UK: The Year Ahead — Slower Growth and Sizable Risks

Slower growth in 2008 with risks to the downside: For the last year or so, UK GDP growth has been strong – quarterly output growth since the beginning of 2007 has been consecutively at or above trend. But growth may have already slowed sharply in 4Q07. Our central forecast for 2008 GDP growth (1.8% after likely 3.0% in 2007) falls a long way short of an outright contraction, but we see risks to our forecasts as skewed to the downside.

Beyond the credit crunch: Even before the financial market turmoil of the summer and consequent tightening of credit conditions, several factors suggested that the UK economy was very likely to slow. The Bank of England had raised rates a cumulative 125 bps since August 2006 and the impact of these rate rises has yet to fully work its way through. The UK’s housing market looked increasingly vulnerable to a correction – possibly a sharp one. Aggregate real disposable income for households has been stagnant and, in aggregate, UK households had been spending almost all of their disposable income in recent quarters — saving is extraordinarily low.
Tighter credit conditions increase slowdown likelihood:
It seems very unlikely that credit conditions will revert to their pre-August 2007 levels in 2008. We expect 2008 to be characterised by tighter bank lending criteria, slower lending growth and wider secured lending spreads compared to 2007. Tighter credit conditions have also made falls in house prices and reductions in the number of housing transactions likely. Derivative contracts written on the national house price index (HBOS measure) are consistent with around a 7-8% fall in nominal house prices in 2008. This would represent a fall of around 10% in real terms. Further, the UK’s main trading partners now look set for slower growth next year, dampening the outlook for UK exports, unless sterling depreciates significantly. Expectations of slower global growth in 2008 are also likely to dampen business investment.

Consumption slower: We expect consumer spending growth to slow significantly in 2008. Our central forecast is 1.5% real consumer spending growth after around 3.0% in 2007 and we expect consumer spending growth to remain below par in 2009. Debt levels and debt service levels are already high. Many households will find their finances under increased strain as fixed rate mortgages re-set, together with tighter lending conditions. Slower housing market activity is likely to imply fewer purchases of goods often associated with a home move (e.g. washing machines, carpets, furniture). Lower house prices also deplete the collateral households have available to borrow against. The household savings rate is likely to rise as consumer spending slows.

Employment growth and wage growth seem unlikely to provide an offset. In an environment of slower output growth (particularly in financial services and real estate), employment growth is likely to be sluggish and unemployment will likely rise. In that environment, wage settlements are unlikely to pick up sharply.

Investment: Our best guess is for real fixed investment spending growth to slow to about 3% after around 5.7% in 2007 and, within that, we expect residential investment growth to slow in both 2008 and 2009. Investment seems likely to be hit by the tightening in credit conditions. Non-financial corporates in the UK can, in aggregate, fund 100% of their fixed investment from retained earnings alone, but need to borrow in order to undertake M&A/direct investment and continue to build up cash assets. The buildings and structures component of investment (just under 40% of total investment) may be particularly adversely affected. But UK firms appear to have relatively strong balance sheets and are shielded to some extent by the recent robust growth of aggregate retained income and healthy levels of profitability. Nevertheless, heightened uncertainty over the outlook and a slower global growth outlook are likely to dampen overall corporate fixed investment. Residential investment also looks likely to slow as the housing market cools.

Inflation: While risks to GDP growth look skewed to the downside, risks to inflation look more symmetric. There are significant risks in both directions for CPI inflation from current levels. Food and energy prices (9% and 7% of total CPI respectively) could rise further in subsequent months. However, we forecast slower GDP growth and rising unemployment – so domestically generated inflation pressures seem likely to weaken. On balance, we think that CPI inflation will remain broadly around the Bank of England’s 2.0% target during 2008 — but spend several months both below and above target.

Monetary policy: Given our central forecast for slower UK GDP growth, but contained inflation, and our view on the balance of risks to those forecasts, we think the single most likely outcome is that the Bank of England will cut interest rates back to neutral by early 2008 (we think a neutral rate is around 5.25%). We think the risks are greater that it cuts by more rather than cuts by less than this. In part this is because the ability of the Bank of England to influence key interest rates in the macro economy — in particular 3M Libor and mortgage rates other than base-rate trackers — may be hampered by conditions in the credit and money markets.

Realistic range for GDP growth is wide: There are several significant risks to the outlook, with several plausible pessimistic and optimistic outturns in addition to our central forecast (see our full note for details). The main differences between the central (our best guess) forecast and the alternatives reflect different assumptions about how consumer spending and saving evolve. Alternative assumptions imply 2008 GDP growth of 0.7% in the pessimistic scenario (including two quarters of negative quarter-on-quarter growth — a ‘technical recession’), and 3.0% in the optimistic scenario.

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