dgwilkinson

February 23, 2015

Is Sterling Overvalued?

Filed under: Economic Crisis, Economic Forecast, Uncategorized — drderrick @ 10:10 am

Over the past five years trade weighted Sterling has appreciated by 8%. Over the same period, it has fallen against the US$ by 6%, and it has fallen against the Yuan by 15% – US$ and Yuan account for 17.5% and 8.9% respectively of the currency basket. The strength of Sterling is entirely due to the weakness of the Euro, which accounts for 46.2% of the currency basket, and against which Sterling has risen by 15%.

Over the past twelve months, while Sterling has fallen against both the US$ and Yuan by 11%, overall the trade weighted index has fallen by only 1%, due again to the weakness of the Euro, against which Sterling has risen by 3%.

Given its great importance, the strength of Sterling against the Euro will have contributed to the startling growth of the UK current account deficit, which now stands at some 6% of GDP – the worst ever! It will also have contributed to the weakness of UK inflationary pressure. Alongside low oil prices, strong Sterling should be seen as one of the temporary contributors to current low inflationary environment.

When the Euro eventually strengthens, the value of Sterling could fall significantly and, together with domestic political factors – discussed here: https://drderrick.wordpress.com/2014/12/29/the-sterling-crisis-of-2015/ – may lead to an overshoot, leading to an undervalued Sterling. While exporters might welcome this, it would also increase inflationary pressures, and the likelihood of the Bank of England raising interest rates.

When this happens the anaesthetising effects of the current interest rate regime will begin to wear off, and the economy will slow.

December 29, 2014

The Sterling Crisis of 2015?

By all accounts, the UK general election to be held in May 2015 is too close to call. On May 8th the nation is expected to wake up to another coalition government, quite possibly composed of three or more Parties. While the composition of the new government cannot yet be foreseen, it seems most likely that either the Conservative Party or the Labour Party will be the senior partner in whatever coalition government emerges from post-election negotiations. While for political pundits this election may well be one of the most interesting in many years, the economic risks are daunting; two very dark economic clouds are on the horizon. The first is the issue of government debt reduction, and the second is the question of UK membership in the EU.

A left-wing coalition led by Labour would put aside for now the question of UK membership of the EU, as Labour, Liberal Democrats, Scottish National Party, and the Green parties are all pro-EU, but they are expected to commit to a much slower pace of deficit reduction than is proposed by the Conservatives. Slower spending cuts, alongside any increased borrowing and higher taxes that they may propose to finance government efforts to stimulate economic growth, may lead to a significant risk that markets may well begin to lose confidence in the government’s commitment or ability to address its growing debt problem, with potentially serious repercussions for the value of Sterling.

If the Conservatives are the senior partner in a more right wing coalition their deficit reduction plans may prove politically difficult to implement, leading to politically expedient delays. The Conservative plan to eliminate a £90 billion annual deficit over the course of the next Parliament will seriously affect the well being of a lot of people, and will not happen without a great deal of political opposition. Of similar danger to the deficit problem is the question of UK membership of the EU. Responding to popular disaffection with the EU – amply demonstrated by the rise of UKIP – the UK Prime Minister David Cameron has pledged to hold an in-out referendum on UK membership of the EU by 2017, if he is returned to Office in 2015. This will cause great uncertainty amongst investors as to what the “rules of the game” will be post 2017. Such uncertainty will depress investment in the UK economy, which will further constrain economic growth and exacerbate the political difficulties of meeting deficit reduction targets. Such a reversal of fortunes would again put pressure on the value of Sterling.

Over the past four years, through a combination of luck and contrivance, the current government has enjoyed a fragile recovery from the market crisis in 2007/08. That economic growth has been due almost entirely to an accumulation of household and government debt, supported by historically low interest rates, that has been used largely to maintain high levels of current consumption. While some moderation in the growth rate of the economy should be expected over the coming years, the election in 2015 poses the greatest domestic challenge the economy has faced over the past seven years. Whichever Party holds the senior position in the government after the elections in May 2015, there is a real risk of a Sterling crisis. Such a crisis in confidence in Sterling might be welcomed by exporters, but it would also exacerbate the extremely high current account deficit, increase consumer price inflation, and necessitate an increase in interest rates faster and further than would otherwise be implemented. If this happens, significantly weaker economic performance than is currently foreseen can be expected, including a return to recession.

