Economic Review - Outlook for 2005.

Foreword

by John Connolly

Senior Partner & Chief Executive

Deloitte

This Review comes to you after another successful year for the UK - the 13th of continuous economic expansion. What's more, this was achieved against a testing global background. But Roger Bootle, our Economic Adviser, asks whether 2005 might be the year when it all starts to go wrong.

Roger notes that this new golden age has been achieved at the expense of a build-up of some major imbalances in the economy, which he believes are now set to unwind. At the top of pile is the housing market, which has already embarked on a major slowdown. And over the next year or so it is set to drag the main pillar of economic growth - household spending - down with it. On top of that, the labour market may soon become less supportive while the prospect of higher taxes, to plug the hole in the public finances, will be a further constraint on growth. What's more, a weaker global environment will hold back any recovery in UK exports.

Nonetheless, Roger believes a continuation of low inflation will open the door to a 14th year of continuous growth. For it will enable the Monetary Policy Committee to cushion some of the blow to the economy by cutting interest rates to 4% by the end of this year and to 3.5% by the end of next year - or possibly even further. But despite this, economic growth is set to slow quite sharply. So although 2005 may not be the year when things go completely wrong, it will probably mark the start of a more difficult period for the UK economy, before the various positive forces at work in the economy reassert themselves in a couple of years' time.

Once again, I hope that this Review helps you in both your immediate and strategic thinking.

Executive summary

The last ten years have been a golden period for the UK economy, with strong and stable GDP growth accompanied by falling unemployment, low inflation and low interest rates. But are things about to go wrong?

The key driver of growth in recent years has been household spending, boosted at least in part by the strong housing market. But the major housing downturn we have feared for some time appears to have arrived.

There is a widespread assumption that the strong labour market will help to limit the extent and impact of the housing market slowdown. But a look back at previous cycles casts doubt on this. In the early 1990s it was the housing downturn that triggered the rise in unemployment, not the other way around.

At the same time, the international environment looks likely to deteriorate again over the next year or two as the imbalances in the US economy act as a major constraint on growth and activity in the euro-zone remains sluggish.

Meanwhile, any hopes that UK exporters might be assisted by a drop in the exchange rate have been called into question by the pound's recent renewed strength. The result is that the external sectors are in no position to compensate for a sharp slowdown in the domestic economy.

Finally, the support provided by the public sector in recent years is also set to fade. Indeed, if taxes have to rise significantly after the general election, as we expect, fiscal policy could become a major drag on the economy.

Thankfully, there is some good news - namely that the monetary authorities are much better placed to respond to these problems than they have been in previous cycles.

While recent months have seen a build-up of cost pressures in response to the surge in oil and other commodity prices, strong competitive pressures in the economy are likely to limit the passthrough into the high street and to keep consumer price inflation subdued.

As a result, the Monetary Policy Committee should be free to bring interest rates down aggressively over the next year or two. We expect rates to drop to 4% by the end of this year, before returning to their 2003 low of 3.5% in 2006.

But while this will help to cushion the blow of a housing downturn and weak global economy, GDP growth is still likely to slow sharply from the 3% plus rate registered in 2004. We expect growth of just 2.0% in 2005, with only a small improvement to 2.2% in 2006.

The upshot is that, while 2005 may not be the year when things go completely wrong, it is likely to mark the beginning of a more difficult period for the UK economy.

Outlook for 2005 - meltdown?

The last ten years have been a golden period for the UK economy. GDP has expanded solidly year after year, the unemployment rate has fallen steadily from double digits to a record low, inflation and interest rates have dropped to levels not seen since the 1960s, and the exchange rate has been strong and stable. Most impressive of all, the economy's recent performance has come against a background of difficult global conditions which, in some previous periods, would almost certainly have pushed the UK into recession.

But as we enter the new year, there are growing signs that the key pillars of the economy's recent resilience are starting to crumble. Free-spending households look finally to be tightening their belts under the weight of record debt levels and falling house prices. The global backdrop is deteriorating again as the pre-election policy stimulus in the United States gives way once more to the constraining effects of the major imbalances built up in the 1990s. And the failure of the UK public finances to respond to the pick-up in the economy has underlined the need for a major post-election fiscal tightening to get the books back in order. Will we look back on 2005 as the year when things started to go wrong?

The golden age

After rapid growth of 3.3% per annum in the 1960s, the economy expanded at a much less impressive rate of 2.4% in both the 1970s and 1980s. The 1990s saw a further slowdown to just 2.1%. But this average was pulled down sharply by the recession in the early years of the decade. In the ten years from 1994 until now, GDP has expanded at a rate of 2.9%. Although this is still a little short of the 1960s performance, it has come against a less favourable international background, so the UK's performance relative to her competitors has been stronger.

