UK: Divergent cycles - Nomura

Philip Rush, Research Analyst at Nomura, suggests that the UK economy has used up its spare capacity, but policy remains unchanged while large imbalances are building up, but a shock, like Brexit, is needed to start their correction.

Key Quotes

“Brisk growth has been surprisingly jobs intensive, causing the LFS unemployment rate to re-attain its trough from the credit boom. With the participation rate and average hours at similar pre-crisis levels and surveys showing record capacity constraints, volumes data appear consistent with an unusually large positive output gap. Average earnings have disappointed, but unit wage costs are stronger.

Low imported inflation is masking this pressure, even though it now accounts for a smaller share of corporate costs. Amid uncertainty about the translation of capacity constraints into above-target inflation, the MPC is focused on such spot numbers, despite them being backward looking. This has delayed our forecast for the first BoE rate hike to February 2017. From there we forecast hikes of 25bp/q up to 2.0% in May 2018.

Such a long delay is not without consequence, despite subdued consumer price inflation. Financial assets are being inflated and investment misallocated, notably toward bidding up the price of existing assets, which reduces the maximum affordable interest rate for households. Altogether, we believe the effective neutral rate has fallen recently.

In 2016, the main domestic risk event that could trigger a correction of these structural imbalances is a vote to leave the EU, which we assign about a 25% probability to. The UK’s new deal with the EU does not change anything, in our view.

If the UK leaves the EU instead, treaties define a two-year period for new arrangements to be negotiated, but there is a painful transition cost. A withholding of the foreign investment that is financing the current account deficit would cause the currency to collapse, inflation to be imported, thereby shrinking real incomes and potentially kick-starting the aborted deleveraging of the household sector.

If confidence tips over and this correction begins, a 10-15% fall in sterling looks likely to us, with nominal house prices falling 10% and a peak-to-trough decline in GDP of 2%. There is considerable uncertainty, but our Brexit-related bear case is significantly different to our baseline, making our forecast bimodal. Over the longer term, the effects will depend on what new relationship is agreed, with the forms in existence elsewhere probably worse. However, a new and potentially better compromise could be agreeable.”