UK: Consumer Weakness Will Persist For Years, Not a Few Quarters

1 August 2017

The recent release of second quarter GDP data had something for everyone.  For the post-Brexit sceptics, the meagre 0.3% gain (following a similarly paltry advance in Q1) confirmed the economic recovery was faltering. Recently, weak consumer spending has been a major headwind, resulting from modest income growth and higher prices following sterling’s post-referendum depreciation. On the other hand, despite Q2 GDP’s overall weakness, some have taken heart from the 1.1% gain in consumer activity, proposing the worst may be over for household spending. Such optimism – combined with perception that Bank of England Governor Mark Carney is becoming more hawkish – has contributed to sterling’s recent rebound.  Unfortunately, this wishful thinking is premature. Indeed, despite the recent bounce, retail sales have been stagnant during the first half of 2017.  And, despite solid export momentum, consumer weakness will remain a headwind for the recovery for several years, not just a couple of quarters!

Living on Borrowed Time

The UK consumer has been on a roller coaster during the past decade.  Following the immediate shock of the financial crisis, household spending contracted a wrenching 4% between 2008 and 2011. This reaction was more considerably more severe than in the Euro-area where personal outlays were stagnant.  And, in the United States (the epicentre of the crisis) real household spending actually rose 2% during this period (which seemed painful enough).

Once the initial shock passed, however, UK consumer confidence recovered somewhat, leading to real household spending gains of over 2% annually since 2012.  Under normal circumstances, this would hardly be regarded as a binge.  During this period, however, household incomes were severely squeezed by deep cuts in government spending. UK consumers took a view that fiscal austerity would not last forever. And, fuelled by ultra-low interest rates, households have supplemented paltry income gains by double-digit increases in consumer credit. For example, credit for auto purchases have advanced over 20% annually since 2014. Likewise, credit card debt accelerated to over 10% in recent years.

As a result, the UK household savings rate has fallen dramatically. Historically, the rate of thrift has been around 6% to 7% of disposable income.  In the immediate aftermath of the financial crisis, however, it rose to over 11%.  Following the recent borrowing binge, the savings rate has plunged to an historic low of 1.7% in Q1 2017 (admittedly, technical factors may overstate this year’s decline).  Even the 5% US savings rate appears frugal in comparison.

To be sure, one can argue about when and by how much the savings rate will rise, but rise it will, especially once interest rates increase.  The Bank of England has already warned banks to prepare for this adjustment, including the possibility of consumer credit defaults as interest rates rise.  Even if the adjustment is orderly, a 3% cumulative rise in the savings rate over the next three years will be a major, prolonged headwind to economic activity for years, not just a couple quarters. This is especially true in an environment in which personal income gains will remain modest.  The alternative — a sharp, one-time hike in the savings rate — would be far worse!

The Link with Trade and Brexit

Likewise, the UK current account deficit, running at 4-5% of GDP in recent years, reflects the low national savings rate.  This external shortfall, which must be financed by foreign capital inflows, leaves the nation vulnerable to shifting global investor sentiment. In simple terms, a current account deficit occurs when overall spending (from government, households, and foreign sources) exceeds the country’s productive capacity. In other words, when national savings are too low to finance the desired level of domestic investment, the shortfall must be borrowed from foreign investors. Reducing the UK current account deficit (and its dependence on foreign capital inflows) will require either higher national savings, or a less desirable reduction in domestic investment.

Since the financial crisis, the national savings rate has remained broadly stable.  As the government pursued fiscal austerity, households sought to cushion the impact by lowering their level of thrift. Looking forward, higher national saving will require either further cuts in the budget deficit or higher household savings.  Ideally, lower public sector imbalances would play the key role.  However, while the government deficit of 3-4% of GDP remains significant, the political climate limits the scope for further reductions near term. As a result, reductions in the current account deficit will require either higher household savings (weak consumption) or undesirable cuts in business investment.

Some pundits point out that while the UK has an external deficit with the European Union, the nation enjoys a surplus with the rest of the world. Further, it is proposed that reconfiguring the post-Brexit trading regime with the EU – to the UK’s advantage –will correct the current account deficit.  The explanation is reminiscent of President Trump’s assertion that America’s trade imbalances reflect unfair trade practices.  Both miss the point that external imbalances simply reflect a deficiency in local savings, not unfair bilateral relationships.  Without correcting this underlying macro issues, bloated current account deficits will persist.  For example, even if the UK deficit with the EU was reduced, deficits elsewhere would increase until domestic savings rose (alternative UK inflation could rise as a result of excessive demand on its productive capacity). By the way, when the US is excluded, the UK’s non-EU trade balance is in deficit as well!

Nevertheless, the UK should focus considerable attention on expanding service sector export opportunities to the European Union. The EU service sector is under-developed and over-regulated. As an example, in the UK’s bilateral trade with both the USA and EFTA, service sector exports represent 55% of overall bilateral trade in goods and services. Meanwhile, service sector sales to the EU represent only 40% of their overall bilateral trade.  If penetration into the EU service sector was similar to that of the USA, UK service sales would expand £50 billion, or 2-3% of UK GDP! Germany is especially problematic: only 32% of UK-German trade is in services.  The USA and others would celebrate if the UK succeeded in opening the EU/German service sector!

Strategic Implications

  • Prolonged consumer headwinds point to a very gradual normalisation of interest rates. The market projects the first base rate hike in Q1 2018, which seems right. Despite my view of the UK consumer, however, I believe the market is too dovish over the medium term. For example, by the March 2019 Brexit deadline, less than 50bp of hikes are expected. Unless negotiations breakdown (I do not expect), the base rate should be above 1% by that time.
  • Pundits interpret BOE Governor Carney’s recent comments as a hawkish shift. I believe he remains sceptical about the post-Brexit outlook. He clarified simply that he was waiting for evidence that exports and capital spending were offsetting the consumer weakness before beginning to normalise monetary policy. So far, the evidence remains mixed.  To be sure, recent trade data and PMI surveys suggest that export momentum remains solid (volumes up 6% in May) into Q3. On the other hand, business investment rose a modest 0.7% in Q1 2017 (although this represents an improvement on 2016’s 1.5% decline).
  • This week’s MPC meeting will help clarify the BOE’s thinking. I anticipate a continued dovish tone. With two new members (neither of whom would be brave enough to defy the Governor on their first vote); the MPC will seem less divided with votes of 7-2 rather than 5-3.  I suspect the MPC will only act once Governor Carney is ready to pull the trigger, which is still months away.
  • Current account deficits pose FX risks. However, the UK still maintains a balanced net international investment position. Although, there is not an immediate, urgent need to reduce the external deficit, persistence imbalances leave sterling vulnerable to shifts in sentiment regarding Brexit talks.
  • I remain of the view that sterling remains undervalued versus the USD (fair value near $/£1.45-1.50). Sterling’s recent strength versus the greenback largely reflects the failure of the Trump administration to deliver on its economic promises. Meanwhile, sterling’s ongoing weakness relative to the Euro reflects concerns about Brexit negotiations.  I suspect this pattern will continue in the months ahead, as the October deadline for agreement on the three initial Brexit issues appears unlikely to be met.