Global Insight Perspective

Significance

U.K. GDP growth has now been in line, or marginally above, trend growth for four successive quarters.

Implications

With growth currently broadly in line with trend, future wage developments will be key to whether or not the Bank of England raises interest rates further.

Outlook

We expect overall GDP growth to be 2.6% in 2006. It is then forecast to ease marginally to 2.5% in 2007.

GDP grew 0.7% quarter-on-quarter (q/q) in the third quarter of 2006, according to a second release from the Office for National Statistics (ONS). This confirms the preliminary estimate. The economy had also expanded by 0.7% q/q in the first two quarters of 2006 and the fourth quarter of 2005. Consequently, the third quarter of 2006 marked the fourth 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 2.7% in the third quarter. This was the highest level since the third quarter of 2004 and up from 2.6% in the second quarter of 2006, 2.3% in the first and a 12-year low of 1.6% in the second quarter of 2005.

Service-Sector Activity Robust

On the output side, growth in the third quarter continued to benefit from robust service-sector activity. The service sector expanded by 0.8% q/q and 3.4% y/y, although this was modestly down from growth of 0.9% q/q and 3.7% y/y in the second quarter. Particularly robust expansion in the third quarter was seen in business services and finance (up 1.4% q/q and 5.2% y/y). However, growth in the distribution, hotels and catering sector slowed to 0.2% q/q and 3.1% y/y in the third quarter from 0.9% q/q and 3.5% y/y in the second, primarily due to slower activity in the retailing sector after a very robust second quarter. Output in the transport, storage and communications sector rose by 0.3% q/q and 2.3% y/y in the third quarter, while government and other services expanded 0.5% q/q and 1.8% y/y.

Industrial production increased 0.1% q/q and 0.2% y/y in the third quarter. Production had previously stagnated in the second quarter, after expanding by a very healthy 0.8% q/q in the first. Overall industrial production was limited in the third quarter, as it had been in the second, by a sharp decline in mining and quarrying output (down 3.9% q/q and 7.4% y/y). These declines in mining and quarrying output were influenced by special factors, as well as by routine maintenance to oil rigs in the North Sea. However, energy supply industries' output rebounded to grow 0.3% q/q in the third quarter, having plunged 2.6% q/q in the second quarter. Even so, output was still down 2.9% y/y in the third quarter.

Encouragingly, manufacturing output rose by a further 0.6% q/q in the third quarter, following expansion of 0.7% q/q in the second quarter and 0.9% q/q in the first. This marked the first time that manufacturing output had expanded for three successive quarters since 2003-04. Furthermore, manufacturing output was up by 1.4% y/y in the third quarter, which was the best performance since the third quarter of 2004. Finally, construction output increased 0.6% q/q in the third quarter of 2006, following growth of 0.5% q/q in the second quarter and 0.8% q/q in the first. Construction output was up 1.7% y/y in the third quarter.

Strong Business Investment Boosts Growth

On the expenditure side of GDP, growth benefited in the third quarter from robust business investment, higher government spending and a build-up of inventories. However, consumer spending growth slowed, while net trade was negative.

Consumer spending growth slowed to 0.4% q/q in the third quarter from 0.9% q/q in the second, when it had been boosted by expenditure related to the football World Cup. This was only modestly above the first-quarter growth rate of 0.3% q/q, while the annual rate of increase was limited to 2.4% in the third quarter. Although high employment and a robust housing market are supportive for consumer spending, they are facing a number of major headwinds.

Gross fixed capital formation was again a significant contributor to growth in the third quarter of 2006. Specifically, total investment rose by 2.3% q/q, following growth of 0.6% q/q in the second quarter and 2.0% q/q in the first. As a result, total investment was up by 5.7% y/y in the third quarter. Overall investment was held back in the second quarter by general government investment falling by 4.2% q/q. Nevertheless, it was still up by 11.1% y/y. Details of government investment in the third quarter are not yet available.

Robust business investment lifted gross fixed capital formation throughout the first three quarters of 2006. Specifically, business investment jumped 3.1% q/q and 6.9% y/y in the third quarter. This was the strongest expansion for two years, and followed healthy growth of 1.6% q/q in the second quarter and 2.0% q/q in the first.

