Defying widespread expectation of a recession, the UK economy weathered the Brexit storm better than the majority of forecasters, ourselves included, anticipated. That was thanks, in large part, to the strength of consumer spending. But that tide has since turned: the brief period of real wage growth is over; household finances are stretched; and June’s inconclusive general election has reignited concerns about the nation’s economic prospects.
In our view, the most plausible explanation for consumption surprising on the upside since last year’s vote is that households were surprisingly rational, bringing forward expenditure in anticipation of sterling weakness ahead. But as we highlighted last quarter, that explanation carries ominous connotations for an economy dependent on the consumer for growth.
Indeed, buying in advance of sterling-induced price increases merely shifts consumption from one quarter to another. Thereafter, unless wages keep pace, consumers’ real purchasing power is reduced. That is bad news for an economy that relies on consumer spending to drive growth. We believe that there is now a greater-than-evens chance of a technical recession in the UK over the next year.
With headline inflation destined for letter-writing territory and wage growth unlikely to keep pace, the squeeze on households’ real incomes is likely to intensify in coming months. Already, they appear to be feeling the pinch. As the chart below highlights, less than a year ago retail goods were falling in price, down 3% or more. Now they are rising by more than 3% per annum. In response, the pace of annual retail sales growth (adjusted for inflation) has slowed sharply.
Our forecast points to peak annual consumer price growth of just over 3% later this year, while some survey-based measures, such as that shown below, point to 4% or more. Although June’s inflation print was considerably weaker than expected, with the headline measure softening to 2.6%, we believe that it has merely paused for breath, before rising again later this year.
Indeed, the biggest discrepancy between our forecast and June’s outturn was due to food price inflation, which accounted for nearly a third of our 0.3 percentage point error. We suspect that the vast majority of forecasters underestimated this component, as food prices are notoriously hard to predict, with the widening wedge between producer and consumer food price inflation perhaps indicative of a renewed supermarket price war.
Summer discounting by clothing retailers and suppliers of recreational goods was also larger between May and June this year than over the same two months a year ago. While this may well reflect the challenging consumer environment, with retailers enticing shoppers through competitive prices and loyalty schemes, sales are — by definition — temporary in nature. As a consequence, we believe that inflation will quicken in the coming months.
Already, efforts by increasingly cash-strapped consumers to preserve consumption have seen them eat into their savings. Data from the Office for National Statistics (ONS) reveal that households are, on average, spending more than ever as a share of their post-tax income. Strip out net pension contributions, and households spent more than they took home in the first quarter of this year. That implies that the British consumer has taken on even more debt.
This reliance on credit to shore up consumption is not only worryingly reminiscent of the pre-crisis years, but is unlikely to last. Following a period of rapid consumer credit growth, supported by cheap rates and extensions of interest-free offers, financial regulators have voiced their concern, and it appears that their warnings are being heeded.
The Bank of England’s latest Credit Conditions Survey, conducted between 22 May and 9 June, reports that lenders have already tightened their credit scoring criteria and reduced the availability of unsecured credit to households, with a further decrease expected in the third quarter. Rising default rates on unsecured lending, which were said to have increased significantly in the second quarter, are also likely to have motivated this decision.
With household finances already stretched, the risk is that a tightening of credit —although ultimately a good thing — could trigger a consumer-led downturn. Another source of potential instability is an abrupt shift in consumer sentiment. As the 2008-09 global financial crisis demonstrated, waning consumer confidence is associated with a sharp increase in the average saving rate.
With June’s unexpectedly inconclusive general election reigniting concerns over the UK’s political and economic outlook, it is not inconceivable that precautionary savings may rise. With economic growth subdued, we find that just a small increase in savings (as little as £10 a week per household) could cause the UK economy to contract.
With this in mind, we remain considerably more pessimistic than most. Not only are finances stretched, meaning that households have limited savings into which they can dip, real incomes are falling and the crackdown on unsecured lending is likely to make the usual buffer of consumer credit both less enticing and less readily accessible. For this reason, with the UK consumer under assault, we believe that there is now a greater-than-evens chance of a technical recession in the UK over the next year.
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