Recession fears rising - Capital Economics
UK Economics

Recession fears rising

UK Economics Weekly
Written by Ruth Gregory

The contraction in GDP in Q2 together with the partial inversion of the gilt yield curve has raised concerns that a recession in the UK is on the way if it’s not already here. We suspect that the UK will avoid a recession before Brexit. But what happens with Brexit on 31st October will ultimately determine whether there is a recession or not. For what it’s worth, we place the chances of a no deal on 31st October at about 40%. That suggests there may be a similar chance of a recession at the turn of the year.

The contraction in GDP in Q2 together with the partial inversion of the gilt yield curve has raised concerns that a recession in the UK is on the way if it’s not already here. Indeed, the 0.2% q/q fall in GDP in Q2 suggests the UK is half way towards a recession. (See here.) And the financial markets seem concerned too. The 5-year gilt yield has fallen fractionally below the 2-year yield for the first time since 2008. (See Chart 1.) That reflects rising pessimism about future growth and the view that the MPC will follow the global trend and cut interest rates. (See here.)

Chart 1: Gilt Yields (%)

Sources: Refinitiv, Bloomberg

Admittedly, as Chart 1 shows, the more closely watched 10-2 gilt year spread is still positive. But in the past, the 10-2 year spread has usually inverted around the same time as, or just after, the 5-2 year spread. (See Chart 2.)

Chart 2: Yield Curve & Recessions

Sources: Refinitiv, Bloomberg, Capital Economics

This has all heightened concerns about a recession since an inverted yield curve has historically been a leading indicator of previous downturns. In the UK, a yield curve inversion has preceded all three recessions over the last 40 years. (See Chart 2 again.)

Granted, an inverted yield curve has not been a foolproof predictor of recessions. More often than not a yield curve inversion has had more to do with other factors than expectations that the economy is about to enter a recession. (See here.) As the circled areas on Chart 2 show, the yield curve has predicted three UK “recessions” that didn’t materialise. And it has been pretty poor at pinpointing when a UK recession might occur. The 10-2 yield curve has inverted between 9 and 79 months ahead of the last two recessions. So there are reasons to be cautious about inferring too much from the curve.

We suspect the economy will avoid a recession before Brexit for two reasons. First, Q2 was not as bad as it looks. Almost all the weakness was because concerns of a no deal Brexit ahead of the original Brexit deadline meant that activity that would have happened in Q2 was brought forward into Q1. And second, many car manufacturers will be working in August when they are normally closed which will probably add about 0.2ppts to q/q GDP growth in Q3. (See here.)

So what happens with Brexit on 31st October will ultimately determine whether there is a recession or not. And the rising chances of a no deal Brexit means that it may be right to consider the recent flattening of the yield curve as a recession warning. For what it’s worth, we place the chances of a no deal on 31st October at about 40%, up from 30% in May. (See here.) That suggests there may be a similar chance of a recession at the turn of the year.

Week ahead

There’s a good chance that the unemployment rate fell from 3.8% in May to 3.7% in June in the figures due to be released on Tuesday. And CPI inflation probably remained at the 2.0% target in July. Meanwhile, we expect a decent rise in retail sales in July in the figures due to be released on Thursday.


Data Previews

Labour Market (Jun.) Tue. 13th Aug.

Forecasts

Time (BST)

Previous

Consensus

Capital Economics

ILO Unemployment Rate

09.30

3.8%

3.8%

3.7%

Average Earnings (inc. bonuses, y/y of 3m av.)

09.30

(+3.4%)

(+3.7%)

(+3.7%)

High tide in the labour market?

In spite of signs that weaker economic activity is starting to weigh on the labour market, there’s a good chance the unemployment rate fell in June.

Employment has risen by 100,000 a quarter on average over the past year whereas we think it only rose by 33,000 in the three months to June. But participation has dropped back even more quickly, causing the unemployment rate to fall from 4.0% in December to 3.8% in May. If participation continued to fall back in June, that small rise in employment would be enough to push the unemployment rate down to 3.7%. Meanwhile, headline pay growth including bonuses probably rose from 3.4% to 3.7% as a weak reading in March falls out of the three-month average.

June may well mark the bottom for the unemployment rate, and wage growth is probably approaching the ceiling. July’s REC availability of staff index hit its highest level since January 2017. That’s consistent with the big falls in unemployment over the past few years that have underpinned higher wage growth coming to an end. (See Chart 3.)

Chart 3: REC Staff Availability & Unemployment

Sources: Refinitiv, REC

Consumer Prices (Jul.) Wed. 14th Aug.

Forecasts

Time (BST)

Previous

Consensus

Capital Economics

Consumer Prices m/m(y/y)

09.30

0.0%(+2.0%)

-0.1%(+1.9%)

0.0%(+2.0%)

Core Consumer Prices m/m(y/y)

09.30

0.0%(+1.8%)

-0.2%(+1.7%)

-0.1%(+1.8%)

Holding steady at the 2% target

While CPI inflation is likely to have remained at 2.0% in July, a fall in energy bills will probably push inflation down to 1.8% before the year is out. Beyond that, we expect the ongoing strength in pay growth to drive inflation back above the 2% target.