With such strong growth accompanied by low and stable rates of inflation and interest rates and falling unemployment, it is little wonder that the Governor of the Bank of England, Mervyn King, has dubbed this period the nice (non-inflationary consistently expansionary) decade.

Beneath the surface

However, scratching the surface of the economy's performance reveals some worrying flaws. In particular, the strong expansion of GDP has been achieved at the expense of a build-up of major imbalances as the policymakers have been forced to compensate for the weakness of those sectors exposed to the weak global environment by deliberately fuelling a boom in domestic demand. Net trade has been a consistent drag on growth in recent years, balanced by a strongly positive contribution from household spending.

Admittedly, this pattern does not look significantly different from that seen in many previous periods. Indeed, some periods such as the late 1980s saw even wider divergences between the contributions of net trade and spending (not that that is much encouragement!). The difference, however, is that the latest bout of unbalanced growth has gone on for longer. Ominously, the divergence seen over the last ten years has been seen only once before - in the decade before the early 1990s recession.

Chickens home to roost in the housing market?

Of course, unbalanced growth is better than no growth at all and the success of the policymakers in stimulating the domestic economy to offset the drag from net trade has been testament to the apparently increased effectiveness of monetary policy under the Monetary Policy Committee (MPC). However, even the MPC itself expressed concern that it might simply be storing up problems for the future and the most obvious area of concern has been the housing market.

Many readers will be familiar with our concerns that the housing market has become fundamentally over-valued in recent years and is due for a major downward correction. Recent data have suggested that such a correction may now be underway, with house prices themselves falling and the number of new mortgage approvals - a key indicator of demand - dropping sharply. Of course, there is still much uncertainty over how far and how fast house prices will fall from here, but the rate at which mortgage demand has so far dropped hardly seems consistent with the gradual soft landing still hoped for by some commentators. We continue to expect house prices to drop by a total of 20% or so over the next two years, but a bigger fall can not be ruled out.

The big question

Now that the housing downturn appears finally to have arrived, the big question is what impact this will have on the wider economy. The MPC has argued that the housing market has had little stimulatory effect on activity as house prices have rocketed in recent years and will therefore have little adverse effect as house prices fall. The correlation between annual changes in house prices and household spending has weakened markedly in recent years.

We have some sympathy with the MPC's position. Indeed, we have argued ourselves that a fall in house prices is likely to have a less damaging impact on the economy than that seen in previous cycles.

But there is a clear danger that the Committee's view proves to be too sanguine. After all, there is no guarantee that the looser correlation between house prices and household spending will be sustained. The correlation again, only this time over a shorter period of five years, alongside the annual rate of house price inflation shows that a similar disconnection occurred in the later stages of the 1980s housing boom. However, the strongly positive correlation quickly re-established itself once the housing market began to weaken, with the result that household spending fell sharply.

Labour market support set to crumble?

Admittedly, wider conditions in the economy are very different from those in the late 1980s/early 1990s. One key difference often advanced is the state of the labour market. The MPC has explained the loosening of the link between house prices and household spending by suggesting that the two are normally driven by changes in income. In the latest cycle, however, income and spending have grown fairly slowly, while house prices have been pushed up by other factors like low interest rates and speculative activity.

In the same way then, provided that income growth continues to be supported by a robust labour market, house prices should be able to adjust downwards with little accompanying slowdown in spending growth.

However, a close look at how previous housing downturns have evolved suggests that the continued support of a strong labour market is by no means a foregone conclusion.

Quarterly changes in unemployment against quarterly changes in real house prices shows that, contrary to the conventional wisdom that previous housing downturns have generally been triggered or at least exacerbated by sharp rises in unemployment, it has often been the housing market which has weakened first. In the last housing downturn, for example, house prices began to fall in June 1989. But unemployment carried on falling for another year, dropping by a further 220,000, before it finally began to rise.

The idea that it was the housing downturn of the early 1990s which may have partly caused the rise in unemployment is also supported by an examination of the sectoral breakdown of the rise. While the biggest job losses not surprisingly came in the manufacturing sector, this was largely a continuation of the trend seen over the previous six years. The big change was a shake-out in those areas directly connected to the housing market, such as construction, and those whose business depends heavily on generally buoyant conditions in the household sector, such as retail, hotels and restaurants.

The upshot is that, while we do not expect unemployment to rise very sharply, there is a clear risk that the widespread assumption that a healthy labour market will help to limit the extent and impact of any downturn in the housing market could prove to be too optimistic. If the early 90s experience is anything to go by, the housing downturn itself could trigger at least some pick-up in unemployment.

