

4.0

4.0

6.6

4.1

3.9

4.0

4.0

Employment

1.1

1.1

1.0

0.5

0.3

0.3

0.4

0.5

1.2

1.2

0.9

0.4

0.4

Productivity (output per hour)

0.3

-0.1

0.6

0.7

0.9

1.3

1.1

1.1

0.5

0.6

0.4

1.1

1.6

Income & Saving (%y/y)

 

 

Nominal Average Weekly Earnings3

3.3

3.5

4.0

4.2

4.0

3.6

3.4

3.3

1.9

2.9

3.7

3.6

3.5

Real Average Weekly Earnings4

1.5

1.2

1.8

2.3

1.6

1.3

1.1

0.8

-0.4

0.3

1.7

1.2

1.2

Real Household Disposable Income

2.5

2.3

2.1

1.6

1.1

1.5

1.6

2.3

1.2

2.2

2.1

1.6

1.7

Saving Ratio (%)

4.1

4.0

3.7

3.9

3.6

4.2

3.8

4.5

8.8

4.2

3.9

4.0

4.3

Prices (% y/y)

 

 

CPI

1.9

2.1

2.1

2.2

2.6

2.4

2.2

2.3

2.3

2.5

2.1

2.4

2.2

Core CPI5

1.9

1.7

1.9

2.0

2.2

2.3

2.1

2.0

2.1

2.1

2.0

2.6

2.2

CPIH

1.8

2.0

2.0

2.1

2.5

2.4

2.3

2.3

2.1

2.3

2.0

2.4

2.3

RPI

2.5

3.0

2.9

2.8

3.1

2.8

2.7

2.8

3.1

3.3

2.8

2.9

3.1

RPIX

2.4

3.0

2.9

3.0

3.3

3.0

2.8

2.9

3.2

3.4

2.8

3.0

2.9

Nationwide House Prices (end period)

0.6

0.5

0.4

1.0

1.1

1.2

1.3

1.5

3.4

0.5

1.0

1.5

2.0

Monetary Indicators (end period)

 

 

Bank Rate (%)

0.75

0.75

0.75

0.75

0.75

0.75

0.75

1.00

0.46

0.75

0.75

1.00

1.25

10-Year Gilt Yield (%)

1.00

0.83

0.92

1.00

1.06

1.13

1.19

1.25

2.19

1.28

1.00

1.25

1.75

Sterling Trade-weighted Index

80.0

80.2

80.3

79.9

80.3

80.6

81.0

81.3

82.8

77.0

79.9

81.3

84.3

$/£

1.32

1.26

1.25

1.25

1.26

1.28

1.29

1.30

1.52

1.28

1.25

1.30

1.35

Euro/£

1.17

1.12

1.13

1.19

1.17

1.16

1.14

1.13

1.21

1.11

1.19

1.13

1.17

Current Account & Public Finances

 

 

Current Account (£bn)

-29.0

-25.5

-30.8

-28.7

-24.5

-29.1

-31.0

-31.2

-74.4

-81.6

-115

-115

-110

% of GDP

-5.6

-4.7

-5.6

-5.1

-4.3

-5.1

-5.4

-5.4

-4.1

-3.9

-5.2

-5.1

-4.7

PSNB6 (£bn, financial year)

90

24

20

10

0

% of GDP (financial year)

5.1

1.1

0.9

0.4

0.0

Global (% y/y)

 

 

World GDP7(CE estimate for China)

3.1

2.9

2.8

2.7

2.6

2.7

2.8

2.9

3.7

3.6

3.0

2.7

3.0

Oil Price (Brent, $pb, end period)

68

67

63

60

62

64

65

65

83.1

53.8

60

65

68

Sources: Refinitiv, Capital Economics; 1Excluding alignment adjustment; 2Excluding valuables; 3Including bonuses; 4Earnings deflated by CPI; 5Excluding energy, food, alcohol & tobacco; 6Excluding Banking groups; 7PPP terms

* Based on our “repeated delay” scenario for Brexit, which assumes that Brexit is delayed again and again at least until the end of 2021.

