We at Fathom have spent the past few weeks visiting our clients, and presenting our thoughts on the outlook for the global economy and its financial markets. As regular readers will be aware, our UK view is somewhat gloomy. While most major economies are enjoying a cyclical upswing, the UK, we explain, is on the verge of what is likely to be a relatively mild recession, driven by falling household expenditure. A number of our clients push back at this point. “But no one else expects a UK recession”, they say. That is broadly true. Our central view is that we will get two quarterly declines in output next year, giving a figure for growth across the calendar year as a whole of 0.3%. That is a long way below the median forecast, of 1.3%, among those economists who submit figures to the Reuters Poll. We may be more bearish than the consensus, but of course that does not mean that we are wrong. Put simply, economists as a group are not very good at spotting recessions, even when one is staring them in the face.
Let us first put our case. Taking account of the UK’s dire productivity growth since the financial crisis, our judgment is that the UK’s trend rate of growth is somewhere in the range 0.5%-1.0%. The economy has grown much more rapidly than that during the past four years or so, and that is why unemployment has fallen so sharply. But this cannot continue. A slowdown of some magnitude had become inevitable even before last year’s EU referendum.
As well leading to an increase in uncertainty, which is perhaps only coming to the fore now that the negotiations are entering a crucial phase, the UK’s vote to leave the EU has been associated with a substantial fall in sterling, putting a squeeze on real wages. To date, households have responded by dipping into their savings, or by borrowing more. But with the saving ratio close to record lows, and with banks under pressure to cut back on unsecured credit, this is unlikely to continue. Retail sales data are noisy from one month to the next, but a clear slowdown in the pace of expenditure growth since the referendum is evident, with data published this week showing that the volume of sales contracted in the twelve months to October for the first time since 2013. Our central forecast is for a mild technical recession in the UK next year, with output contracting in Q1 and Q2 as households retrench, and neither net trade nor investment provide a sufficient offset.
So much for the Fathom view. No-one else seems that bothered by the prospect of recession, so we can breathe easy, surely? Well, let us stop for a moment, and consider how effective economists have been at spotting recessions in the past. We have plentiful data on both public- and private-sector growth forecasts in the run-up to, and immediate aftermath of, only one previous UK recession — and that is the most recent one. This is undoubtedly what statisticians like to call a ‘small sample’. Nevertheless, the recession of 2008/09 saw the sharpest contraction of UK economic output since the Second World War. People ought to have seen it coming, or so one might think. But remarkably, they did not.
Let us start with the facts, as they stand at present. UK economic output began to fall in 2008 Q2. It fell again in 2008 Q3 and Q4. It then continued to fall in 2009 Q1 and Q2, marking five consecutive quarters of contraction. The total reduction in output, from peak to trough, was 6.1%.
On the eve of the crisis, during the quarter in which output peaked, the Bank of England published the February 2008 Inflation Report. What did it show? Well, a recession in the UK was seen as a distant prospect. In fact, it did not get a mention. Literally. The word recession did not appear anywhere in the 56-page document. The MPC publishes its central projections as four-quarter percentage changes. On that basis, its forecast for growth over the four quarters to 2009 Q1 was +1.7%. The actual outturn was -5.9%.
In addition to point forecasts, the whole distribution of possible outcomes was also made available, in the form of a fan chart. Back in February 2008, it saw just a 5% chance that output would contract over the following four quarters. Looking at the whole period since the 1950s, output has contracted over a period of four quarters around 10% of the time. In other words one could say that, on the eve of the 2008/09 recession, the Bank of England saw the chances of a UK recession as ‘less than normal’.
As our table shows, as time passed, the MPC’s central projections for growth in the four quarters to 2009 Q1 were revised down, and the prospects of an outright contraction began to rise. But the central projection did not drop below zero, and the likelihood of an outright contraction did not move above 50%, until November 2008 — six months after output began to fall. And the word ‘recession’ made its first appearance in that same issue of the Inflation Report.
The Bank of England produces a rich set of forecasts for the UK economy, which perhaps makes it an easy target when things go wrong. It is certainly fair to say that other official forecasters did no better. Both the IMF and the OECD provide annual point forecasts for UK growth, four times a year in the case of the IMF and twice a year in the case of the OECD. As with the MPC, these organisations were not predicting an outright contraction until 2008 Q4, six months after UK output began to fall.
So much for the official bodies, how about private-sector economists? The picture here is much the same. The consensus among private-sector economists for growth in calendar year 2009 did not turn negative until the final quarter of 2008, six months after the economy began to contract. It is worth noting, however, that at least one forecaster appearing in the Reuters Poll was predicting a contraction in August. And by early September, before the collapse of Lehman Brothers, the median respondent to the Reuters Poll saw a 55% chance that the UK would enter a technical recession within the next twelve months. Not bad, and a little ahead of the Bank of England, but that was still almost two quarters in to the downturn.
What is the upshot of all this? We have recently pushed back the point at which we expect UK output to contract. We now expect to see a relatively mild technical recession early next year. We would be the first to admit that even our latest point forecasts for UK growth will almost certainly be proved wrong, not least because mild technical recessions are quite rare. As we said last year, when growth drops below a certain threshold, and unemployment begins to rise, output can fall quite sharply. Another way of putting this is that the empirical distribution of GDP growth rates in the UK, and elsewhere, is far from normal, and has a pronounced negative skew, as our final chart shows. So, the outcome may be worse than we are expecting. Or it may be better — a recession may be avoided entirely. However, our message is this: do not take comfort from the fact that neither official nor private-sector forecasters are predicting a recession. They almost never do.
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