Global Insight Perspective

Significance

Second-quarter growth of 0.8% q/q means that the economy has now expanded modestly above trend, or in line with trend (seen at 0.6-0.7% q/q), for three successive quarters.

Implications

The stronger growth in the second quarter will increase speculation that the Bank of England will raise interest rates in the near term, possibly even at its August meeting.

Outlook

We expect GDP growth to improve from 1.9% in 2005 to 2.6% in 2006, and then to stabilise at this level in 2007.

GDP Growth Accelerates in Q2

GDP grew 0.8% quarter-on-quarter (q/q) in the second quarter of 2006, according to a "flash" estimate from the Office for National Statistics (ONS). This was the best performance since the second quarter of 2004, and was up from growth of 0.7% q/q in both the first quarter of 2006 and the fourth quarter of 2005. Consequently, the second quarter of 2006 marked the third successive quarter that the economy had grown modestly above, or in line with, trend growth (widely believed to be 0.6-0.7% q/q). Growth had previously been limited to 0.2-0.6% q/q in the second half of 2004 and the first three quarters of 2005. Meanwhile, year-on-year (y/y) growth improved to 2.6% in the second quarter of 2006. This was the highest level since the fourth quarter of 2004 and up from 2.3% in the first quarter of 2006 and a 12-year low of 1.7% in the second quarter of 2005.

Service-Sector Growth Improves

On the output side, growth in the second quarter benefited from stronger service-sector activity. This expanded by 1.0% q/q and 3.6% y/y, up from growth of 0.7% q/q and 3.3% y/y in the first quarter. Particularly robust expansion in the second quarter was seen in business services and finance (up 1.2% q/q and 4.8% y/y), while there was a marked strengthening in output in the distribution, hotels and catering sector (up 1.2% q/q and 3.3% y/y). This was lifted by higher activity in the retail industry, which reflected improved consumer spending. Output in the transport and communications sector rose by 0.7% q/q and 3.0% y/y in the second quarter, while government and other services expanded 0.7% q/q and 2.5% y/y.

Industrial production edged down 0.1% q/q in the second quarter, following the marked improvement in the first quarter, when it had expanded by 0.8% q/q. Consequently, industrial production was down by 0.8% y/y. However, overall industrial production was dragged down in the second quarter by sharp declines in electricity, gas and water output (down 2.8% q/q and 3.6% y/y) and in mining and quarrying output (down 3.0% q/q and 9.7% y/y). These declines were influenced by special factors. More encouragingly, manufacturing output rose by a further 0.5% q/q in the second quarter, having expanded 0.9% q/q in the first quarter. As a result, manufacturing output was up by 0.7% y/y in the second quarter, which was the first positive performance since the fourth quarter of 2004. Finally, construction output expanded 0.5% q/q in the second quarter of 2006, following growth of 0.9% q/q in the first quarter. However, construction output was still down 0.3% y/y.

Consumer Spending Picks Up

No details are available yet of the expenditure side of GDP in the second quarter of 2006. However, it is clear that consumer spending picked up markedly after only muted growth in the first quarter, as it was boosted by the football World Cup and this year's later Easter. Indeed, retail sales volumes grew 2.1% q/q in the second quarter, although it should be borne in mind that they account for around just 35% of total consumer spending. Exports also appear to have been robust in the second quarter, following strong growth in the first quarter, as they continued to benefit from healthier expansion in the Eurozone. However, imports were also evidently strong in the second quarter, so it is not clear whether or not net trade made a positive contribution to overall GDP growth.

Outlook and Implications

In spite of its markedly improved performance in the second quarter, we believe that consumer spending is likely to be largely restrained for some time to come by moderate earnings growth, a rising tax burden (added to by an average 4.5% increase in council tax in 2006), markedly higher utility bills, strong gasoline (petrol) prices, and elevated debt levels. Furthermore, unemployment is rising, while an increasing number of people have concerns about their pension situation. The downside of personal expenditure should be limited by high employment, attractive prices on the high street amid intense competition, and relatively low interest rates. Even if the Bank of England does raise interest rates before the end of the year, monetary policy is likely to be tightened only modestly over the coming months. Current healthy housing-market turnover and overall markedly firmer house prices, together with a recent pick-up in mortgage equity withdrawal, will also provide some support to consumer spending, although we do not expect house prices to see sustained significant increases.

Having picked up significantly in the first quarter, business investment should be relatively healthy overall in 2006 and 2007. Nevertheless, its upside could well be limited by ongoing concerns and uncertainties among some companies about the outlook, squeezed margins in several sectors (particularly retailing and manufacturing), and many companies' growing pension shortfalls. Even so, investment should be supported by generally healthy corporate balance sheets and profitability, low financing costs, and the perceived need of many companies to upgrade or expand capacity after holding off from significant investment for an extended period.

Further strong public investment and expenditure will support growth in the near term, as the government has already committed further significant spending in fiscal year (FY) 2006/07 towards improving public services. Nevertheless, the boost to growth from the public sector will gradually diminish. Meanwhile, healthier growth in the Eurozone and a relatively competitive pound should provide further support to U.K. exports in the near term at least, although we suspect that Eurozone growth may falter to some extent towards the end of this year and in 2007. Indeed, we expect global growth to be generally softer in the latter months of 2006 and during 2007. Specifically, we forecast global growth to edge up from 3.6% in 2005 to 3.8% in 2006, but then to moderate to 3.3% in 2007. On top of this, we believe that the pound will trend up against the U.S. dollar over the medium term, as the latter is pressurised by the huge U.S. current-account deficit and the eventual ending of the U.S. interest-rate tightening cycle by the Federal Reserve, although this should be countered by sterling easing back against the euro.

The second-quarter GDP expansion of 0.6% q/q and 2.6% y/y exactly matches the projection contained in our June detailed quarterly and July monthly interim forecasts. Consequently, we still expect growth to improve from 1.9% in 2005 to 2.6% in 2006, and then to stabilise at that level in 2007.

The above-trend growth in the second quarter will boost expectations that the Bank of England could raise interest rates as early as August. However, given the significant uncertainties about the longer-term growth outlook and the current continuing lack of evidence that high energy prices are having marked second-round inflationary effects, we suspect that the Bank of England will continue to hold fire on interest rates in the near term at least.