Osborne's upbeat economic view endorsed by City

AS Britain enters the ninth year since the onset of the global financial crisis, one little-noticed event towards the end of 2015 highlighted the very two-sided outlook for the world’s fifth-largest economy.

In late October the UK government auctioned off £4bn worth of 50-year debt. Despite offering an interest rate of just 2.5% a year for five decades, it attracted record demand and was oversubscribed by a factor of five.

On the one hand, the immense demand from investors can be seen as a positive verdict on Britain’s economic management, its target to balance the budget by 2020, and its reputation as an investment destination. On the other, the fact that investors are prepared to lock up their cash until 2065 with comparatively little income in exchange suggests little expectation of a pick-up in economic growth that would require serious hikes in interest rates.

There is an element of truth to both stories. The UK economy probably grew by 2.5% in 2015, slightly ahead of its long-term trend. As George Osborne was able to say on the fringes of the 2015 annual meeting of the International Monetary Fund in Peru, the economy is almost 12% larger than when he became chancellor, exactly in line with the US recovery.

“That is very different from the picture painted by those who criticised the UK’s policies during that period – some of whom are no longer in post,” he said, in an acerbic putdown of Olivier Blanchard, former IMF chief economist and a critic of the UK’s economic strategy.

His upbeat view has been endorsed by City economists whose average prediction is for 2.5% growth, with some punting for growth as high as 2.8%, according to the monthly survey by the UK Treasury.

But at the same time there are signs of a slowdown. Construction output contracted 2.2% quarter on quarter in the three months to September while manufacturing fell 0.3%. This helped drag growth in the third quarter down to 0.5%, from 0.7% in the previous three months.

“The manufacturing sector is clearly currently a cause for serious concern,” says Howard Archer, chief UK economist at IHS Global Insight.

Factory slowdown

More recent data from the purchasing managers index, which collects snapshot views of executives at the coalface of British business, identified a similar retrenchment in the services sector that makes up four-fifths of the economy.

It posted its weakest rise in activity in nearly two and a half years in September, according to the Chartered Institute of Procurement and Supply.

“The further softening of growth in the services sector must now be causing some concern for the sustainability of the recent recovery in the UK economy,” says David Noble, its group chief executive officer.

Economist Allan Monks of JP Morgan, who expects the economy to hit 2.6% in 2015 and slow to 2.3% in 2016, says data suggests a “significant loss” of growth momentum. However, he says low inflation and rising wage growth are still supporting real-income growth that is feeding through to rising retail sales and consumer confidence. This, in turn, translates into an annual 3% rate of growth in consumer spending.

The worry is that a slowdown in business activity and investment, as well as a likely recession in manufacturing, contrasts with strong consumer spending and borrowing.

Simon Wells, chief UK economist at HSBC, says that while the level of real household consumption is 3.4% above its pre-crisis peak in the second quarter of 2015, investment is 3.1% below.

“The domestic economy is looking more unbalanced. The recovery is slightly less reliant on investment, and driven more by household consumption,” he says.
But if the economy has been bolstered by strong spending by consumers who enjoy rising house prices, a big worry is what will happen when interest rates start to rise after being at 0.5% since March 2009.

Mark Carney, the governor of the Bank of England, warned in October that one in 25 mortgage holders were at risk of being unable to pay their debts if rates were to rise over the coming year. “That’s a possibility, not a certainty, of rate rises [but it] is far, far better to let the British people know so they can prepare,” he said.

So far, the pain has been deferred as the timing of the first rate rise in seven years has been delayed from the autumn of 2015 to the spring of 2016. A majority of City economists expects the bank rate to close 2016 at 1%, which is still very low by historic standards – and financial markets are not pricing in a hike until 2017.

Overall, the domestic economic outlook for 2016 looks bright but the rewards will be shared unequally between the winners (services, consumers and homeowners) and the losers (manufacturers, exporters and public services).

Overseas problems

But an issue that may determine the performance of the UK economy is how the government and business deal with the external shocks that may affect the UK.
Chief among these is Europe, which brings old threats and new. As it is the UK’s main trading partner, weakness in the eurozone – the IMF expects growth of just 1.5% in 2016 – will add to the pain being felt by exporters.

