Business cycles, like “bull markets, are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.”
Based on a quote from Sir John Templeton
The recovery in UK GDP appears to be running out of steam. The economy has expanded at an impressive rate since the start of 2013 – impressive that is at least relative to the anaemic pace set by her G7 peers. However, the latest data suggest that growth is slowing and in this article we discuss possible explanations.
The Bank of England’s latest Inflation Report sets out the facts. Quarterly growth slowed at the turn of the year from 0.6% in Q4 to 0.4% in Q1 and Bank staff expect growth to slow further in Q2 to 0.3%. The business surveys corroborate that slippage in momentum in the official data: the PMI activity balance for the services sector fell 1.5 points to 52.3 in April, the lowest level since February 2013. Nor is the shift in tone confined to the data on activity.
Exhibit 1: The preliminary estimate of British GDP growth showed the economy lost momentum in the first quarter of 2016 (graph shows changes in quarterly and annual UK GDP for the period between 2007 through to first quarter 2016).
Source: Bloomberg, as at 20 May 2016.
The Report notes that survey measures of investment intentions have eased, demand for bank credit has softened among large companies, employment growth has slowed markedly, and there has been a ‘striking fall’ in commercial property transactions.
One explanation for the apparent slowdown in demand is that it is an illusion. The national statisticians publish their first estimates of the level of activity in a given quarter within a matter of weeks of the end of that quarter. Over time, they receive additional information about the level of output, income and expenditure which allows them to refine those early estimates. On occasion, the profile of growth painted by the initial estimates has been revised quite substantially with time as more data has become available. In this case, the Bank of England expects the mature data to show a more measured pace of decline between the fourth quarter of 2015 and the first quarter of 2016. Bank staff highlight in particular the weakness of activity in the construction sector as one area in which revisions might occur. Nonetheless, the slowdown in demand since late 2015 does indeed appear to be the real deal.
For those of a statistical persuasion, the fact that growth has slowed in the United Kingdom may not come as a surprise. A cursory glance at the data reveals that uninterrupted periods of robust expansion do not last indefinitely. Sooner or later the expansion phase of the business cycle comes to an end. Indeed, many investors claim that the US and UK economies have been in the mature stage of a cyclical recovery for some time and are therefore ‘due a recession’, or at the very least a temporary pause in growth. From this perspective the slowdown in growth in the UK is not a puzzle; on the contrary it is consistent with the natural order of things.
Economists on the other hand are sceptical that recoveries die of old age. They look instead for a causal factor – a culprit – which explains the demise of the recovery, and for many commentators, central bankers are the usual suspects. In the immediate aftermath of a deep recession, central banks need to keep interest rates sufficiently loose in order to stimulate above trend growth in demand so that the spare capacity that emerged during the recession can be eliminated. Once the economy is back in balance, then the stance of policy must be normalised to ensure that demand growth slows to match the rate of expansion of the supply side. Likewise, in the opposite phase of the business cycle, central banks must tighten policy in a boom to engineer sub-trend growth to bring the economy back into balance, and that might even involve an outright contraction in output.
The small hitch with the narrative that the current recovery died of natural monetary causes is that there has been no gradual tightening of the monetary stance that has choked off above trend growth. The Bank of England has left interest rates and the size of its quantitative easing portfolio on hold, and if anything the market has been pushing back the expected timing and scale of the future hiking cycle. Moreover, the European Central Bank has effectively eased a broader measure of sterling monetary conditions through the spillover effects of its asset purchase programme.
The other place to look for explanations for a slowdown is shocks: developments at home and abroad which weigh on demand. One obvious candidate explanation for our puzzle is the anaemic state of the global economy which has made the UK recovery increasingly reliant on the resilience of domestic demand. Had income growth been more robust overseas, net trade might not have detracted from growth in the second half of 2015. The (until recent) strength of sterling is also likely a contributory factor here, weighing on the overseas demand for UK output, particularly in the manufacturing sector, and boosting demand for imports.
The recent decline in oil prices is also likely to have influenced the profile of UK GDP. On the one hand, households have enjoyed a welcome boost to disposable income which has supported consumption. On the other, the new reality of lower oil prices will have weighed on investment in the UK’s extraction sector. It is hard to pin point when exactly consumers spent the oil dividend. However, the data on investment spending are more revealing: extraction investment fell by around 40% over the year to 2015 Q4 knocking three and a half percentage points off overall growth in business investment.
Finally, there is one domestic factor that has likely contributed to the slowdown in demand. The Inflation Report documents in some detail how the uncertainty generated by the upcoming referendum over the United Kingdom’s membership of the European Union has weighed on the economic outlook. Bank staff note that elevated uncertainty can depress demand through a number of channels: directly via higher precautionary savings and delayed investment, but also indirectly via a tightening in financial conditions as risk premia widen.