Pioneer’s Head of Global Asset Allocation Research, Monica Defend, along with Europe and EMEA Global Asset Allocation Research Senior Economist, Andrea Brasili, recently released an update on the UK economy. The update was based on the 2Q14 preliminary results for gross domestic product (GDP), which came in higher than expected. They expect growth above 3%, higher inflation in 2015, and a gradual shift in monetary policy towards higher rates. Highlights from their report are below. To read the full report, click here.
Growth: Above 3%
In Q2 2014, UK GDP rose again at a strong rate, up 0.8% quarter-over-quarter (QoQ), 3.1% year-over-year (YoY), surprising on the upside and surpassing for the first time the pre-crisis peak in real GDP (hit in Q1 2008).
The preliminary release does not contain details on the expenditure side, but the output side shows the service sector accounting for almost all of the 0.8% gain, whereas agriculture was a detractor. Such a resilient economic expansion, barely dented by the pound sterling (GBP) appreciation and an external environment that was not particularly strong, argue for an upward revision of forecasts: we now expect GDP to expand by 3.0% assuming the pace of the economy in the second half of the year will be slightly lower than the first half of 2014.
An ongoing reduction in unemployment and a strengthening domestic demand explain the current strength. Downside risks to such robust performance are centered around a possible bubble in the housing sector and the widening current account deficit. Other elements still worth monitoring are lackluster productivity growth and weak wage dynamics.
Inflation: Expected to Rise in 2015
After May’s low inflation reading (1.5% YoY), June showed a strong rebound to 1.9% YoY. In the minutes of its early July meeting, the Monetary Policy Committee (MPC) interpreted this bounce by suggesting that it could be somewhat upwardly distorted by the different timing of summer sales versus last year. However, they also made it clear that future developments are related to the amount of slack in the economy and to the pricing power of firms. On that side it is interesting to see recent developments regarding output PPI and CPI as a proxy of firms’ margins.
As we upgraded the forecasts for the economy, we also increased those for inflation. Our forecasts for inflation suggest that it will likely remain below the Bank of England (BOE) target until Q1 2015, and then it will accelerate.
Monetary Policy: A Gradual Move Towards Higher Rates
Since March 2009, the BOE has kept its official interest rate at a record low 0.50% to support economic growth. The economic data in recent quarters has indicated that the UK economy is improving significantly (2Q 2014 +3.1% YoY), and the BOE has indicated that the recovery “has gained momentum” and “is becoming more broad- based and entrenched”. In the May inflation report the BOE indicated that it plans to maintain interest rates at the current 0.5% level even after the headline unemployment rate has declined below 7%. That level is now defined as a “threshold” rather than a “trigger” as in the past; unemployment was at 6.5% in May according to International Labor Organization (ILO) criteria. The Bank “sees scope to reduce slack further before rate increases” even though the “margin of UK spare capacity has narrowed slightly”. It also indicated that it currently envisions future rate increases to be gradual and to plateau at a lower level than in the past. That said, the BOE is now actively debating when to raise rates, and the first 25 basis point (bps) rate increase is looming on the horizon, within perhaps two or three quarters on the basis of the present verbal guidance.
The BOE will keep rates low as long as the accommodative stance does not impair the stability of prices and of financial markets. The BOE is also reinvesting any cash flow from maturing gilts (Bonds issued by the British government) in its portfolio, as it does not plan to unwind the quantitative easing just yet. The plan is currently to defer any asset sales until after having enacted “SEVERAL” rate increases.