Is the UK different? - Capital Economics
UK Economics

Is the UK different?

UK Economics Weekly
Written by Andrew Wishart

Whereas US yield curve inversions are close to a fool-proof predictor of US recessions, a recession in the UK has only followed inversions in the gilt yield curve on 50% of occasions. That’s not dissimilar from our best guess that there is a 40% chance of a no deal Brexit on 31st October, in which case a recession would probably follow. But investors appear to be underestimating the chances of interest rates rising if there isn’t a no deal. While the soft data has been disappointing, the hard data released this week support our view that if Brexit is delayed, cancelled or a deal is struck the MPC would hike interest rates.

Whereas an inverted yield curve has been a good indicator of US recessions, the UK yield curve is less reliable. The US treasury yield curve has inverted before all five US recessions in the past five decades, with only one false positive. Over the same period the gilt yield curve has inverted six times, but in only three instances did a recession follow. In fact, the UK yield curve is better at predicting US recessions than those in the UK!

That shows how much UK asset prices are dictated by the rest of the world, and highlights the scope for the UK economy to surprise market expectations. (See here.) Nonetheless, given 50% of gilt yield curve inversions have been followed by a recession, the possibility is worth careful consideration.

It could go either way. (See here.) Higher inflation and disruption to trade following a no deal Brexit would probably tip the UK economy into recession. Our best guess is that there is a 40% chance of a no deal on 31st October (see here) – not dissimilar from the 50% chance of a recession implied by the inversion in the gilt yield curve. Interest rate cuts would surely follow.

But if there isn’t a no deal, the economy may well surprise to the upside, and require slightly higher interest rates (see here) – an outcome that investors are underestimating in our view. (See Chart 1.)

Chart 1: Market & CE Interest Rate Expectations

Sources: Bloomberg, Capital Economics

Admittedly, the poor survey data suggest the UK economy will struggle regardless of Brexit, justifying looser monetary policy now. But the hard data has held up well. Our data surprise indices show that while the soft data has come in well below expectations, the hard data has been as expected, if not a little stronger. (See Chart 2.)

Chart 2: CE Economic Data Surprise Indices*

Sources: Bloomberg, Capital Economics

That was particularly noticeable this week, with employment (see here), inflation (see here) and retail sales (see here) all beating the consensus forecast. Alongside rising expectations of a cross-party effort to block no deal when MPs return from their summer break in September, that prompted the pound to move away from its recent lows.

There were a number of temporary factors that flattered this week’s data. In particular, Amazon’s “Prime day” probably gave online sales a boost, and volatile computer game prices pushed up inflation. But with productivity still weak (output per worker fell 0.3% q/q in Q2) and wages growing at their fastest pace in 11 years, underlying price pressures are building. Stronger demand if Brexit is delayed, cancelled, or a deal is struck would give firms confidence to pass higher labour costs on. In these scenarios we think the MPC would respond by hiking interest rates, even if other central banks are going the other way. Only in a no deal do we think the MPC would cut rates, to 0.25% if not further.

Week ahead

We suspect the public finances figures released Wednesday will show a smaller surplus in July than last year due to the recent trend of higher government spending.


Data Previews

Public Finances (Jul.) Wed. 21st Aug.

Forecasts

Time (BST)

Previous

Consensus

Capital Economics

PSNB ex. Banking Groups

09.30

+£7.2bn

-£2.9bn

-£2.0bn

Smaller July surplus than last year

Following the rise in public sector borrowing in June, the public finances probably posted a small surplus in July. However, we expect the figures will show the public finances have deteriorated compared to last year.

Borrowing on the PSNB ex. measure of £7.2bn in June brought cumulative borrowing in the year to date up to around £18bn, about £5bn more than by June last year.

July is typically a big month for receipts as large companies pay an instalment of their corporation tax bill and the second payment of self-assessed liabilities from last year are due. What’s more, ongoing strength in the labour market should have supported receipts too.

But we think that government spending probably continued on its upward trend since the start of the financial year due to spending promises made in the November Budget last year.

We have pencilled in a surplus of £2.0bn in July, less than the surplus of around £3.5bn in July 2018. That would leave borrowing in the first four months of the fiscal year at around £16bn, around 60% higher than this time last year. (See Chart 3.)

Chart 3: Public Sector Net Borrowing (Ex. Banks, £bn)

Sources: Refinitiv, OBR, Capital Economics

Economic Diary & Forecasts

Upcoming Events & Data Releases

Date

Country

Release/Indicator/Event

Time (BST)

Previous*

Consensus*

CE Forecasts*

UK Data Response

Mon 19th

UK

Rightmove House Prices (Aug)

(00.01)

-0.2%(-0.2%)

Tue 20th

UK

CBI Industrial Trends Survey (Aug)

(11.00)

-34

-23

Wed 21st

UK

PSNB ex. Banking Groups (Jul)

(09.30)

+£7.2bn

-£2.9bn

-£2.0bn

DR

Thu 22nd

UK

CBI Distributive Trade Survey (Aug)

-16

Fri 23rd

No Significant Data Released

Also expected during this period:

24th –26th

G7 Summit

Selected future data releases and events

28th Aug

UK

BRC Shop Price Index (Aug)

(00.01)

(-0.1%)

30th Aug

UK

GfK Consumer Confidence (Aug)

(00.01)

-11

DR

UK

Net Consumer Credit (Jul)

(09.30)

+£1.0bn

UK

M4 Money Supply (Jul)

(09.30)

+0.1%(+2.3%)

Also expected during this period:

28th -9th

UK

Nationwide House Prices (Aug)

+0.3%(+0.3%)

*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

-0.2(+1.2)

+0.5(+1.8)

-0.2(+1.2)

+0.4(+1.0)

+0.3(+1.1)

(+1.3)

(+1.5)

(+2.0)

Household spending

+0.5(+1.8)

+0.6(+1.9)

+0.5(+1.8)

+0.4(+1.8)

+0.5(+2.0)

(+1.9)

(+2.0)

(+1.7)

CPI inflation (%)

(+2.1) (Jul)

(+1.9)

(+2.0)

(+2.0)

(+1.9)

(+1.9)

(+2.3)

(+2.3)

ILO unemployment rate (%)

3.9 (Jun)

3.9

3.8

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 (%)

0.44

1.00

0.83

0.75

1.00

1.00

1.25

1.75

$/£, end period

1.22

1.32

1.27

1.25

1.25

1.25

1.30

1.35

Euro/£, end period

1.10

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