Key Forecasts Tables

Table 2: Brexit Deal Scenario*

2019

2020

Annual (% y/y)

Q1

Q2f

Q3f

Q4f

Q1f

Q2f

Q3f

Q4f

Average

2010-17

2018

2019f

2020f

2021f

Demand (% q/q)

GDP

0.5

-0.1

0.5

0.4

0.4

0.4

0.5

0.5

2.0

1.4

1.4

1.7

2.2

Consumer Spending

0.6

0.4

0.4

0.5

0.4

0.5

0.5

0.5

1.7

1.8

1.8

1.8

1.7

Fixed Investment

1.2

-1.1

0.6

0.2

0.8

0.9

1.5

1.5

3.6

0.2

0.5

2.8

4.6

Net Trade1 (contribution, ppts)

-0.5

0.6

-0.4

0.4

-0.1

-0.1

-0.1

-0.1

-0.1

-0.1

-0.6

-0.1

-0.1

CPI (% y/y)

1.9

2.1

2.1

2.1

2.5

2.3

2.0

2.1

2.3

2.5

2.0

2.2

2.2

Unemployment (ILO measure, %)

3.8

3.9

3.9

4.0

4.0

4.0

4.0

4.0

6.6

4.1

3.9

4.0

4.0

Average Weekly Earnings2 (% y/y)

3.3

3.5

4.0

4.2

4.0

3.6

3.4

3.3

1.9

2.9

3.7

3.6

3.5

Bank Rate (%, end period)

0.75

0.75

0.75

0.75

0.75

0.75

1.00

1.00

0.46

0.8

0.75

1.00

1.50

10-Year Gilt Yield (%, end period)

1.00

0.83

0.92

1.00

1.13

1.25

1.38

1.50

2.19

1.3

1.00

1.50

2.00

£/$ (end-period)

1.32

1.26

1.25

1.25

1.28

1.30

1.33

1.35

1.52

1.3

1.25

1.35

1.40

Sources: Refinitiv, Capital Economics; 1 Excluding valuables; 2 Nominal, Including bonuses

* Assumes a Brexit deal is struck on 31st October 2019.

Table 3: Brexit No Deal Scenario*

2019

2020

Annual (% y/y)

Q1

Q2f

Q3f

Q4f

Q1f

Q2f

Q3f

Q4f

Average

2010-17

2018

2019f

2020f

2021f

Demand (% q/q)

GDP

0.5

-0.1

0.5

-0.5

-0.1

0.3

0.7

0.7

2.0

1.4

1.1

0.5

2.2

Consumer Spending

0.6

0.4

0.4

-0.2

0.0

0.2

0.5

0.5

1.7

1.8

1.6

0.6

1.8

Fixed Investment

1.2

-1.1

0.6

-1.0

-0.9

1.0

0.9

0.9

3.6

0.2

0.2

-0.2

3.5

Net Trade1 (contribution, ppts)

-0.5

0.6

-0.4

0.1

-0.1

-0.2

0.1

0.2

-0.1

-0.1

-0.7

-0.1

0.1

CPI (% y/y)

1.9

2.1

2.1

2.4

2.9

2.9

3.0

3.0

2.3

2.5

2.1

3.0

2.7

Unemployment (ILO measure, %)

3.8

3.9

3.9

4.0

4.1

4.2

4.4

4.5

6.6

4.1

4.0

4.3

4.5

Average Weekly Earnings2 (% y/y)

3.3

3.5

4.0

4.2

4.2

3.6

3.1

2.9

1.9

2.9

3.6

3.6

3.4

Bank Rate (%, end period)

0.75

0.75

0.75

0.50

0.25

0.25

0.25

0.25

0.46

0.75

0.50

0.25

0.50

10-Year Gilt Yield (%, end period)

1.00

0.83

0.92

0.50

0.50

0.50

0.50

0.50

2.19

1.28

0.50

0.50

1.25

£/$ (end-period)

1.32

1.26

1.25

1.15

1.16

1.18

1.19

1.20

1.52

1.28

1.15

1.20

1.25

Sources: Refinitiv, Capital Economics; 1 Excluding valuables; 2 Nominal, Including bonuses

* Assumes the UK leaves the EU without a trade deal on 31st October 2019.

