UK: At Risk of Recession?

In the UK, the memory of the last recession has faded somewhat. The last quarter of negative quarter-on-quarter real GDP growth was 15 years ago in 1992. But recession is being discussed as a real possibility in several countries around the globe, and the UK is one of them. Historically, contractions in GDP growth in the UK are relatively common. While not our central case, our plausible ‘pessimistic’ scenario incorporates a mild ‘technical’ recession (i.e., two consecutive quarters of negative quarterly GDP growth) and there is a significant possibility that events turn out rather worse than this.

“Recession”, is a powerful word and needs to be defined carefully. In talking about the chances of a recession one should be clear as to whether one means a couple of quarters of slightly negative quarter-on-quarter GDP growth or something much more serious. Whether a recession is short and sharp or shallow and prolonged would obviously have different implications for asset prices and economic outcomes.

Recession not that unusual in the UK. No one recession looks like another and there are, at least in recent history, so few examples of UK recessions that basing any scenario analysis on a past recession is rather hazardous. Nevertheless, it is instructive to look at the average characteristics of UK recessions. There are several striking things about recessions in the UK:

A contraction in GDP in any one quarter is a relatively frequent occurrence and need not signal a recession — defined as either two quarters of negative GDP growth or as a fall in the level of GDP over one full calendar year. There have been 39 quarterly contractions in GDP since Q1-1956 — 19% of observations.

‘Technical recessions’ — 2 consecutive quarters of negative growth — have not been uncommon over the past 50 years, occurring some 7% of the time. What is more striking is how relatively unusual it is to have gone so long without experiencing a recession. The quarters of technical recession have tended to be in clusters, in the mid-1950s, the mid-1970s, the early 1980s and the early 1990s, with one additional observation in late 1961.

The average size of contraction is similar to the size of average growth. In other words, during a technical recession, for example, the level of GDP in a recessionary quarter contracts by enough in one quarter (on average, by 0.7%) that it will take approximately two quarters of average growth to restore GDP back to its former level.

GDP has contracted over a full year (i.e., the GDP level in any one year has been less than the GDP level in the previous year) five times since 1956 (10% of observations). The average size of contraction has been -1.4%. Again, these observations are clustered, occurring in 1974 and 1975 then in 1980 and 1981 and most recently in 1991. In terms of the size of peak to trough contraction over the recession, the mid-1970s and early-1980s recessions were worse than the early 1990s. However, on our calculations the negative output gap during this downturn was of comparable size to the previous two recessions. In other words, a shallower recession can be as serious as something sharper in terms of an economy operating below potential.

Our ‘pessimistic’ scenario: Our subjective probability of the UK economy evolving somewhere close to our pessimistic scenario over the next year or so and recording a mild technical correction is around 35%. This is significantly higher than the probability in ‘normal times’ which, based simply on the historical record we would put at around 10%. In this scenario, the household saving rate rises sharply with two quarters of contraction in household spending; business investment contracts in the first half of 2008; unemployment rises to a seven year high. In this scenario, the UK records a (very moderate in the context of previous recessions) technical recession and 0.7% growth overall in 2008. The key to whether this scenario actually comes to pass is consumer spending and saving behaviour. We see at least three potential (interlinked) triggers.

Trigger one: Sharp prolonged tightening in credit conditions. Funding conditions for banks have worsened sharply and credit conditions have subsequently tightened for many households. In particular, the interest charged on sub-prime mortgages has risen sharply. However, data suggest that this has not yet strongly affected average quoted mortgage rates. Since the end of last year, quoted mortgage rates have risen across products, but much of this reflects the interest rate rises seen over the year from the Bank of England (75bp to July) rather than additional credit tightening. Our pessimistic scenario could be triggered if tight bank funding conditions do not significantly improve over the first few months of 2008. Lenders might then pass on a relatively small portion of Bank of England rate cuts to borrowers and make significantly less credit available to households. Households would need to save more in order to build a deposit sufficient for banks to lend to them for house purchase and households would be less able to smooth consumption using borrowing, encouraging precautionary savings. In order to attract retail deposits to plug some of their funding gap, banks may not reduce the rates offered to depositors as the Bank of England cuts rates, incentivising higher savings.

Trigger two: Strong reaction to a housing market correction. Signs are mounting that the housing market is slowing and that house prices are falling in most areas. Even before the summer, the balance of risks already seemed firmly in the direction of slower housing market activity and pricing in the UK. Simple measures of housing valuation and affordability have looked stretched for some time, and they continue to do so. However, even a sharp housing market correction does not mean we will necessarily see a recession. We think that the link between household spending and house prices is variable over time and may not be especially strong. Yet there is some degree of linkage and falling house prices would likely largely act through the collateral channel, through general effects on consumer confidence and by dampening demand for goods often associated with moving house (e.g., washing machines, carpets, furniture). There is a clear risk that households react more strongly to falls in house prices than in our central forecast, particularly when combined with tighter credit conditions that would potentially increase the importance to households of having collateral in their homes.

Trigger three: Job cuts. As growth prospects for the UK’s main trading partners and for household demand fade and become more uncertain, investment plans may be sharply curtailed, hiring plans stalled and jobs cut. In our central case, the labour market remains relatively robust. If job cuts were to pick up strongly, domestic demand prospects could fade further, housing activity could fall sharply while mortgage arrears and repossessions pick up.

By Melanie Baker and David Miles London
Morgan Stanley
December 16, 2007