Global background to weaken

Even if the early 1990s' experience is repeated and the housing downturn leads to job-shedding in those areas most closely related to the housing market and household spending, this need not trigger a vicious circle of falling house prices and rising unemployment if a strong global background supports employment in other sectors of the economy. After all, the global economy looks likely to have expanded by some 5.0% in 2004, the strongest performance since 1976.

But as we explain in the world economy sections on pages 12 to 17, this performance looks unlikely to last and, indeed, the "soft patch" seen in the US economy has already prompted forecasters to begin to revise down their expectations for growth next year. Admittedly, part of this downturn has probably reflected the dampening effects of the high level of oil prices seen this year. However, while this factor may have brought forward the slowdown in activity, we strongly suspect that a major downturn would have occurred anyway as the policy stimulus of the last few years fades and the major imbalances in the economy - the yawning current account deficit and the very low level of personal savings - act as a serious constraint on growth.

Accordingly, we expect growth in the United States economy to slow from over 4% in 2004 to just 2.5% in 2005, rather weaker than the current consensus forecast of around 3.5%. More importantly for UK firms, we also expect growth in the euro-zone economy - the destination for close to half of UK goods exports - to remain sluggish.

Hopes of a lower pound set to be dashed?

One development which would help to offset the impact of weak overseas demand on the sectors of the UK economy exposed to the rest of the world would be a drop in the exchange rate. We have expressed the view before that sterling has been over-valued for some years. The real effective exchange rate - which takes into account relative movements in costs and/or prices in the UK and its key trading partners - has been at historically high levels since the late 1990s.

As we have already discussed, the adverse impact of this on the economy has been at least partially disguised by the offsetting strength of the domestic economy. But if the latter weakens over the next year in response to a housing downturn, the damage caused by the strong pound should become much more evident.

Coupled with further falls in expectations for interest rates (more on this later), this could prompt the exchange rate to drop back sharply. This in turn could give UK exporters a much-needed boost and help the economy re-balance away from consumers towards the external sectors.

Recent developments in the foreign exchange markets, however, have cast doubt on the prospects of a boost to the economy from a lower pound. In recent months, the pound has generally sat between the US dollar and the euro, rising against the falling dollar but falling against the euro. Given the greater importance of the euro-zone as a destination for UK exports, this has allowed the sterling trade-weighted index to ease gently lower.

But this pattern came to an abrupt halt at the end of 2004, when the pound suddenly jumped higher against both the dollar and the euro, causing the trade-weighted index to reverse much of its previous falls. This move does not appear to have been justified by the news on the UK economy, which has remained pretty weak.

Accordingly, other forces appear to be at work and one possible factor is a shift in investment flows out of US assets in response to fears that Asian central banks may cease their purchases of US treasuries. If flows into the European markets have been limited by low euro-zone interest rates and fears of intervention by the European Central Bank to prevent the euro from rising yet further, then sterling may have become the main beneficiary.

Our best guess is that this effect proves to be temporary and that economic fundamentals in the form of slower growth, falling interest rates and the poor external position prompt further falls in the sterling index over the course of 2005 and in 2006. But the pound's recent strength has emphasised the risks to this view.

What's more, even if the sterling index does continue to fall, this might not have the beneficial effects on the economy that might be expected. This is because the weights used in the index are based on a narrow measure of trade, which almost certainly underplay the importance of UK trade with the US and other dollar bloc countries.

We re-calculate the sterling index on the basis of more up-to-date weights incorporating a wider measure of UK's trade with other countries. This puts much more weight on the pound's strength against the US dollar, with the result that the pound's overall value is some 5% higher than under the published index. The implication is that further falls in the published sterling trade-weighted index may have little stimulatory effect on the economy if they are accompanied by further rises in the pound against the US dollar.

Public sector support set to fade

Another key prop for the economy in recent years which looks likely to become significantly less supportive is the public sector. Government spending has recently been boosting annual GDP growth by up to 1% and, without it, growth would therefore have looked a lot less impressive. Indeed, GDP excluding government spending has grown at an average rate of just 2.1% in the last five years compared to 2.9% in the previous five. Were it not for the boost from government spending, the second half of Mervyn King's nice decade would have looked distinctly less nice than the first.

But the cost of the strong support of the public sector has been a dramatic deterioration in the state of the public finances, with the large budget surpluses of five years ago being replaced by hefty budget deficits.

This has put the Chancellor's own fiscal rules in serious danger of being broken. In response, Mr Brown has already announced a sharp slowdown in the growth of public spending over the next three years. The real growth of total spending is set to slow from an average rate of close to 5% in the last five years, to less than 2% by 2008-09.