Overview

Rising chances of a no deal and Labour government

  • Our three forecasts based on different Brexit outcomes illustrate how politics could push the economy along vastly different paths over the next few years. (See Chart 1.) But there are a few common themes regardless of the politics, such as looser fiscal policy and higher inflation.
  • While the economy probably contracted in Q2 for the first time since 2012, we doubt that will mark the start of a recession. Much of the weakness is because activity was shifted from Q2 into Q1 to beat the original Brexit date of 29th March. So just as the 0.5% q/q gain in GDP in Q1 made the economy look stronger than it was, any fall in Q2 (we’re expecting -0.1% q/q) would make it look weaker than it is. GDP will probably rise in Q3. (See Chart 2.)
  • What happens next depends on Brexit, and the chances of a no deal on 31st October are rising regardless of whether Boris Johnson or Jeremy Hunt becomes Prime Minister. There is a wide range of plausible outcomes for GDP growth after a no deal depending on the preparations, the tariffs set, the policy response and UK/EU relations. Our assumption is that interest rate cuts and looser fiscal policy would help GDP growth rebound from the initial slump quicker than is widely expected. (See Chart 3.)
  • If there’s a Brexit deal, a fall in uncertainty would probably result in many firms starting the investment projects they previously put on ice. GDP growth could then rise from about 1.4% this year to around 2.2% in 2021. (See Table 2.) If Brexit was repeatedly delayed until at least the end of 2021, business investment would probably rise a bit anyway, resulting in GDP growth rising to 2.0% in 2021. (See Table 1.)
  • The chances of a general election and a Labour government also appear to be rising. Much like with a no deal, a Labour government could mean different things for the economy. But we suspect the potential boosts from higher public spending and public investment would be more than offset by the potential drags from higher taxes and Labour’s anti-business policies.
  • Regardless of the politics, three economic trends seems in train. First, the global economy will be a more persistent drag on the UK than most expect. Indeed, a sharp decline in US equity prices later this year may trigger a large fall in UK equity prices. (See Chart 4.)
  • Second, fiscal policy will probably be loosened in all scenarios. After a no deal Brexit, that would play an important role in supporting the economy. In the other Brexit scenarios, it would provide an extra boost to GDP growth.
  • Third, as businesses pass on the previous rises in wage growth, inflation may spend much of the next two years above the 2% target. (See Chart 5.) That would especially be the case after a no deal, as the boost to import price inflation from a weaker pound could lift inflation above 3%.
  • Looser fiscal policy and higher inflation point to higher interest rates. That said, even if there is a deal or many delays to Brexit, the soft global backdrop would probably mean rates aren’t raised until the middle of 2020. And if there was a no deal, rates would probably be cut from 0.75% to 0.25%. (See Chart 6.)
  • A no deal Brexit would surely push gilt yields lower and prompt the pound to fall, perhaps from $1.25 now to around $1.15. Other Brexit outcomes could result in gilt yields and the pound rising. (See Chart 7 & 8.)

Overview Charts

Chart 1: GDP in Different Brexit Outcomes (%y/y)

Chart 2: Real GDP

Chart 3: GDP in Different No Deal Outcomes (% y/y)

Chart 4: Equity Price Indices

Chart 5: CPI Inflation (%)

Chart 6: Bank Rate (%)

Chart 7: 10-Year Gilt Yields (%)

Chart 8: $/£ Exchange Rate

Sources: Refinitiv, IHS Markit, Capital Economics


External Demand

No support from overseas

  • Softer global growth combined with resilient domestic demand, particularly if Brexit is delayed or a deal is agreed, means net trade will remain a drag on GDP growth. As such, the current account deficit will remain large, leaving the pound vulnerable to a sharp fall.
  • The widening in the trade deficit in Q1 as firms imported goods and raw materials ahead of the original 29th March Brexit date has already been reversed. (See Chart 9.) But the bigger issue is that export growth has remained relatively soft.
  • Chart 10 shows that exports have risen by 20% on average in the three years following previous large falls in the pound. This time, they are up by just 7%. Exporters haven’t responded to the increase in their margins afforded by the weaker currency by increasing output as they have in the past. That’s because many exporting firms are operating at capacity, and Brexit has dissuaded them from investing to expand.
  • Even if Brexit is resolved, and that investment is undertaken, the chances of a substantial boost to exports looks slim. Growth in global trade volumes has already ground to a halt, which has restrained UK export orders. (See Chart 11.)
  • Moreover, we think global growth will fall short of the consensus forecast. We expect growth in the US economy to slow sharply in the second half of this year as the impact of last year’s fiscal stimulus fades and the full impact of the Fed’s previous interest rate hikes is felt. Meanwhile, growth in the euro-zone is likely to stay sluggish.
  • Only a fraction of the global slowdown is due to the US-China trade war. And the further escalation in the US-China trade war we expect won’t hurt the global economy or the UK economy much. Therefore, even if trade tensions thaw, the demand for the UK’s exports will remain muted. (See Chart 12.)
  • Imports should hold up better than exports. If there is a Brexit deal or another delay, domestic demand and import growth should be resilient. (See Chart 13.)
  • Putting this together, the external sector will remain a drag on the economy. This year net trade may take 0.6 percentage points (ppts) off GDP growth before subtracting around 0.1 ppts in both 2020 and 2021. (See Chart 14.)
  • In a no deal scenario, both exports and imports would plunge as delays at the ports would prevent goods from entering and leaving the country for a few weeks. Weak domestic demand in the aftermath may mean imports take longer to recover. As a result, the external sector might provide some support to the economy, but only enough to offset a fraction of the overall slowdown in GDP growth.
  • In most scenarios, the trade deficit will remain around 2% of GDP – the largest it has been in a decade. The investment income balance is also likely to record a sizeable deficit. That’s because stronger growth in the UK than overseas would mean the amount UK assets return to their foreign owners will rise, while the UK’s income from overseas assets could fall. (See Chart 15.)
  • As such, the overall current account deficit is likely to remain around 5% of GDP. (See Chart 16.) That leaves the pound at risk of another large fall in the next five years or so.