November 6, 2014

UK MACROECONOMIC OUTLOOK ON 2015 to 2017

Filed under: Economic Crisis, Economic Forecast, UK Economy — drderrick @ 11:12 am

Ongoing and accelerating economic growth over the past 18 months has surprised most economists, and forecasts have all been revised up. 12 months ago the consensus of the economists surveyed by the Treasury was for growth of 2.2% in 2014. That has now risen to 3.1%. A closer look at the key elements of the economy may help to explain why we have seen this unexpected rise in growth, and provide some clues as to how that may develop over the next few years.

While the economy is on track to expand by some 2.5 to 3% over the course of 2014, suggestions in some quarters that “the recovery is now firmly established” are premature. Looking closely at the published statistics, the only substantial growth in the economy has been almost entirely in the service sector, which accounts for over 78% of all economic output. Although the first half of 2014 has seen some growth in the production sectors, after a long period of static and declining output, most remain significantly below their 2011 activity levels. By contrast, most industries in the services sector have seen, and continue to enjoy, good growth. This is especially the case with the wholesale and retail trades, with transport and storage, and with professional and administration services, which have led the expansion of services output. Given the size of the services sector in the economy, recent indications that the growth of services output may be slowing suggest the economic recovery may be encountering renewed difficulties.

In terms of expenditure, the growth over the past 18 months or so can be traced to substantially faster than expected growth in household consumption and government spending. While it has been encouraging to also see a substantial improvement in business investment, there has been a correspondingly large increase in inventories, which suggests that there may be some moderation in investment spending over the coming months. Similarly, with government continuing to run a £100 billion budget deficit, it is difficult to imagine government-spending continuing at recent levels over the course of the forecast period. With global economic conditions deteriorating, especially in the Eurozone, net exports are unlikely to make any positive contribution to growth for some time. That leaves, household consumption – accounting for some 62% of domestic spending – as the only significant potential source of economic growth.

Over the past few years, household spending has been remarkably buoyant and resilient, but it is increasingly unclear how much longer it can continue to grow. There are a number of underlying reasons for the growth in consumer spending, including wealth effects from rapidly rising house prices, and improvements in employment rates. With average real wages under continued pressure, however, of particular importance have been a number of government initiatives to encourage borrowing and spending by businesses and households, and by the extremely low interest rates that ease the burden of servicing large and growing debts.

Chart 1: Household Net Lending (+) and Borrowing (-) – £ millions

Household Credit

Source: ONS

Bank of England figures show that net consumer borrowing began to increase about 2 years ago and has been accelerating since. It is currently growing at an annual rate of 5.4%. As a result, as shown in Chart 1, household finances are deteriorating and reductions in spending may need to be made – especially when interest rates rise.

Households spend just over £1 trillion each year, and Chart 2 shows a breakdown of that spending by type. It shows that households spend almost as much on “enjoyment” alone (£257 billion) as all the spending on investment in the economy (£281 billion). While much household spending is non-discretionary in the short term, spending on “enjoyment” can be trimmed relatively quickly. Any such curtailment of household spending, possibly due to the deterioration in household finances suggested by Chart 1, would quickly arrest the growth seen over the past 18 months.

Chart 2: Household Spending by Type

Spending by Type

Source: ONS

In short, there are no signs yet of a sustainable recovery of the economy, and the growth that there is remains very vulnerable to the interest rate increases expected during 2015.

In light of the challenges faced by the UK, as well as by other economies around the world, the outlook for the next few years is especially uncertain. Continued high private household debts, further constraints on government spending, and an expected start to the normalisation of monetary policy during 2015, contribute great uncertainty to growth forecasts over the coming 3 years. Currently I expect the economy to continue to grow throughout 2014 but start slowing as we move into 2015, and continue to weaken over the course of the following months. Of course, it would not be surprising to see some modest growth in some quarters over the course of the next 3 years but, in my view, there is little reason to expect overall annual economic growth to accelerate beyond the end of 2014.

The median estimate for GDP growth in 2015 of the economists surveyed by the Treasury is 2.3%, slightly higher than my forecast of 2.1% growth. Looking further forward, most published economic forecasts see continued, if modest, growth being maintained.

