Coronavirus complicates new policymakers’ task - Capital Economics
UK Economics

Coronavirus complicates new policymakers’ task

UK Economics Weekly
Written by Andrew Wishart

The drop back in equity prices this week heaps more pressure on the new head honchos at the Treasury and the Bank of England to deliver some measures to help mitigate the economic effects of the coronavirus. But while this will surely be the main focus of the Budget on Wednesday, the new Chancellor may still announce some increase in public investment. And although it would be unwise to rule anything out, we suspect the Bank of England will eventually favour a 0.25% interest rate cut supplemented with other more targeted measures to mitigate the effects of the coronavirus rather than the 0.50% cut the markets are increasingly expecting.

With the number of coronavirus cases in the UK having reached 116 and rising, we now think that a change in consumer behaviour and working practices will weigh on economic activity this year. Consumer spending is particularly important in the UK, accounting for two-thirds of GDP. So consumers’ reaction to the outbreak has the potential to be particularly damaging. Discretionary spending in the retail, entertainment and hospitality sectors are most likely to be adversely affected.

All told, we have reduced our Q2 GDP forecast from 0.4% q/q to 0.0% q/q and our growth forecast for 2020 as a whole from 1.0% to 0.7%. (See here.) If the virus is more serious or longer lasting than we anticipate, the UK could slip into a mild recession with GDP falling in Q2 and Q3. Given the uncertainty, we are tracking a number of timely indicators, such as cinema admissions and footfall, to give us an indication of how the toll on the economy is stacking up in real-time. (See here.)

The spread of coronavirus in the UK complicates the task of the new boys in charge of monetary and fiscal policy. The weaker outlook means that that the new Bank of England Governor, Andrew Bailey, will preside over a cut in interest rates at the 26th March meeting, or possibly in an emergency move beforehand.

According to Bailey and the outgoing Governor, Mark Carney, the Bank is still “looking at the evidence on the precise balance of what the shock is likely to be” before making a judgement. But Carney’s comment this week that the policy response to the virus will be “powerful and timely” suggested there is some chance of him presiding over an emergency cut in a final fling as Governor. The fresh fall in UK equity prices today leaves them down over 12% since a fortnight ago, a larger fall than in the US, which increases the pressure on the MPC to act swiftly. (See here.)

The market has priced in a 50bps cut in interest rates from 0.75% to 0.25% by May. But for several reasons, our hunch is that the MPC will opt for a more moderate response and cut rates by 25bps.

First, financial conditions in the UK have not tightened by as much as elsewhere as the pound has fallen by 3.5% in trade-weighted terms over the past few weeks. Second, as the coronavirus should be a temporary shock, the Bank is more focused on “bridging” policies to prevent viable firms going under during the period of softer demand and disruption rather than altering interest rates, which takes some time to have its full effect. Third, the Bank has less room to cut rates than the Fed – it is starting at 0.75% while the Fed started at 1.50-1.75%. And finally, a major further loosening in fiscal policy appears to be in the pipeline, reducing the onus on monetary policy to do the heavy lifting.

Indeed, while the coronavirus has pushed next Wednesday’s Budget from the front pages to the business pages, it looks like the new Chancellor, Rishi Sunak, has made last minute changes to focus on mitigating the economic fallout from the virus. (See our Budget Preview here.)

This puts the timing of the large fiscal stimulus that underpins our view that GDP growth will pick up to 2.0% in 2021 in doubt. On the one hand, a health emergency gives the Chancellor a reason to suspend the fiscal rules and spend now. On the other, he may now be preoccupied with a package of smaller measures to help those areas of the economy likely to be hit hardest by the coronavirus outbreak and delay the implementation of the large rise in government investment advertised in the manifesto.

The week ahead

The further sell off in financial markets raises the chances of an unscheduled MPC meeting to cut rates next week. Just before the Budget on Wednesday, the release of GDP figures for January should show that the sharp improvement in sentiment after the election fed through to stronger activity before the coronavirus hit.