External Demand Charts

Chart 9: Monthly Trade Balance (£bn)

Chart 10: Import & Export Volumes Excluding Erratics (%)

Chart 11: PMI Manufacturing Export Orders Balance

Chart 12: Trade Partner GDP & UK Exports (% y/y)

Chart 13: Domestic Demand & Imports (% y/y)

Chart 14: Net Trade (Contribution to y/y GDP, ppts)

Chart 15: UK Domestic Demand Relative to its Trade Partners & Investment Income Balance

Chart 16: Current Account Balance

Sources: Refinitiv, IHS Markit, Capital Economics


Consumer Spending

Households to remain strongest part of the economy

  • While we doubt household spending will accelerate, we don’t expect it to slow much either. Indeed, households will probably remain the strongest sector of the economy.
  • Solid growth in real household incomes has been behind the recent resilience in consumer spending. (See Chart 17.) Admittedly, income growth will probably peak this year as employment growth slows. Indeed, the contribution to real income growth from employment may halve between 2019 and 2021. But we don’t expect income growth to slump as the contribution from real wages will probably rise. (See Chart 18.)
  • Meanwhile, disposable incomes could yet be supported by tax changes. Indeed, the tax cuts and increase in the threshold for National Insurance contributions proposed by Boris Johnson could boost household incomes by nearly 1.5%. (See Chart 19.)
  • If a Brexit deal is agreed or if there are repeated delays, rising interest rates would mean that at some point over the next two years consumers will have to devote more income to servicing the high level of debt. (See Chart 20.)
  • But even if there is Brexit deal and interest rates were to rise to 1.50% by the end of 2021, interest and capital repayments would probably only rise from the equivalent of 13.4% of disposable income to just above 14% of disposable income. (See Chart 21.)
  • In our Brexit deal and delay scenarios, consumption growth holds steady at 1.8% in both 2019 and in 2020, before nudging down in 2021 to 1.7%. (See Chart 22.)
  • In a no deal Brexit, however, real consumption growth would be hit by a fall in consumer confidence and a rise in inflation. That could push down consumer spending growth to around 0.6% in 2020. But given that we don’t expect the unemployment rate to rise much, consumer spending growth would probably rebound to around 1.8% in 2021.
  • Perhaps the biggest risk in any Brexit scenario is not weaker income growth or higher interest rates, but higher saving. We’ve assumed in all our scenarios that the saving rate will fall a little bit, from 4.1% now to 3.6%. Although that’s low by historical standards, low interest rates, high net wealth and the low unemployment rate mean a low saving rate is more sustainable than before. (See Chart 23.)
  • Even so, things would be different if for some reason the saving rate rose. For example, a rise to 6% would reduce consumer spending growth from 1.8% to 1.0% and a rise to the long-term average of 8% would cut consumer spending growth to zero. (See Chart 24.)
  • Another risk would be a Labour government, as Labour has pledged to fund increases in day-to-day spending with higher taxes. Labour’s proposed measures could amount to a 1% drag on household incomes. (See Chart 19 again.) And while Labour’s planned rise in the minimum wage would support wages, there is a risk that firms pay for higher labour costs by reducing non-wage benefits or employment.
  • Overall, slower income growth probably means that the best is probably behind households. But unless there is a no deal Brexit, consumer spending growth may still hold up well.

Consumer Spending Charts

Chart 17: Real Household Incomes & Spending (% y/y)

Chart 18: Contributions to % y/y Real Household Income (ppts)

Chart 19: Effect of Possible Tax Changes (% of Income)

Chart 20: Household Debt & Repayments (% of Income)

Chart 21: Debt Servicing Costs (As a % of Income)

Chart 22: Real Household Spending

Chart 23: Unemployment Rate & Household Saving Ratio

Chart 24: Real Household Spending (% y/y)

