The anticipation of next week’s election delivering a substantial majority for the Conservative Party and leading to a Brexit deal has already triggered a turning point in the financial markets, with the pound rising to a seven-month high of $1.31 and a two-and-a-half-year high of €1.18 against the euro, and may soon prompt the economy to rediscover a bit of verve too. With the latest data suggesting that the 0.3% q/q rise in GDP in Q3 will give way to a smaller increase in Q4, or an outright contraction if the PMIs are to be believed, a turnaround is needed to prevent the Bank of England from cutting interest rates from 0.75% to 0.50%. We suspect that the combination of some reduction in Brexit uncertainty and a further fiscal stimulus after the election will mean that GDP growth in Q4 proves to be the nadir.
- The anticipation of next week’s election delivering a substantial majority for the Conservative Party and leading to a Brexit deal has already triggered a turning point in the financial markets, with the pound rising to a seven-month high of $1.31 and a two-and-a-half-year high of €1.18 against the euro, and may soon prompt the economy to rediscover a bit of verve too. With the latest data suggesting that the 0.3% q/q rise in GDP in Q3 will give way to a smaller increase in Q4, or an outright contraction if the PMIs are to be believed, a turnaround is needed to prevent the Bank of England from cutting interest rates from 0.75% to 0.50%. (See Chart 1.) We suspect that the combination of some reduction in Brexit uncertainty and a further fiscal stimulus after the election will mean that GDP growth in Q4 proves to be the nadir.
- Output & activity indicators show that the risks to our forecast that the economy expanded by 0.2% q/q in Q4 lie on the downside.
- Household indicators will exaggerate the weakening in consumer spending growth as November’s retail sales figures will exclude Black Friday. But December’s data will probably look much better.
- External indicators suggest that soft global growth will weigh on exports in the near term.
- Labour market indicators show that employment fell in Q3, but that there is still not much spare capacity.
- Inflation indicators imply that CPI inflation will probably remain below 2% for most of next year.
- Financial market indicators are increasingly pricing in a Conservative election win and a Brexit deal, which leaves less upside after the election and more downside should Labour pull off a surprise victory.
Chart 1: GDP & All-Sector Activity PMI
Sources: IHS Markit, Refinitiv
- Having recovered from a quarterly contraction of 0.2% in Q2 by expanding by 0.3% in Q3, GDP growth appears to have softened again at the end of 2019 (2). The effect of Brexit deadlines on stock building and trade has muddied the water, but it’s clear that stagnant investment and a slowdown in consumer spending growth has held the economy back, partly offset by a rise in government spending growth (3).
- Monthly GDP fell in August and September, so the starting point for Q4 is weak. And low composite PMIs for the euro-zone and the US show that global demand has remained soft (4). Both the all-sector PMI and the CBI growth indicator suggest that the UK economy contracted in Q4 (5). Our GDP tracker is a little more upbeat and is currently pointing to a 0.1% q/q expansion (6).
- Either way, the risks to our forecast that the economy will grow by 0.2% q/q in Q4 are to the downside. But seeing as a sizeable fiscal boost from much higher government investment is on the horizon regardless of who wins the election (7), GDP growth should pick-up over the next few years.
Chart 2: GDP
Chart 3: Components of Domestic Demand (% y/y)
Chart 4: Composite Activity PMIs
Chart 5: Business Surveys & GDP
Chart 6: Capital Economics GDP Tracker & GDP (% q/q)
Chart 7: Government Investment (% GDP)
Sources: Refinitiv, IHS Markit, CBI, CE, Labour, Conservatives
- Consumer spending growth is likely to slow in Q4 from Q3’s 0.4% q/q rise but it could bounce back if there is a Brexit deal. We are not too concerned by the 4.9% drop in the BRC’s annual rate of like-for-like sales in November as it excludes Black Friday (8). The ONS data will also miss Black Friday this year, so November could be a poor month for retail sales, but December should be stronger (9). Nonetheless, October’s 0.3% m/m drop means there is a risk that quarterly sales growth turns negative in Q4 (10).
- However, consumer confidence and spending could be boosted after the election if the Conservative Party wins and agrees a Brexit deal (11). Indeed, the uncertainty around the election and Brexit is one reason households are shying away from big-ticket purchases, such as cars (12).
- What’s more, the services PMI fell further in November and points to barely any growth in consumer spending on services in Q4 (13). Admittedly, we think the PMIs are overstating the weakness in the economy. However, consumers are unlikely to empty their wallets this Christmas.
Chart 8: BRC & ONS Measures of Retail Sales Volumes
Chart 9: Total Retail Sales Excluding Fuel (Volumes, Seasonally Adjusted, % m/m)
Chart 10: Retail Sales Volumes (Excluding Fuel)
Chart 11: Consumer Confidence & Election Polls
Chart 12: Car Registrations & Consumption of Vehicles (% q/q)
Chart 13: Services PMI & Services Consumption
Sources: Refinitiv, BRC, GfK, SMMT, Capital Economics
- Net trade provided a positive contribution to GDP growth in Q2 and Q3, but that is unlikely to mark the beginning of a trend given weak export demand. A 5% q/q increase in export volumes outstripped a 2% q/q rise in imports in Q3 (14), causing net trade to add 0.9ppts to quarterly GDP growth. But this boost was mainly a timing effect as firms continued to unwind the stockbuilding they undertook to prepare for the original Brexit deadline in March (15). Trade seems to have returned to what might be considered a “normal” level in September (16).
- The underperformance of exports to the EU relative to those to the rest of the world this year might be a tentative sign that the medium- and long-term consequences of Brexit have started to materialise (17). But equally, it could just reflect particularly weak growth in the euro-zone.