Data Previews

Monthly GDP & Services Output (Jan.) Wed. 11th Mar.

Forecasts

Time (GMT)

Previous

Consensus

Capital Economics

Monthly GDP m/m(3m/3m)

09.30

+0.3%(0.0%)

+0.2%(+0.1%)

+0.4%(+0.1%)

Services Output m/m(3m/3m)

09.30

+0.3%(+0.1%)

+0.2%(+0.1%)

+0.3%(+0.1%)

The good times won’t last long

We’re expecting that a strong January will contribute to the economy growing by 0.2% q/q or more in Q1, but the effects of the coronavirus will probably mean that it stagnates or contracts in Q2.

The reduction in political and economic uncertainty after December’s election ruled out a no deal Brexit on 31st January probably meant that the 0.3% m/m rise in GDP in December was followed by something like a 0.4% m/m gain in January. After all, January’s activity PMIs revealed improvements across the main sectors. We have pencilled in a 1.0% m/m rise in construction output, a 0.5% m/m gain in industrial production (see preview below) and a 0.3% m/m increase in services output.

The PMIs also suggest that February could be pretty good. (See Chart 1.) But by March we suspect that concerns over the coronavirus will be starting to hamper activity in most sectors, with the transport and arts/entertainment sectors particularly exposed.

Chart 1: All-Sector PMI & GDP

Sources: Refinitiv, IHS Markit

Industrial Production (Jan.) Wed. 11th Mar.

Forecasts

Time (GMT)

Previous

Consensus

Capital Economics

Manufacturing Output m/m(y/y)

09.30

+0.3%(-2.5%)

+0.2%(-3.5%)

+1.0%(-2.8%)

Industrial Production m/m(y/y)

09.30

+0.1%(-1.8%)

+0.3%(-2.6%)

+0.5%(-2.3%)

Early end to the manufacturing party

After falling by 0.8% q/q in Q4, industrial production probably rebounded in January. However, the resurgence in manufacturing is likely to be short-lived as the effects of the coronavirus on supply chains may start to be felt in February and March.

The surge in the output balance of the IHS Markit/CIPS manufacturing PMI from 45.6 in December to 50.1 in January suggests that manufacturing output jumped by 2.0% m/m in January. (See Chart 2.) We think that’s a little punchy, so have gone for a 1.0% m/m rise instead.

There might be some more positive news from the oil sector where production should have recovered from temporary outages earlier in the winter. However, electricity and gas production probably dropped by about 2.0% m/m in January, which may have offset an increase in oil output.

As a result, we think that monthly growth in industrial production was probably 0.5% in January. However, the impact of coronavirus-related shutdowns in Asia has started to impact supply chains, which could weigh on manufacturing output in February and March.

Chart 2: Manufactuing PMI & Output

Sources: Refinitiv, IHS Markit

International Trade (Jan.) Wed. 11th Mar.

Forecasts

Time (GMT)

Previous

Consensus

Capital Economics

Trade in Goods & Services Balance

09.30

+£7.7bn

-£0.6bn

-£0.5bn

Trade balance likely to have returned to deficit

December’s £7.7bn trade in goods and services surplus is unlikely to have been sustained. We think the balance returned to deficit in January.

The trade in goods and services balance recorded an uncharacteristic surplus in December as export volumes jumped by 9.3% m/m, outpacing the 0.5% m/m increase in imports. But the rise in export volumes had more to do with the £7.5bn spike in the volatile non-monetary gold component – which includes gold bullion, gold coin and semi-manufactured gold and scrap – than anything else.

Since this is more influenced by trading on the London Bullion Market than economic influences, it is difficult to forecast. But the recent surge may have had something to do with the 31st January Brexit deadline. After all, trade in non-monetary gold has been influenced by previous Brexit deadlines. (See Chart 3.) Assuming that exports of non-monetary gold returned to more normal levels of around £0.2bn in January, that might have led to a slump in overall export volumes of 10% m/m.

