The UK economy in 2018

But we do know something. We know that policy uncertainty is unusually high. Scott Baker, Nick Bloom and Steven Davis, three US-based academics, have compiled an index of this going back to 1997. It shows that although uncertainty has fallen recently from the record high it reached immediately after the EU referendum, it is still far above its long-term average.

This alone is damaging. Professor Bloom says research gives us “suggestive but not conclusive evidence that uncertainty damages short-run growth by reducing output, investment, hiring, consumption and trade”.

Most forecasts for 2018 reflect this consensus. A survey by the Treasury found that economists expect capital spending growth to fall next year to 1.3 per cent after 2.2 per cent growth this year.

From one perspective, this is odd. Borrowing costs are at a near-record low. Profitability, according to the ONS’s measure, is high. And the Bank of England and OBR agree that there’s little spare capacity in the economy. All these should point to a big rise in capital spending. But nobody expects this. A big reason why they don’t is that these positives are offset by heightened uncertainty.

We shouldn’t, however, blame Brexit alone. If uncertainty about it were the only thing holding back capital spending, we’d expect it to recover once the uncertainty is resolved. But the OBR doesn’t expect this. It foresees no acceleration in business investment in 2019, 2020 or 2021.

A big reason for this is that Brexit isn’t the only obstacle to investment. There are many other things: a lack of monetisable innovations; a fear that future innovations will render today’s investments unprofitable; a desire to build up cash in part because increasingly important intangible assets cannot be used as collateral; and a mismatch between companies that have cash but few investment opportunities and those that have opportunities but no cash. Such structural barriers to capital spending won’t disappear soon.

Nor is Brexit the only uncertainty we face. Another is: what will happen to household incomes?

Perhaps the biggest economic surprise of 2017 is that low unemployment did not lead to greater wage inflation. Many economists believe it will eventually do so: most expect stronger wage growth next year. But even this, when combined with the fall in CPI inflation which most expect, would still leave us with only a slight increase in real wages.

One reason for this was pointed out in a speech earlier this year by Andy Haldane, the Bank of England’s chief economist. Workers, he said, have suffered a loss of bargaining power, so they cannot parlay a tight labour market into real wage increases to the extent that they could years ago.

Another influence upon wage growth is productivity growth: its stagnation since 2008 is the main reason why real wages have flatlined since then. And here too there are uncertainties. Although the OBR slashed its forecasts for productivity recently, the Office for National Statistics (ONS) reported that it jumped by 0.9 per cent in the third quarter. Although nobody expects that pace of growth to continue, it is a warning that productivity might surprise us on the upside. If it does, real wage growth should exceed expectations.

But at a price. Economists at the National Institute of Economic and Social Research (NIESR) point out that, in the short run, “there is a long-established negative association between employment and productivity growth”. This implies that faster productivity growth would not do much to raise household incomes immediately: some would get higher wages, while others would lose their jobs.

Which brings us to another uncertainty: insofar as household incomes do increase next year, to what extent will this lead to increased spending and to what extent to higher savings?

The OBR expects some of the latter: it foresees a slight increase in households’ savings ratio. One reason for this is simply that people try to smooth out their spending over time. When incomes fall – as they have this year – we dip into our savings or borrow more to maintain our spending. But when incomes rise, we rebuild our savings and pay off our borrowing – and the OBR expects this to happen next year.

Another reason, though, is that credit conditions are tightening. The Bank of England’s latest survey found that lenders expect a “significant decrease” in the availability of unsecured credit in coming months.

Herein lies another uncertainty: how big a problem is personal debt? In aggregate, the numbers aren’t worrying. Total household borrowing – most of which is mortgage debt – is £1.56 trillion, while disposable income is £1.37 trillion. This is equivalent to someone with after-tax income of £2,000 a month having a total debt of £27,500. This seems manageable.

Except, of course, that debt isn’t spread evenly. The issue is not its size but its distribution. The question is: what will happen to the minority of people who are highly indebted? If they enjoy rising incomes, there’s no problem. If, on the other hand, they lose their jobs – something that can happen even if aggregate unemployment doesn’t change – they might be forced to slash their spending and default on their loans, which in turn could cause lenders to restrict credit to others. So far, we’ve avoided the latter fate. But we might not stay so lucky.

All these uncertainties mean that the Bank of England is not expected to raise interest rates much next year. Futures markets are pricing in a three-month interbank rate of 0.86 per cent for December 2018 – implying they expect a one-quarter-point rise and a less than 50:50 chance of a second. This means that savers face another two years of negative real returns on cash.

A second reason why interest rates won’t rise much is that it is fiscal policy that will tighten rather than monetary policy. Although chancellor Philip Hammond announced some spending increases last month, earlier decisions – such as cuts in tax credits and the cap on spending – mean that cyclically adjusted net borrowing is expected to fall from 2.3 per cent of GDP to 1.8 per cent in 2018-19. This will hold down growth.

