Forecasting a parallel universe - Capital Economics
UK Economics

Forecasting a parallel universe

UK Economics Weekly
Written by Andrew Wishart

In our latest UK Economic Outlook, “An economic multiverse” (16th July), we set out the different paths politics could send the economy down. The MPC took a different approach this week, forecasting an alternative reality that will never be realised while still avoiding setting out its view on a no deal.

MPC living in an alternative reality

In our latest UK Economic Outlook, “An economic multiverse (16th July), we set out the different paths politics could send the economy down. The MPC took a different approach this week, forecasting an alternative reality that will never be realised while still avoiding setting out its view on a no deal.

At first glance, the Bank of England’s new forecast suggests the UK is still on course for much higher interest rates. But the forecast is a nonsense. (See here.) It’s based on two boosts to the economy that can’t both occur. The Bank assumes a “smooth” Brexit (i.e. a deal). But the growth and inflation projections also benefit from market expectations that interest rates will be cut next year, due to the substantial chance of a no deal Brexit that is now priced in. If the first assumption holds true, investors’ expectation for interest rates would quickly rise.

There were some useful takeaways. The Bank has downgraded its view on near-term growth. The GDP forecast based on a steady policy rate of 0.75% was slashed from 1.7% to 1.1% in 2020. (See Chart 1.) That was due to lower investment, as Brexit uncertainty has become “entrenched”, and softer global growth. The further escalation in the China-US trade war and the ongoing travails of the manufacturing sector (see here) suggest the latter is unlikely to reverse soon.

Chart 1: Bank of England GDP Forecasts (% q/q)

Sources: Refinitiv, BoE

Sticking with the forecast based on steady interest rates, weaker activity only pulled inflation down marginally. But the new forecast assumes the pound stays 4% lower than in May. If sterling recovers those losses, the Bank would be forecasting inflation of 1.9% as opposed to 2.1% in two years’ time.

The bank maintains that it expects excess demand in 2022 if there is a Brexit deal. So it would still raise interest in that case. But in contrast to the rather misleading message from its main forecast, it doesn’t seem to think it would have to raise them by much. The even bigger shame is that the Bank has not published a forecast for the increasingly likely reality of no deal. We have. (See here.)

Selling sterling

While the Bank got stuck into its quarterly forecasting exercise, investors have been positioning for a different set of circumstances. The increasing probability of a no deal has pushed the pound down to $1.21 (€1.09), putting a dampener on any overseas getaways in August. (See Chart 2.) We have deduced a no deal is now about 50% priced in. If we are right, a fall to $1.13 and close to parity with the euro is in store if a no deal is realised. (See here.) But, unhelpfully for currency traders, there is also ample scope for a rebound if no deal is avoided.

Chart 2: Probability of a No Deal Brexit & $/£

Sources: Refinitiv, Betfair, Capital Economics

Week Ahead

The release of the services PMI for July on Monday looks set to show that the economy made a poor start to Q3. GDP, released Friday, will probably confirm the economy stagnated in Q2.

Data Previews

IHS Markit/CIPS Services PMI (Jul.) Mon. 5th Aug.

Forecasts

Time (BST)

Previous

Consensus

Capital Economics

Business Activity Index

09.30

50.2

50.2

50.0

All-Sector PMI

09.30

49.2

49.3

All-sector PMI points to weak start to Q3

The services PMI probably edged down slightly in July. A pick-up in the construction PMI might have helped the all-sector PMI hold broadly steady. But that would still suggest GDP contracted in July.

The services PMI fell from 51.0 in May to 50.2 in June alongside declines in the new orders and output balances. As the new orders index is a good leading indicator of the headline index, the services PMI probably remained weak in July.

Admittedly, the European Commission’s measure of confidence in the services sector rebounded in July from -12.7 in June to -5.9. But that’s still far below the long-run average of +4.1. And the Bank of England Agents’ score of consumer services turnover fell at the start of Q3 too. As a result, we have pencilled in a slight fall in the services PMI from 50.2 in June to 50.0.

Taken together with the manufacturing and construction surveys already released, we suspect the all-sector PMI was fairly steady. Even so, it would still be consistent with GDP contracting at the start of Q3. (See Chart 3.)