Sources: Refinitiv, Capital Economics, IFS, Labour Manifesto, BoE


Investment

Hamstrung by Brexit

  • Weak investment will continue to weigh on demand until Brexit is resolved. If there is a no deal, things will get worse before they get better. But a deal would release substantial pent up investment and drive overall economic growth higher.
  • Surveys of capacity utilisation are still at levels consistent with fast investment growth. (See Chart 25.) But despite needing to invest, firms are still holding off. Indeed, the rise in business investment since the financial crisis has been weak by historical standards. (See Chart 26.)
  • Clearly, that’s due to concerns about the UK’s future trading relationship with Europe and the risk of a downturn triggered by a no deal. That’s not going to change soon. In fact, it has got worse since the delay to Brexit in March extended the uncertainty. (See Chart 27.)
  • But we think there is some pent up investment that will be released if and when Brexit is resolved. Of course, if there is a no deal Brexit, some projects that are currently on hold would be cancelled, and the initial disruption and uncertainty would probably cause investment to decline next year. But if the disruption fades, business investment would rise again in 2021.
  • Another delay to Brexit might be better for investment than most think. After the rhetoric of the Conservative leadership race, firms would struggle to believe politicians would allow a no deal regardless of what they say. As a result, firms might find the confidence to start some investment projects that had been on hold.
  • The best result for investment, though, would be a deal, including a two year status quo transition period. In that scenario, we think investment would be 3% higher than in a no deal scenario next year, enough to add 0.8ppts to overall GDP growth in 2020. (See Chart 28.)
  • Subdued growth in house prices means residential investment, which accounts for about a quarter of total investment, will be weak however Brexit pans out. (See Chart 29.) And even if there were a Brexit deal, a surge in house prices isn’t on the cards. With house prices already high, regulation introduced in the wake of the financial crisis capping how much buyers can borrow will prevent prices from going anywhere fast.
  • But that weakness will probably be offset by higher government investment. Following the spending pledges given during the Conservative leadership contest, we wouldn’t be surprised to see the government’s plans for public investment revised up. If elected, a Labour government would increase investment substantially too. (See Chart 30.)
  • While subdued investment has restrained demand, we don’t think the supply potential of the economy has been too badly affected. After all, while investment hasn’t risen much, it hasn’t fallen much either. So firms have still been increasing the economy’s capital stock by about 2% each year. (See Chart 31.)
  • Finally, businesses may continue to spend on stockbuilding to prepare for another possible no deal Brexit on 31st October, as they did in Q1. (See Chart 32.) However, this is a timing effect and spending on stocks won’t permanently boost GDP.

Investment Charts

Chart 25: Capacity Utilisation & Business Investment

Chart 26: Recoveries in Business Investment After Recessions (100 = Peak in GDP)

Chart 27: Investment Intentions & Business Investment

Chart 28: Investment (% y/y)

Chart 29: House Prices & Residential Investment (% y/y)

Chart 30: Government Investment (As a % GDP)

Chart 31: Business Investment & Capital Stock (% y/y)

Chart 32: Stockbuilding & Net Trade (Contribution to q/q GDP, ppts)

Sources: Refinitiv, BCC, BoE, CBI, Labour Manifesto, Capital Economics


Labour Market

Slower employment growth on the horizon, regardless of Brexit

  • Employment growth is likely to slow regardless of what happens with Brexit, but wage growth should remain fairly robust.
  • Employment growth has slowed this year from 222,000 in the three months to January to just 28,000 in the three months to May. That’s dragged down the annual rate from 1.5% to 1.1% and a further fall lies ahead.
  • Admittedly, some of the recent slowdown is probably related to Brexit. Indeed, businesses appeared to boost hiring ahead of the original 29th March Brexit deadline, which reduced the need to fill jobs in April and May. (See Chart 33.) Average hours worked rose before March and dipped back after too.
  • But some of the weakness probably just reflects the normal ebb and flow of the labour market. Chart 34 shows that the 3m/3m rate of employment growth always swings around.
  • Even so, there are key reasons why we expect annual growth in employment to slow from about 1.1% now to about 0.4% next year.
  • First, in any Brexit scenario firms will increasingly run into hiring problems as the pool of unused labour dries up. The number of part-time workers wanting a full-time job has fallen sharply. (See Chart 35.) And with the participation rate only a fraction below its recent record high, it doesn’t look like there is scope for a substantial rise in the workforce.
  • Second, if there is a Brexit deal then firms are likely to shift back towards investing in plants and machinery in order to boost output rather than relying on additional labour.
  • Third, if there is a no deal Brexit, firms will probably press the pause button for a little while and are unlikely to rush to hire additional labour. That said, we also doubt they will shed much labour either, given most of the disruption cause by Brexit should be temporary.
  • As a result, we think that the unemployment rate has probably hit a low point at 3.8% and is likely to tick up to 4.0% in 2020 (if a no deal Brexit is avoided) or to about 4.5% (if there is a no deal Brexit). (See Chart 36.)
  • Some of the latest surveys suggest that wage growth may have peaked too. (See Chart 37.) But we suspect that the tightness of the labour market will mean it stays close to 3.5% for a while yet. What’s more, both candidates to be the next Prime Minister have announced plans to boost public sector pay.
  • Even in a no deal Brexit we think wage growth would only slip to around 3.0%. That would be low by recent standards, but quite good compared to the past few years. (See Chart 38.) However, productivity growth will need to rise at some point to sustain real earnings growth. (See Chart 39.)
  • One risk to our forecasts is a change in government. A Labour government led by Jeremy Corbyn would increase the minimum wage substantially, which would feed through into higher wages. (See Chart 40.) But if it put too much burden on businesses, then it could lead to even slower employment growth.
  • All told, regardless of Brexit, solid wage growth and the low unemployment rate should mean the labour market continues to provide reasonable support to the economy over the next couple of years.