The improvement in business investment in the third quarter was widespread, although manufacturing capital expenditure somewhat disappointingly only rose by 1.7% q/q, after contracting by 6.4% q/q in the second quarter and 2.7% q/q in the first. Consequently, manufacturing investment was still down by 5.5% y/y in the third quarter. This suggests that manufacturers' capital expenditure is currently still being limited by squeezed margins. More encouragingly, investment in the dominant services sector expanded by 2.4% q/q and 6.9% y/y in the third quarter, while investment in construction and other production surged 6.2% q/q and 23.0% y/y.

Inventories (including an alignment adjustment) climbed back up to £754 million (US$1.5 billion) in the third quarter after falling sharply to £398 million in the second quarter from £1.9 billion in the first. This helped domestic demand growth rebound to 0.9% q/q in the third quarter, after it had moderated to 0.4% q/q in the second from 1.0% q/q in the first. Domestic demand was up 2.8% y/y in the third quarter.

Net Trade Negative

Net trade reduced overall GDP growth by 0.2 percentage point in the third quarter, following a positive contribution of 0.2 percentage point in the second. Exports fell by 10.9% q/q in the third quarter, after jumping 4.5% q/q in the second quarter and 8.5% q/q in the first. However, the trade data has been hugely distorted by the ONS's attempts to deal with value-added tax (VAT) fraud. U.K. exports were up 4.4% y/y in the third quarter, and appear still to be benefiting from relatively healthy global growth, especially the improved performance of the Eurozone. However, U.K. exporters may have suffered to a limited extent in the third quarter from a firmer pound. Meanwhile, imports fell 9.2% q/q in the third quarter, after growing 3.4% q/q in the second quarter and 8.9% q/q in the first. Imports were up 4.6% y/y in the third quarter.

Outlook and Implications

Going forward, we suspect that consumer spending growth will be relatively muted—particularly compared to the robust levels seen during 1993-2004—as its upside is limited by a number of factors. These include moderate earnings growth, higher interest rates, a rising tax burden, markedly increased utility bills and elevated debt levels. Furthermore, unemployment is rising, while an increasing number of people have significant concerns about their pension situation.

The downside of personal expenditure should be limited by high employment and still far-from-punitive interest rates. Although the Bank of England raised its key interest rate by 25 basis points in both August (to 4.75%) and November (to 5.00%), it is still relatively low by past norms and seems unlikely to rise significantly higher, if at all. Furthermore, we expect prices to remain largely contained due to intense competition, despite the recent efforts of some companies and retailers to push up prices. Current healthy housing-market turnover and overall markedly firmer house prices, together with a recent overall 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 seen robust expansion in the first three quarters of 2006, business investment should be relatively strong in the near term at least. Investment should be supported by increasing capacity constraints in some sectors, generally strong corporate balance sheets, healthy returns on capital, a buoyant equity market and still relatively low interest rates by long-term norms. However, the upside for investment could be limited by company margins continuing to be significantly squeezed by high input prices and intense competition (particularly in the retailing and manufacturing sectors). In addition, several companies are facing large shortfalls in their pension schemes, which threaten to take an increasing toll on their capital. Finally, some companies have significant concerns about the longer-term economic outlook.

Further strong public investment and expenditure will support growth over the rest of 2006 and during 2007, as the government has already committed further significant spending in fiscal year (FY) 2006-07 and 2007-08 towards improving public services. Nevertheless, the boost to growth from the public sector will diminish markedly further ahead, as the government seeks to improve public finances

Meanwhile, ongoing relatively robust growth in the Eurozone should provide further support to U.K. exports in the near term at least. However, we expect U.K. exports to lose significant momentum in 2007 because we suspect that Eurozone growth may falter to some extent. In addition, U.S. growth is projected to moderate significantly. Consequently, Global Insight forecasts global growth to slow markedly from 3.9% in 2006 to 3.3% in 2007. On top of this, the pound traded at a two-year high on its trade-weighted index in late October, and we believe that it will trend up further against the U.S. dollar over the medium term. This should be at least partly countered though by sterling easing back against the euro.

Consequently, we suspect that growth will be modestly softer overall during the final quarter of 2006 and throughout much of 2007. As a result, in our November monthly interim forecast, we projected U.K. GDP growth to improve from 1.9% in 2005 to 2.6% in 2006, but then to edge back to 2.5% in 2007.

Contact: Raul Dary

24 Hartwell Ave.
Lexington, MA 02421, USA
Tel: 781.301.9314
Cel: 857.222.0556
Fax: 781.301.9416
raul.dary@globalinsight.com

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