- Meanwhile, overall export demand is likely to stay soft. World trade volumes are still contracting, albeit marginally (18). And surveys of export orders suggest things will get worse for UK exporters before they get better (19).
Chart 14: UK Total Trade Volumes
Chart 15: Net Trade & Stockbuilding (Contribution to q/q GDP Growth, ppts)
Chart 16: Total Trade Volumes (£bn, 2016 Prices)
Chart 17: Goods Export & Import Values (Referendum =100)
Chart 18: World Goods Trade & UK Goods Export Volumes (% y/y)
Chart 19: Goods Export Volumes & Export Orders
Sources: Refinitiv, IHS Markit, CBI, BoE, BCC, Capital Economics
- Deeper cracks are starting to appear, but with the unemployment rate at a 45-year low there is not much spare capacity in the labour market. The 58,000 drop in employment in Q3 was probably a lagged response to the 0.2% q/q contraction in GDP in Q2. Based on past form, Q3’s 0.3% q/q gain in GDP might prompt a 70,000 (+0.2% q/q) rise in employment in Q4 (20).
- Even so, the survey evidence is consistent with a further softening in both employment and wage growth. Annual growth in job vacancies has been declining since the start of 2019 and suggests that employment growth may soon grind to a halt (21). Other surveys paint a similar picture (22 & 23). They also suggest that the recent easing in the demand for workers could cause pay growth to slow further after the drop from 3.7% in August to 3.6% in September (24).
- However, with the unemployment rate at 3.8%, there does not seem to be much slack in the labour market. Indeed, broader indicators of labour market tightness, such as inactive workers who would like a job and part-time workers who want to work full-time, have remained close to their pre-crisis lows (25).
Chart 20: Real GDP & Employment
Chart 21: Employment Growth & Job Vacancies (% y/y)
Chart 22: Employment PMI & Employment
Chart 23: REC Staff Placements & Employment
Chart 24: REC Permanent Salaries Index & Pay
Chart 25: Broader Measures of Labour Market Tightness
Sources: Refinitiv, IHS Markit, REC, Capital Economics
- Recent developments have done little to change our view that in 2020 inflation will spend more time below than above the Bank of England’s 2% target. The drop in CPI inflation from 1.7% in September to 1.5% in October left it at its lowest level in almost three years (26).
- Admittedly, the fall mainly reflected a slump in energy inflation and so was not a reflection of a weakening in underlying inflationary pressures (27). Gas and electricity prices fell sharply in October due to the reduction in the regulator Ofgem’s energy price cap. And the recent slide in wholesale prices suggest utility prices will fall further when the price cap is reviewed in April 2020 (28).
- That said, underlying price pressures look benign. Although the annual growth rate of unit labour costs rose from 2.3% in Q1 to 3.6% in Q2 (29), firms are still absorbing higher costs in their margins rather than passing them onto consumers (30). Input price inflation fell to a three-and-a-half-year low of -5.1% in October, while the drop back in output price inflation suggests that core goods inflation may soon ease to zero (31). Overall, inflation seems unlikely to rise above 2% next year.
Chart 26: CPI Inflation (%)
Chart 27: Contribution to the Change in CPI Inflation in October (ppts)
Chart 28: Wholesale Energy & Utility Prices
Chart 29: Contributions to Unit Labour Cost Growth (ppts)
Chart 30: Core Services CPI Inflation & Average Earnings
Chart 31: Core Output Prices & Core Goods CPI (%y/y)
Sources: Refinitiv, SMMT, Capital Economics
- The market has almost fully priced in a Conservative Party election win and a Brexit deal, so in that event the market rally is likely to be small. However, a Labour victory could lead to some sharp drops in sterling and equity prices. Sterling rose further in early December hitting $1.31/£ as Boris Johnson’s election poll results improved (32). If the Conservatives win and a Brexit deal is agreed, we think that the pound could rise to $1.35. But if Labour win then we think sterling could drop to $1.20, or lower (33).
- Meanwhile, the FTSE 100 has been volatile over the past month but is roughly back where it was at the start of November, in line with the subdued movements in overseas indices (34). After underperforming the FTSE 100 for the last two years, the prospect of a Conservative win in the general election and a Brexit deal has brought the more domestically-exposed FTSE Local back into line with the main index (35).
- While investors still see a good chance of a rate-cut in the near term, the increasing probability of a Conservative majority has pushed up interest rate expectations further out (36). Finally, we think that investors’ fear of higher taxes resulting would result a sharp drop in equity prices if there is a surprise result and Labour managed to form a government. What’s more, specific industries would be even harder hit by nationalisation plans and windfall taxes (37).
Chart 32: Election Poll Results & $/£
Chart 33: $/£
Chart 34: Global Equity Indices (Jan. 2019 = 100)
Chart 35: UK Equity Indices (Jan. 2018=100)
Chart 36: Expectations for Bank Rate (%)
Chart 37: Sector Shares in MSCI’s UK Index (%)
Sources: Bloomberg, Refinitiv, Ipsos MORI, Capital Economics
Paul Dales, Chief UK Economist, +44 20 7808 4992, firstname.lastname@example.org
Ruth Gregory, Senior UK Economist, +44 20 7811 3913, email@example.com
Thomas Pugh, UK Economist, +44 20 7808 4693, firstname.lastname@example.org
Andrew Wishart, UK Economist, +44 20 7808 4062, email@example.com
William Ellis, Research Economist, +44 20 7808 4068, firstname.lastname@example.org