Overall, economists expect 2018 to see a very slight slowdown in growth next year – from 1.6 to 1.4 per cent. This implies growth in GDP per head of under1 per cent. And the OBR expects sub-1 per cent growth until at least 2022. By contrast, growth averaged2.4 per cent per year in the 50 years to 2007. This means that if the OBR is right, real incomes in 2022 will be 24 per cent lower than they would have been if the economy had continued to grow at its pre-crisis rate. The big picture, therefore, is that economic growth is desperately weak by post-war standards.

But of course, forecasts are wrong. How wrong might they be?

Since 2000 the average error in consensus forecasts at this time of year for growth the following year has been just under 0.5 percentage points. 2017 fitted this pattern: economists expected 1.1 per cent growth, but it now looks as though we’ll get 1.6 per cent. This average, however, is inflated by the failure to foresee the depth of the 2008-09 recession. Forecasts are reliable, except in recessions.

This implies that we can be moderately confident that 2018 will see weak growth, by pre-crisis standards. If the forecasts are grievously wrong, it’s likely to be because we get something much worse.

Price-conscious consumers add to pressure on middle-market retailers

The UK consumer is under pressure. As 2017 comes to a close, rising price inflation, climbing interest rates and stagnant wage growth mean there can be little doubt about that. A US retail tradition, Black Friday, has taken hold in the UK and become one of the most controversial trading days in the retail calendar. Love it or loathe it, retailers are forced to take part. After all, excluding oneself looks churlish and not particularly customer-friendly. But does it make any difference to financial performance? And does a cyber bonanza mask deeper problems with consumer confidence which, at other times of the year and certainly into 2018, might become more apparent?

Several high-profile retailers announced “record” Black Friday trading. But this should hardly be surprising. When times get tough, the tough go bargain hunting. More telling will be the flurry of Christmas trading updates released throughout January. This might give investors a clearer picture of whether Black Friday and Cyber Monday simply act as a pull-forward of the usual Christmas volumes, and whether trading has moderated between the end of November and Christmas Day. The last year or two suggest this may be the case, as many retailers have chosen to start what used to be referred to as the Boxing Day sales early.

The UK consumer has always been price conscious, but as price inflation worsens this is likely to be exacerbated. As per the Office for National Statistics (ONS) consumer prices inflation is the rate at which the prices of goods and services bought by households rise or fall, and is estimated by using price indices. One way to think of this is by picturing a shopping basket containing all the goods and services purchased by households. Movements in price indices represent the changing cost of this basket. According to the ONS, the consumer prices index (CPI) 12-month rate reached 3.1 per cent in November 2017 –  barely changed from October 2017 – but in terms of food and non-alcoholic beverages an inflation rate of 4.1 per cent was the highest since September 2013.

The way to contextualise price inflation – which has largely been the result of weaker sterling driving up retailers’ costs – is against wage growth. Suffice to say, the two have not kept pace. Long-term data from the ONS suggests that, although nominal pay has improved over the past decade or so, this hasn’t been true in real terms. In real terms wages are largely flat – at least on a weekly average earnings basis. According to research group IHS Markit’s latest Household Finance Index (HFI), financial worries are at their most pronounced since June, with inflation perceptions sharpening and more than half of households expecting a further rate rise in the next six months. It found that while households are still spending, they’re dipping into savings or using unsecured debt to meet rising living costs, but credit availability is worsening.  

These statistics shed light on the struggle of ‘middle-market’ retailers – a name commonly used to describe high-street stalwarts such as Marks and Spencer (MKS) and Next (NXT). These companies, which typically charge middle-of-the-road, mass-market prices, often struggle in times of strife to coerce customers into making discretionary purchases. It also helps explain why luxury retailers have performed well recently and why, if the currency rout continues, they are likely to keep doing well. Not only do they benefit from translating global earnings into pounds, but the number of tourist shoppers in London has risen as customers take advantage of the exchange rate. Furthermore, regular customers of Burberry (BRBY), Mulberry (MUL) or even LVMH (MC.) are typically immune to any downturn-induced spending squeeze.

But do these retailers’ share prices face a reversal threat in 2018? If the pound comes back, the argument goes that the currency tailwind will diminish and share prices are likely to lose support. There’s truth in that, but individual company stories are still important. For instance, new management at Burberry has the potential to breathe new life into the product line, which could re-ignite demand for the brand beyond advantageous exchange rates. LVMH – our luxury top pick – is so well diversified across multiple brands and product lines that we can’t believe it would suffer too badly if luxury becomes less appealing.  

Instead our concerns lie mainly with the UK high street. Recent results from the likes of Mothercare (MTC) and Pets at Home (PETS) have been less than inspiring. Part of this is down to changing consumer tastes and specifically the continued transition to online shopping. But middle-market retailers are struggling to differentiate themselves at a time when pennies are precious. In our view, trading figures in February and March could be especially telling. In fact, we expect they’ll be pretty dismal. Harriet Russell