Labour Market Charts

Chart 33: Employment (3m/3m Change, 000s)

Chart 34: Employment

Chart 35: Measures of Labour Market Slack

Chart 36: Unemployment Rate (%)

Chart 37: Private Sector Earnings & REC Salaries Survey

Chart 38: Earnings (3m av. of % y/y)

Chart 39: Real Pay & Productivity (% y/y)

Chart 40: % of Employees Paid the Minimum Wage

Sources: Refinitiv, BoE, REC, Labour Manifesto, Capital Economics


Inflation

On the way up – how high depends on Brexit

  • Given the recent rises in commodity prices and labour costs, it seems pretty likely that inflation is going to rise above its 2% target later this year. But how far above 2% depends on how Brexit is resolved.
  • CPI inflation has hovered around the Bank of England’s 2% target for the past six months as sharp increases in electricity prices and airfares inflation have been offset by weak clothing price inflation and the lagged impact of a fall in import price inflation. (See Chart 41.) However, import goods inflation has started to rise again and domestic pressures are also building, which should push inflation back above 2% before long. (See Chart 42.)
  • Past movements in agricultural commodity prices suggest that food inflation will rise from 1% in May to a peak of about 3% by the end of 2019, adding 0.2ppts to inflation. (See Chart 43.) Admittedly, the fall in wholesale gas and electricity prices should cause Ofgem to revise down its energy price cap in October, which will weigh on inflation. (See Chart 44.)
  • But more importantly, core inflation (excluding food, energy, alcohol and tobacco) will probably strengthen as strong wage growth pushes up costs. Indeed, annual growth in unit labour costs has been high over the past few years as productivity growth has lagged well behind pay growth. (See Chart 45.)
  • Admittedly, core services inflation (excluding VAT, education and airfares) has been lower than we would have expected based on average earnings growth. (See Chart 46.) But this is probably due to firms squeezing their margins rather than passing on rising costs, which cannot continue indefinitely.
  • The upshot is that inflation is likely to rise regardless of what happens with Brexit. If there is a deal then we don’t think that it will rise that far above 2% as a 5% or so increase in the trade-weighted sterling index should push import price inflation down from its current rate of 1.8% to zero. (See Chart 47.) That would knock a full percentage point off inflation over the next few years and would offset much of the increase in domestic cost pressures. But inflation would still be above 2% for the next few years.
  • If there is a delay, then a smaller rise in the pound would probably leave inflation a little bit higher than if there were a deal.
  • But in the case of a no deal, we think that the pound is likely to fall further, potentially boosting import price inflation by about 1%. Meanwhile, pay growth would only be slightly lower than otherwise. So inflation could rise to 3% or more by the end of 2020. (See Chart 48.)
  • In addition, any spending splurge, either by a new Tory Prime Minister or a Labour government, is likely to add to the existing inflationary pressure as the economy is already operating close to full capacity.
  • Overall, then, it seems likely that inflation is on the way up regardless of what happens with Brexit.

Inflation Charts

Chart 41: Import Price Inflation & Core Goods Inflation

Chart 42: CPI & Core CPI Inflation (%)

Chart 43: Wholesale & Consumer Food Prices

Chart 44: Wholesale Prices & Utility Consumer Prices

Chart 45: Unit Labour Costs (% y/y)

Chart 46: Services Inflation & Average Earnings

Chart 47: Sterling Trade-Weighted Index & Import Prices

Chart 48: CPI Inflation (%)