Chart 3: IHS Markit All-Sector PMI & GDP

Sources: IHS Markit, Refinitiv, Capital Economics

Monthly GDP & Services Output (Jun. & Q2) Fri. 9th Aug.

Forecasts

Time (BST)

Previous

Consensus

Capital Economics

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

09.30

+0.3%(+0.3%)

+0.1%(0.0%)

+0.1%(0.0%)

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

09.30

0.0%(+0.3%)

+0.1%(+0.2%)

+0.1%(+0.2%)

Flat is better than falling

Growth in the services sector probably offset falls in output in the industrial and construction sectors to result in the 0.5% q/q rise in GDP in Q1 giving way to no growth at all in Q2.

The 0.8% q/q probable slump in industrial production in Q2 is likely to have knocked about 0.1ppts off GDP. (See next preview.) Similarly, the wet weather in June probably caused construction output to drop by 1.6% q/q, knocking off another 0.1ppts from GDP.

However, we think that services output rose by 0.1% m/m in June and by 0.2% q/q in Q2 overall. Even though that would be a slowdown from the 0.3% q/q rise in Q1, it would still be enough to offset the falls in the industrial and construction sectors to leave Q2 GDP flat.

That will probably show up on the alternative expenditure measure of GDP as a slowdown in household spending growth from 0.6% q/q in Q1 to 0.3%. And the 0.9ppt boost to growth from stockbuilding and the 0.5ppts drag from net trade are likely to be more than reversed. (See Chart 4.)

Chart 4: Contribution to % q/q GDP (ppts)

Sources: Refinitiv, Capital Economics

Industrial Production (Jun.) Fri. 9th Aug.

Forecasts

Time (BST)

Previous

Consensus

Capital Economics

Manufacturing Output m/m(y/y)

09.30

+1.4%(0.0%)

-0.2%(-1.1%)

+0.6%(-0.3%)

Industrial Production m/m(y/y)

09.30

+1.4%(+0.9%)

-0.2%(-0.2%)

+0.5%(+0.4%)

Contraction confirmed

The industrial production data for June will probably confirm the message from the surveys that the manufacturing sector contracted in Q2.

Manufacturing output ticked up in May as firms, most notably car plants, restarted production after contingency shutdowns in April to guard against possible no deal disruption. This rebound might have run a bit further in June. We have pencilled in a 0.6% m/m rise in manufacturing output.

However, underlying momentum in the sector is deteriorating. Indeed, monthly increases in output in May and June are unlikely to offset the large fall in April. As a result, manufacturing output probably fell by about 1.8% on the quarter, in line with the downbeat surveys. (See Chart 5.)

Moreover energy and gas usage is consistent with a small fall in utilities output on the month.

The upshot is that industrial production probably fell by 0.8% q/q in Q2, which would subtract a touch over 0.1ppts from overall quarterly GDP growth.

Chart 5: IHS Markit/CIPS Manufacturing PMI & Manufacturing Output

Sources: Refinitiv, IHS Markit, Capital Economics

Trade (Jun.) Fri. 9th Aug.

Forecasts

Time (BST)

Previous

Consensus

Capital Economics

Trade in Goods & Services Balance

09.30

-£2.3bn

-£2.7bn

-£2.6bn

Net trade to boost Q2 GDP, despite a widening in June’s trade deficit

Net trade should provide a decent boost to Q2 GDP. But exporters still face plenty of headwinds, not least the weakening global backdrop. As such, we think that the external sector will act as a drag on GDP over the rest of 2019.

The strong 2.3% m/m rise in export volumes in May is unlikely to have been repeated in June. The new export orders balance of the IHS Markit/CIPS manufacturing survey points to a smaller 1% m/m rise in goods exports. (See Chart 6.) Admittedly, slowing retail sales growth and weak investment – which tend to be highly import-intensive – probably kept a lid on import growth. But we think that the net effect is likely to have been a widening in the trade deficit. We have pencilled in an increase from £2.3bn in May to £2.6bn in June.

But even if we are right that would still suggest that the deficit for Q2 as a whole was a whopping £11.6bn smaller than in Q1 (£8.6bn compared to £20.3bn) – thanks to an unwinding in the boost to imports from stockpiling ahead of the original Brexit deadline. This suggests that net trade (exc. valuables) may have added about 1ppt to GDP in Q2, reversing the 0.4ppts drag in Q1. Looking ahead though, we still expect net trade to remain a drag on growth for the rest of this year and for most of next.