But it seems very unlikely that slower spending growth alone will be sufficient to put the public finances back on a sustainable footing. A significant increase in taxes also looks very likely once the general election - expected in May 2005 - is out of the way. We estimate that a rise of around u10bn per annum would be required to begin the next economic cycle with the current budget in balance and hence adhere to the Golden Rule that the government will borrow only to invest over the economic cycle. The bulk of this is likely to arrive in 2006. The bottom line is that the public sector is set to turn from a strongly positive influence on the economy into a potentially significant drag over the next few years.

The good news - rates headed back to 3.5%

So far, so bad. A number of the key drivers of the economy over recent years look set to grind to a halt over the next 12 months, if not go into reverse. But there is some potentially crucial good news - namely that the monetary authorities are much better placed to respond to these adverse developments than they have been to many similar sorts of problems in the past.

The key is inflation. In contrast to previous cycles when the policymakers have often been prevented by lingering price pressures from responding swiftly to emerging problems in the real economy, no such obstacles appear to exist this time. Even alongside rocketing house prices, general inflation pressures have remained remarkably subdued. CPI inflation has been below its 2% target since 1998.

Admittedly, recent months have seen signs of a significant build-up of cost pressures at the beginning of the inflation pipeline. Producers' raw material costs have risen sharply on the back of higher oil and commodity prices. And while other elements of costs such as unit wage costs have remained pretty subdued, firms have lifted their selling prices anyway in an apparent attempt to widen their profit margins.

Core producer output price inflation has climbed to it highest rate since February 1996. If this increase were to be sustained, there is a clear danger that stronger cost pressures will feed through into higher consumer prices, potentially making it very difficult for the MPC to respond to weaker activity by cutting interest rates.

Thankfully, however, several factors suggest the inflation outlook will not present a major barrier to lower interest rates in 2005. For a start, we suspect that the rise in cost pressures will begin to fade again before very long. After all, even if oil prices remain at current levels, the direct impact of their increase on inflation (as opposed to the level of prices) will fade after a year. Of course, there could be longer-lasting damage via knock-on effects on inflation expectations and wages, but there are few signs of such effects so far.

Secondly, even if cost pressures continue to build, we expect the powerful competitive pressures evident in the economy to restrict the pass-through into the high street. The previous close relationship between producer output prices and core retail goods prices has broken down over the last year or so as high street prices have continued to fall despite the rise in factory gate prices.

Accordingly, while we certainly would not rule out a further rise in CPI inflation over the coming months, we expect it to remain pretty subdued over the next several years.

Conclusions and forecasts In the light of the issues we have discussed above, it is not at all difficult to construct a seriously gloomy scenario for the UK economy over the next few years. Having propped up growth in the face of difficult global conditions, the household sector finally runs out of steam in the face of falling house prices, a weakening labour market and rising taxes as the Chancellor is forced to tighten fiscal policy aggressively. Debt-ridden households attempt to re-build their balance sheets by saving a much higher proportion of their income, with the result that household spending falls sharply.

Meanwhile, the global background deteriorates again as the imbalances in the US economy constrain growth there and the eurozone remains weak. With the sterling exchange rate forced higher by further portfolio flows out of US assets, the externally-exposed sectors such as manufacturing slump. If higher inflation prevents the MPC from responding, all the ingredients for a full-blown recession in the economy would be in place.

Thankfully, there are some good reasons for believing that things won't get this bad. Although the international background is unlikely to be favourable, a lower exchange rate should help to limit the extent of the hit to the economy from net trade. Meanwhile, continued low inflation will allow the MPC to cut interest rates aggressively to cushion the blow to households from falling house prices.

Our forecast is for UK interest rates to drop from their current level of 4.75% to 4.0% by the end of 2005, before edging back down to their 2003 low of 3.5% in 2006. However, given that the 2003 level was reached at a time of rapid house price inflation, it is not too hard to envisage rates falling even further alongside a major housing downturn. Our forecast suggests that market interest rate expectations and bond yields have scope to fall significantly from current levels.

But while these factors should keep the economy away from recession, it still seems very likely that GDP growth will slow sharply from the strong rates seen over the last year as some of the key drivers of growth in recent years weaken. We have shaved our growth forecast for 2005 down from 2.3% to 2.0%, well below the likely out-turn in 2004 of 3.2% and some way below the consensus forecast of 2.5%. 2006 could see a slight improvement if a lower pound helps net trade to make a positive contribution, although we expect household spending growth to remain weak as house prices continue to fall and taxes rise.

2005 may not turn out to be the year when things went completely wrong, but it looks likely to mark the start of a rather more difficult period for the UK economy.

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Mr Roger Bootle

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