Sources: Refinitiv, Capital Economics


Monetary & Fiscal Policy

All roads lead to looser fiscal policy, but not necessarily higher rates

  • As all political roads appear to lead to looser fiscal policy, at some point interest rates may have to rise to compensate. That said, interest rates would surely be cut if there were a no deal Brexit. And in all other Brexit outcomes, rate hikes are still some way off.
  • The lower tax and higher spending policies that Boris Johnson and Jeremy Hunt have said they would implement as Prime Minister would cost around £20bn and £40bn respectively (0.9% and 1.8% of GDP). Some of those policies may be implemented in a Budget before Brexit.
  • Johnson and Hunt have been vague on how they would fund their policies. But they have both mentioned using the £26bn (1.2% of GDP) of fiscal “headroom” generated by the cyclically adjusted budget deficit being projected to be below 2% of GDP in 2020/21. (See Chart 49.) While that may sound like money sitting in a savings account, it is more like an overdraft. Spending it would result in a higher deficit and more borrowing.
  • That said, if there’s a Brexit deal, the stronger economy would reduce the deficit and perhaps even eliminate it by 2022/23. (See Chart 50.) Policy may then be loosened without borrowing being higher than the OBR projects.
  • If there’s a no deal, a weaker economy would raise the deficit above the 2% of GDP stipulated by the fiscal rule. But we suspect policy would be loosened to support the economy anyway, even if that meant rewriting the fiscal rule. We expect a discretionary loosening in policy of at least 0.5% of GDP, but it could be bigger.
  • Fiscal policy may also be looser under a Labour government as its planned tax hikes may not be able to fund its spending plans. (See Chart 51.)
  • So looser fiscal policy is on the way, but it could come alongside lower borrowing (if there’s a Brexit deal) or higher borrowing (if there’s a no deal or a Labour government).
  • The financial markets are not convinced that this will lead to higher interest rates. Since May, they have gone from fully pricing in a 25bps rate hike over the next two years to almost fully pricing in a 25bps rate cut. (See Chart 52.)
  • Some of that is due to the rise in the chances of a no deal, as in that scenario both we and the markets think the MPC would cut interest rates, perhaps from 0.75% now to 0.25%.
  • But the very latest rise in the chances of a rate cut has come despite the chances of a no deal being stable. (See Chart 53.) That suggests the markets are pricing in the possibility of a rate cut even if there is a Brexit deal or a delay.
  • Admittedly, the MPC has become more concerned about the outlook for both the global and domestic economies. But if there were a Brexit deal or a number of delays, we suspect GDP growth and inflation would be higher than the MPC expects. (See Chart 54.) Rate hikes would therefore be more likely than rate cuts.
  • That said, the soft global backdrop and rate cuts by other central banks would probably mean the MPC wouldn’t raise rates soon after a deal. Even if there’s a deal, we doubt that interest rates would be raised before the middle of next year. (See Chart 55.)
  • Overall, while Brexit will largely determine what happens to interest rates, at some point rate hikes may catch the markets off guard. Gilt yields would then rise sharply. (See Chart 56.)

Monetary & Fiscal Policy Charts

Chart 49: Cyclically-adjusted Budget Deficit (% of GDP)

Chart 50: Public Sector Net Borrowing (Exc. Banks, £bn)

Chart 51: Government Receipts & Spending (% of GDP)

Chart 52: Market Expectations for Bank Rate (%)

Chart 53: Probability of a No Deal & Bank Rate Cut (%)

Chart 54: CPI Inflation (%)

Chart 55: Bank Rate (%)

Chart 56: 10-Year Gilt Yields (%)