Meanwhile, a pick-up in domestic demand at the start of the year is likely to have resulted in a robust rise in import volumes, perhaps by about 2.5% m/m. Overall, we expect the £7.7bn trade surplus in December became a small deficit of about £0.5bn in January.

Chart 3: Non-Monetary Gold (£bn)

Source: Refinitiv


Economic Diary & Forecasts

Upcoming Events & Data Releases

Date

Country

Release/Indicator/Event

Time (GMT)

Previous*

Consensus*

CE Forecasts*

UK Data Response

Mon 9th

No Significant Data Released

Tue 10th

UK

BRC Retail Sales Monitor (Feb)

(00.01)

0.0%

Wed 11th

UK

GDP (Jan, m/m(3m/3m))

(09.30)

+0.3%(0.0%)

+0.2%(+0.1%)

+0.4%(+0.1%)

DR

UK

Services Output (Jan, m/m(3m/3m))

(09.30)

+0.3%(+0.1%)

+0.2%(+0.1%)

+0.3%(+0.1%)

DR

UK

Industrial Production (Jan)

(09.30)

+0.1%(-1.8%)

+0.3%(-2.6%)

+0.5%(-2.3%)

DR

UK

Manufacturing Output (Jan)

(09.30)

+0.3%(-2.5%)

+0.2%(-3.5%)

+1.0%(-2.8%)

DR

UK

Construction Output (Jan)

(09.30)

+0.4%(+5.0%)

+0.2%(+2.6%)

+1.0%(+3.4%)

DR

UK

Trade Balance (Jan)

(09.30)

+£7.7bn

-£0.6bn

-0.5bn

DR

UK

Budget (2020)

(12.30)

DR

Thu 12th

UK

RICS Past House Price Balance (Feb)

(00.01)

+17%

+20%

Fri 13th

No Significant Data Released

Selected future data releases and events

Tue 17th

UK

Labour Market (Jan)

(09.30)

DR

Fri 20th

UK

Public Finances (Jan)

(09.30)

DR

*m/m(y/y) unless otherwise stated

Sources: Bloomberg, Capital Economics

Main Economic & Market Forecasts**

%q/q(%y/y) unless stated

Latest

Q1 2020

Q2 2020

Q3 2020

Q4 2020

2019

2020

2021

GDP

0.0(+1.1) (Q4)

+0.2(+0.6)

0.0(+0.7)

+0.3(+0.5)

+0.5(+1.0)

(+1.4)

(+0.7)

(+2.0)

Household spending

+0.1(+1.3) (Q4)

+0.5(+1.4)

0.0(+0.9)

+0.3(+0.9)

+0.6(+1.4)

(+1.4)

(+1.1)

(+1.9)

CPI inflation (%)

(+1.8) (Jan)

(+1.8)

(+1.4)

(+1.4)

(+1.7)

(+1.8)

(+1.6)

(+1.7)

ILO unemployment rate (%)

3.8 (Dec)

4.0

4.0

3.9

3.9

3.8

3.9

3.8

Bank rate, end period (%)

0.75

0.50

0.50

0.50

0.50

0.75

0.50

0.75

10 yr gilt, end period (%)

0.28

0.45

0.65

0.80

1.00

0.82

1.00

1.25

$/£, end period

1.30

1.31

1.32

1.34

1.35

1.33

1.35

1.40

Euro/£, end period

1.15

1.20

1.23

1.26

1.29

1.18

1.29

1.33

Sources: Capital Economics, Refinitiv

**Assumes the UK and the EU agree some kind of fudge that means there is not a big step change in their relationship on 31st Dec. 2020.


Andrew Wishart, UK Economist, +44 20 7808 4062, andrew.wishart@capitaleconomics.com