The good news is that one of the shadows hanging over the outlook in 2015 – the threat of Greece being ejected from the eurozone and a collapse in the single currency – has lifted, at least for now. Although the UK is not hugely engaged with Greece, a Grexit would have delivered a shock to the wider eurozone whose ripples would have been felt on Britain’s shores.

The decision by Greek prime minister Alexis Tsipras to effectively accept the tough terms of the €86bn (£62bn) EU bailout, and the subsequent re-election of his Syriza party means that Greece can look forward to stability going into the new year.
“Having stared into the Grexit abyss, Tsipras and Greek voters now seem largely inclined to pursue the required reforms,” says Holger Schmieding, chief economist at Berenberg Bank.

Yet that may only mean a return to business as usual. “Once the oil windfall is spent, the eurozone will once again settle into a prolonged period of sluggish growth and uncomfortably low inflation with ever-rising government debt,” says Karen Ward, chief European economist at HSBC.

But with Grexit now off the radar, Brexit is clearly one of the key European economic risks for 2016. David Cameron won the general election on a pledge to hold the in-out vote by the end of 2017 but is showing a determination to hold the poll in late 2016.

Campaigners and economists on both sides of the debate will argue that Britain will either thrive or suffer if the UK quits the EU, depending on their stance. But while the economic impacts of the vote outcome will not be felt until 2017, uncertainty ahead of the poll could act as a drag on growth.

Both US president Barack Obama and his Chinese counterpart Xi Jinping have dropped clear hints that they want to see Britain remain a member of the EU. Overseas investors may also hold back investment decisions until after the referendum is held.

JP Morgan has warned that the transitional costs if Britain leaves the EU are likely to be “substantial”, as uncertainty over future arrangements would likely cause investment to fall and consumers to defer spending.

Breakable China

But Europe is not the only potential spanner in the works. A second key risk is weaker activity in key emerging markets, particularly China. The recent botched revaluation of the renminbi, the ensuing collapse in share prices, the slowdown in growth and the seventh rate cut this year have all indicated that the world’s second-largest economy is going through a pronounced slowdown.

The chancellor has given a clear signal that he wants Britain to be China’s main partner in the West. The UK was first to sign up as a member of the China-led Asian Infrastructure Investment Bank in the face of opposition from the United States.

The chancellor laid out a red carpet for Xi during his four-day state visit to the UK, which the Treasury said led to £40bn of deals of being signed (although that included some previously announced deals). This raised the question of whether Britain was backing the wrong horse at the wrong time. However, Bank of America Merrill Lynch (BoAML) says the UK should be well insulated from even a sizeable slowdown in China, whose export market is a tenth the size of the European Union.

Even a collapse in Chinese growth – from 7% now to as low as 3.5% – would mean the direct trade hit to GDP would be just 0.09%. “The trade impact would be a minor irritation for the UK economy as a whole,” says its UK economist Robert Wood.

John Cridland, the head of the CBI who has long argued for the UK industrial strategy to shift its focus eastwards, hailed signs of a “thriving trading partnership [that] lies at the heart of the UK’s economic future. From infrastructure projects to digital technology, the UK is the top destination for Chinese foreign direct investment in Europe, while UK exports to China have more than trebled since 2007.”

Assuming that China’s recent troubles are teething troubles on its journey towards much-needed rebalancing, away from exports and investment towards domestic consumption and services, rather than a full-blown crisis, the UK should not be too affected, says BoAML’s Wood.

“Britain is not immune to ups and downs in the world economy but the third-quarter growth figures perhaps demonstrate, subject to the usual health warnings, a good degree of insulation.”

Despite his upbeat comments in Peru, Osborne appears aware of the dangers of hubris. “I am very alert to the risks to the UK. Britain is not immune from what’s going on in the world as we are perhaps more interconnected than any other major economy,” he said.

“All the more reason to strengthen our defences and get our own house in order. Far from thinking the job is done – there is an enormous amount more to do.” ?