Sources: Refinitiv, IHS Markit, OBR, BoE, Labour Manifesto, CE


Long-term Outlook

Productivity recovery to support long-term growth

  • The drag on the economy’s potential growth rate from lower migration and an ageing population over the next few decades will probably be offset by a boost from higher productivity growth.
  • While Brexit will influence the economy over the next few years, it’s unlikely to have a big impact on growth in the long term. Larger forces will be at play, in particular the extent to which productivity growth recovers after its dire performance in recent years.
  • There are good reasons to think that faster productivity growth is in store. The UK’s strengths, such as its openness to foreign direct investment and the flexibility of its labour market, mean that UK productivity growth should catch up with the likes of Germany.
  • And the UK’s relatively progressive attitude to adopting new technology, at least relative to Europe, should allow it to take advantage of new growth industries such as artificial intelligence, aerospace, and biotechnology. The UK already has a comparative advantage in these areas so it is well placed to capitalise on productivity-boosting innovations.
  • We expect these factors to raise productivity growth to 1.5% by the mid-2020s, more than double the rate seen in the past ten years. (See Chart 57.)
  • This should help offset the adverse effects on the economy’s potential growth rate of the reduction in the working age population, due to increasing life expectancy, relatively low fertility rates and the retirement of the post-war “baby boomers”. (See Chart 58.) Indeed, the proportion of the population above the retirement age is set to rise from about 18% in 2018 to around 25% by 2040.
  • And the UK’s retirement age is already one of the highest in the EU – the State Pension Age is set to increase to 67 in 2028 and to 68 from 2037-39 – and participation is significantly above the EU average. So there’s not much scope for these factors to rise further.
  • The UK will probably impose a stricter immigration policy after it leaves the EU, which would further reduce labour force growth. We expect annual labour force growth of just 0.2% over the next 20 years.
  • All told, we think that real GDP growth will average around 1.7% over the next 20 years, down from 2.0% or so over the last few decades. (See Chart 59.)
  • Meanwhile, unless the government restrains spending or increases revenues, the ageing population will lead to a steady worsening in the public finances. Our forecast is that the debt to GDP ratio rises back to 80% in the 2030s, after falling to 70% in the mid-2020s. Even so, we think the government deficit of 5.0% will be only a little higher in the 2030s than its average of 4.0% over the past five years.
  • Finally, given its relatively good history of controlling inflation, there’s no reason to believe the Bank of England will let inflation diverge from its 2.0% target in the long term. But as productivity growth picks up, we think that the neutral interest rate will rise towards a long-run rate of around 2.5% in the 2030s.
  • Meanwhile, we expect the 10-year gilt yield to average 3.25% in the 2030s (see Chart 60), despite the deterioration in the public finances. Indeed, there are no signs that the bond market is concerned about the UK’s ability to pay.

Long-term Outlook Charts

Chart 57: Output Per Hour Worked (% y/y)

Chart 58: Contributions to Potential Real GDP (ppts)

Chart 59: Real GDP (%y/y)

Chart 60: Bank Rate & 10-Year Gilt Yield (%)

Sources: Refinitiv, Capital Economics

Table 4: Key Long-term Forecasts (% y/y, Averages, unless otherwise stated)*

Actual

Forecasts

2000-2007

2008-2012

2013-2017

2018-2022

2023-2027

2028-2037

Real GDP

2.8

0.0

2.2

1.6

1.6

1.7

Real consumption

3.3

-0.4

2.4

1.8

1.8

1.9

Productivity

1.8

-0.2

0.6

1.0

1.5

1.5

Employment

1.0

0.2

1.5

0.6

0.2

0.2

Unemployment rate (%, end of period)

5.3

8.0

4.4

4.1

4.3

4.3

Wages

4.3

1.8

1.9

3.5

3.6

3.5

Inflation (%)

1.6

3.3

1.5

2.2

2.0

2.0

Policy interest rate (%, end of period)

5.50

0.50

0.50

1.50

2.50

2.50

10-year government bond yield (%, end of period)

4.50

1.81

1.23

2.05

3.25

3.25

Government budget balance (% of GDP)

-1.5

-8.6

-4.0

0.0

-2.5

-5.0

Gross government debt (% of GDP)

33

67

85

79

69

83

Current account (% of GDP)

-2.5

-3.4

-4.7

-4.6

-3.5

-3.6

Exchange Rate (US dollar per pound sterling, end of period)

2.0

1.6

1.4

1.3

1.4

1.4

Equity Market (FTSE 100, end of period)

6,457

5,898

7,688

7,065

8,460

12,215

Nominal GDP ($bn)

2282

2510

2759

3002

3741

5054

Population (millions)

60

63

65

67

69

70

* Based on our “repeated delay” scenario for Brexit, which assumes that Brexit is delayed again and again at least until the end of 2021.


Paul Dales, Chief UK Economist, +44 20 7808 4992, paul.dales@capitaleconomics.com
Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com
Thomas Pugh, UK Economist, +44 20 7808 4693, thomas.pugh@capitaleconomics.com
Andrew Wishart, UK Economist, +44 20 7808 4062, andrew.wishart@capitaleconomics.com
Gabriella Dickens, Assistant Economist, +44 20 3974 7421, gabriella.dickens@capitaleconomics.com
William Ellis, Research Economist, +44 20 7808 4068, william.ellis@capitaleconomics.com

Written by
Ruth Gregory Senior UK Economist
ruth.gregory@capitaleconomics.com +44 (0)20 7811 3913
Thomas Pugh UK Economist
thomas.pugh@capitaleconomics.com +44 (0)20 7808 4693
Andrew Wishart UK Economist
andrew.wishart@capitaleconomics.com +44 (0)20 7808 4062
Gabriella Dickens Assistant Economist
gabriella.dickens@capitaleconomics.com +44 (0)20 3974 7421
Capital Economics Economist Research Assistant
William.Ellis@capitaleconomics.com +44 (0)20 7808 4068