The contribution of energy prices to CPI inflation probably fell in July. Prices at the fuel pump dropped by 1.4% m/m in July, compared to a 0.5% m/m fall in July 2018. And since retailers have not fully passed on the fall in oil prices, fuel prices will probably exert more downward pressure on inflation in the coming months. (See Chart 4.) Utility prices are likely to have had a downward influence on inflation too, if only because the 1.1% and 1.8% m/m rises in gas and electricity prices in July 2018 haven’t been repeated. The summer clothing price discounts were smaller than usual in June, suggesting that the summer sales may have started later this year compared with 2018. So a slightly weaker inflation rate for clothing seems likely too.

Offsetting these effects, food inflation probably rose in July due to past rises in agricultural commodity prices. Overall, CPI and core inflation may have held steady in July at 2.0% and 1.8% respectively.

Chart 4: Oil Price & CPI Fuel Prices

Sources: Refinitiv, DBEIS, Capital Economics

Retail Sales (Jul.) Thu. 15th Aug.

Forecasts

Time (BST)

Previous

Consensus

Capital Economics

Retail Sales Volumes (Including Petrol)

09.30

+1.0%(+3.8%)

+0.1%(+2.6%)

+0.5%(+3.3%)

Consumers continue to spend on the high street

After a strong rise in June, we expect another decent increase in retail sales at the start of the third quarter.

The 1.0% m/m rise in retail sales in June more than reversed the declines in April and May and showed there is some signs of life in household spending yet.

Admittedly, the CBI and BRC surveys are at weak levels. But at least they improved in July. The CBI’s reported sales balance rebounded from -42 in June to -16. And the BRC reported that annual growth in like-for-like retail sales volumes was +0.1% y/y in July, up from -1.6% in June. As a result, our implied real measure of BRC retail sales suggests sales growth picked up in July. Food stores in particular may have been helped by warmer-than-usual weather in July.

With real wage growth remaining robust in recent months, consumers have the ability to spend. And July’s GfK measure of consumer confidence indicated households were more upbeat about their own finances and the economic outlook at the start of Q3 suggesting they may be willing to spend too – despite Brexit uncertainty.

All in all, we have pencilled in a 0.5% m/m rise in retail sales in July. (See Chart 5.) If we are right, even if growth stagnates in August and September, retail sales should still grow by 1.0% q/q in Q3 as a whole, contributing 0.05ppts to GDP.

Chart 5: Retail Sales Volumes

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 12th

No Significant Data Released

Tue 13th

UK

Change in Employment (Jun, 3m/3m)

(09.30)

+28,000

+69,000

+33,000

DR

UK

ILO Unemployment Rate (Jun)

(09.30)

+3.8%

+3.8%

+3.7%

DR

UK

Average Earnings Inc. Bonus (Jun, 3m/yy)

(09.30)

(+3.4%)

(+3.7%)

(+3.7%)

DR

UK

Average Earnings Ex. Bonus (Jun, 3m/yy)

(09.30)

(+3.6%)

(+3.8%)

(+3.9%)

DR

Wed 14th

UK

CPI (Jul)

(09.30)

0.0%(+2.0%)

-0.1%(+1.9%)

0.0%(+2.0%)

DR

UK

Core CPI (Jul)

(09.30)

0.0%(+1.8%)

-0.2%(+1.7%)

-0.1%(+1.8%)

DR

UK

RPI (Jul)

(09.30)

+0.1%(+2.9%)

0.0%(+2.8%)

+0.1%(+2.9%)

DR

UK

PPI Input (Jul)

(09.30)

-1.4%(-0.3%)

+0.5%(+0.3%)

0.0%(-0.3%)

DR

UK

PPI Output (Jul)

(09.30)

-0.1%(+1.6%)

+0.1%(+1.7%)

+0.2(+1.8%)

DR

UK

House Price Index (Jun, m/m)

(09.30)

(+1.2%)

Thu 15th

UK

Retail Sales Inc. Fuel (Jul)

(09.30)

+1.0%(+3.8%)

+0.1%(+2.6%)

+0.5%(+3.3%)

DR

Fri 16th

No Significant Data Released

Selected future data releases and events

Tue 20th

UK

CBI Industrial Trends Survey (Aug)

(11.00)

Wed 21st

UK

Public Finances (Jul)

(09.30)

DR

Thu 22nd

UK

CBI Distributive Trades Survey (Aug)

(11.00)

*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)

+0.5(+1.8)

+0.5(+2.0)

(+1.9)

(+2.0)

(+1.7)

CPI inflation (%)

(+2.0) (Jun)

(+1.9)

(+2.0)

(+1.9)

(+1.8)

(+1.9)

(+2.2)

(+2.3)

ILO unemployment rate (%)

3.8 (May)

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 (%)

0.48

1.00

0.83

0.87

1.00

1.00

1.25

1.75

$/£, end period

1.21

1.32

1.27

1.25

1.25

1.25

1.30

1.35

Euro/£, end period

1.08

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.


Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com