UK Growth Outlook

GDP 14-17

These outlooks are usually based on a few key assumptions that are increasingly doubtful:
With the economy growing at nearly 3%, and the unemployment rate at a 6 year low and falling at the fastest rate on record, the assumption that interest rates will remain unchanged seems increasingly unsustainable. The Bank of England is now widely expected to begin increasing interest rates by the middle of 2015.
It is also assumed that the deteriorating current account deficit becomes a growing surplus, but the latest official figures show that in Q2 2014 it had deteriorated to 5.2% of GDP, which is the worst in recorded history in both cash terms and as a percentage of `GDP. With the Eurozone economy – the UKs largest trading partner – suffering from a wide range of serious problems, there is no reason to suggest a turn-around in the foreseeable future.
Business investment is expected to continue to grow strongly, despite the many risks and challenges faced by the economy. Given the current economic uncertainties, it seems unreasonable to continue to assume that strong private investment will be maintained for long, or to be a strong driver of overall growth over the next few years.
Above all, the more optimistic forecasts assume household spending will be maintained and continue to grow: an assumption about which there is increasing doubt.
As David Kern, Chief Economist at the British Chambers of Commerce has argued:
“Rises in sterling, making UK exports more expensive, and uncertainties around early interest rate increases are adding to the difficulties, and our excessively large current account deficit is posing risks. UK growth cannot rely permanently on rising consumer spending, which is driven by buoyant housing market and excessive household debt. Unless investment and net exports make bigger contributions to growth, the recovery will stall.“

Given these problems, I suggest that UK average annual GDP growth will be somewhat weaker than the consensus outlook. I expect the economy to grow by 2.6% over the course of 2014, by 2.1% in 2015, 1% in 2016, and 0.7% in 2017. Moreover, the possibility of an in/out EU referendum in 2017 add great uncertainty and means that the risks are mainly that the outturn will be worse than currently foreseen.

December 13, 2013

UK MACROECONOMIC OUTLOOK ON 2014 to 2016

Filed under: Economic Forecast, UK Economy — drderrick @ 1:00 pm

Ongoing and accelerating economic growth in 2013 has surprised most economists, and forecasts have all been revised up. Overall, the economy is now expected to grow by about 1.4% in 2013. That said, in my view, suggestions in some quarters that “he recovery is now firmly established” are premature. Looking closely at the published statistics, the growth in 2013 can be traced to government programmes to subsidise bank lending, and to the Bank of England policy of maintaining interest rates at “life support” levels. The subsidised bank lending has done little to improve the finances of the small and medium sized businesses it was aimed at, and has instead supported increased mortgage provision. This, together with programmes directly aimed at subsidising house buying, have begun to inflate house prices, with some positive effects for the construction sector, and related business services. Rising house prices have also had a wealth effect on private consumers and current private consumption has also risen, despite falling real incomes. Productive business investment remains very weak, and the external trade balance continues to deteriorate. In short, there are no signs yet of a sustainable recovery of the economy, and the growth that there is remains very vulnerable to the interest rate increases expected by 2015.

In light of the challenges faced by the UK, as well as by other economies around the world, the outlook for the next few years is especially uncertain. Continued high private household debts and an expected start to the normalisation of monetary policy by 2015, contribute great uncertainty to growth forecasts over the coming 3 years. Currently, I expect the economy to continue to grow in 2014 but start slowing by the second half, when it will be growing at about 2.3%, and continue to weaken over the course of the following months.  Of course, it would not be surprising to see some modest growth in some quarters over the course of the next 3 years but, in my view, there is little reason to expect overall annual economic growth to accelerate beyond the middle of 2014.

The median estimate for GDP growth in 2014 of the economists surveyed by the Treasury is +2.3%.  Looking further forward, most published economic forecasts see growth accelerating toward 3% or higher. These outlooks are invariably based on the assumptions that interest rates remain unchanged, that business investment increases dramatically, and that the deteriorating balance of payments deficit becomes a growing surplus – that all the things that need to happen do mysteriously happen. The first of these seems highly unlikely – at least after the election in 2015 – while the latter two are unexplained and simply assumed to happen.

By comparison, my model of the UK macro-economy suggests that UK GDP growth will be 1.4% in 2013;  2.0% in 2014; +1.0% in 2015; and +0.9% in 2016.  Consequently I would argue that planning for slowing overall GDP growth of not more than 4% over the course of the whole of the next 3 years would be prudent.

 

Create a free website or blog at WordPress.com.