Chart 6: Manufacturing PMI & Goods Exports

Sources: Refinitiv, Capital Economics


Economic Diary & Forecasts

Upcoming Events & Data Releases

Date

Country

Release/Indicator/Event

Time (BST)

Previous*

Consensus*

CE Forecasts*

UK Data Response

Mon 5th

 

UK

New Car Registrations (Jul)

(09.00)

(-4.9%)

   

UK

IHS Markit/CIPS Services PMI (Jul)

(09.30)

50.2

50.2

50.0

DR

   

UK

IHS Markit/CIPS Composite PMI (Jul)

(09.30)

49.7

49.8

49.6

DR

   

UK

IHS Markit/CIPS All-Sector PMI (Jul)

(09:30)

49.2

49.3

DR

Tue 6th

 

UK

BRC Retail Sales Monitor (Jul)

(00.01)

(-1.6%)

Wed 7th

 

UK

Halifax House Prices (Jul, m/m(3m/y))

(08.30)

-0.3%(+5.7%)

+0.3%(+4.4%)

Thu 8th

 

UK

RICS Past House Price Balance (Jul)

(00.01)

-1

-1

Fri 9th

 

UK

GDP (Q2, Prov., q/q(y/y))

(09.30)

+0.5%(+1.8%)

0.0%(+1.4%)

0.0%(1.5%)

DR

   

UK

GDP (Jun, m/m(3m/3m))

(09.30)

+0.3%(+0.3%)

+0.1%(0.0%)

+0.1%(0.0%)

DR

   

UK

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

(09.30)

0.0%(+0.3%)

+0.1%(+0.2%)

+0.1%(+0.2%)

DR

   

UK

Industrial Production (Jun)

(09.30)

+1.4%(+0.9%)

-0.2%(-0.2%)

+0.5%(+0.4%)

DR

   

UK

Manufacturing Output (Jun)

(09.30)

+1.4%(0.0%)

-0.2%(-1.1%)

+0.6%(-0.3%)

DR

   

UK

Construction Output (Jun)

(09.30)

+0.6%(+1.7%)

-0.2%(+0.5%)

-2.5%(-1.6%)

DR

   

UK

Trade in Goods & Services (Jun)

(09.30)

-£2.3bn

-£2.7bn

-£2.6bn

DR

Selected future data releases and events

Tue 13th

 

UK

Labour Market (Jun)

(09.30)

DR

Wed 14th

 

UK

CPI (Jul)

(09.30)

DR

   

UK

Core CPI (Jul)

(09.30)

DR

Thu 15th

 

UK

Retail Sales Inc. Fuel (Jul)

(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 2019

Q2 2019

Q3 2019

Q4 2019

2019

2020

2021

GDP

+0.5(+1.8)

+0.5(+1.8)

0.0(+1.5)

+0.4(+1.2)

+0.3(+1.3)

(+1.4)

(+1.5)

(+2.0)

Household spending

+0.6(+1.9)

+0.6(+1.9)

+0.3(+1.6)

+0.4(+1.5)

+0.5(+1.8)

(+1.7)

(+1.9)

(+1.7)

CPI inflation (%)

(+2.0) (Jun)

(+1.9)

(+2.0)

(+2.0)

(+2.0)

(+2.0)

(+2.4)

(+2.2)

ILO unemployment rate (%)

3.8 (May)

3.8

3.9

3.9

4.0

3.9

4.0

4.0

Bank rate, end period (%)

0.75

0.75

0.75

0.75

0.75

0.75

1.00

1.25

10 yr gilt, end period (%)

0.56

1.00

0.83

0.87

1.00

1.00

1.25

1.75

$/£, end period

1.21

1.32

1.27

1.23

1.25

1.25

1.30

1.35

Euro/£, end period

1.09

1.17

1.12

1.12

1.19

1.19

1.13

1.17

Sources: Capital Economics, Refinitiv

** Based on a scenario in which Brexit is repeatedly delayed. For forecasts based on a deal or a no deal, please see our UK Economics UpdatePick your own Brexit forecast”, 1st July 2019.


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