The long awaited first stab at UK gross domestic product (GDP) over Q1 2008 was released on Friday. Much has been written regarding the continuing crisis in the credit markets and the plight of the US economy, however, recent survey data indicates that whatever the problems in store for the UK over the next twelve months, so far activity appears to be holding up fairly well.

The country’s leaders should, however, not be lulled into a false sense of security. The International Monetary Fund (IMF) delivered a particularly hard hitting assessment of prospects and given that the economic imbalances in this country are as severe as in the United States there is no room for complacency.

We currently look for the UK economy to grow by 1.8% over 2008, marginally ahead of consensus (1.7%) and down from 3.0% in 2007. Although this would represent a slide back to sub-trend growth the greater concern surrounds the outlook for 2009 at which point the unwinding of the current account and personal indebtedness imbalances, coupled with the stretched state of government finances indicates a very real concern that growth in the future could be even weaker.

UK economy: the ongoing credit crisis

The most immediate problem surrounds the ongoing credit crisis and its adverse impact on the country’s financial institutions. Whilst politicians and banks argue regarding who might be to blame for the problems now affecting the global financial institutions, little has so far been done outside the US at present to resolve matters (although at the time of writing the Bank of England is rumoured to be planning to swap mortgage backed securities for, so far undisclosed amounts of government bonds for as long as possibly 1-3 years, along similar lines to the Fed’s Term Securities lending Facility).

The longer this dysfunctional state of affairs goes on, the greater the chances that serious damage might be done to the real economy. Given the significance of the financial sector to the UK economy’s well being, a prolonged period of dislocation could knock as much as 1.0% point off growth over the next twelve months.

Of greater concern is the adverse impact of the credit crunch on households and their spending intentions. Given that consumption accounts for around two-thirds of total activity, any adverse shocks emanating from the financial institutions are likely to have an even more significant (and lasting) impact. Here recent news has been far from encouraging with difficulties showing up, in particular, in the mortgage market.

The link between the mortgage market and consumption

Unsurprisingly, mortgage demand has fallen sharply over the past three months with potential buyers facing greater constraints than at any time since the last pronounced housing market downturn back in 1990-91. At present average house prices are expected to fall by between 5-10% over the next twelve months but with fairly pronounced regional variations. The figure could yet be exacerbated by the fact that the buyer holds the whip hand and distressed sellers may yet be forced to accept lower offers, particularly where no or only small chains exist.

Although the outlook for the housing market is bleak, the link between falling house prices and falling consumer spending is not obvious. Firstly, house prices have risen a long way in a relatively short space of time and many home owners will still be sitting on substantial equity built up over the past decade.

However, consumer confidence is undoubtedly impacted by falling house prices and concomitant negative media headlines regarding most people’s single biggest investment. In that confidence can be impacted by changes in, as well as the absolute level of, house prices any negative moves are likely to have an adverse effect on potential spending intentions.

Unemployment and savings

The other factor likely to impact on spending is households’ perception of employment prospects. Falling economic activity and falling corporate profitability can become self-reinforcing. Although the validity of labour market data has been called into question, it seems likely that when faced by sharply higher input costs, companies will attempt to maintain margins by cutting back their, generally, single biggest cost, labour.

We view rising unemployment as highly likely as the slowdown gathers pace and therefore, while consumer spending has held up pretty well so far, it cannot be guaranteed to continue as the slowdown begins to bite.

Furthermore, just as in the US, the UK’s household savings ratio recently plunged to all time low levels (see chart below). The combination of falling house prices and increased uncertainty regarding the outlook for the wider economy, coupled with fears over job prospects, are almost certain to encourage consumers to save more and consume less.

UK households’ savings ratio (%)

The corporate sector is less clear-cut

Turning to the corporate sector we believe that the outlook is less clear-cut, but by no means upbeat. Responding to concerns regarding falling demand, companies are likely to cut back investing intentions with construction spending under particular pressure following falls in commercial property prices.

Until Q3 2007 UK-based companies were racking up ever higher profits and margins had reached record levels. Whilst profitability is now under clear downward pressure and analyst earnings forecasts are being revised lower as a matter of course, many companies still have the benefit of being able to draw on retained profits built up over the past decade to see them through the downturn.

From an activity perspective much hinges on the ability of the export sector to limit the extent of the downturn (it alone cannot reverse it). In this context much depends on sterling’s fortunes on the foreign exchange markets.

Pages: 1 2

Pages: 1 2