AXA IM's David Page - UK reaction: Positive Q4 GDP likely to see UK avoid double-dip recession

David Page, Head of Macro Research at AXA Investment Managers, comments on the latest UK GDP figures:

• UK GDP posted a rise of 1.0% in Q4, firmer than expected. Expansion of growth in Q4 should rule out a double dip recession, despite our expectation of a sharp contraction in Q1.
• GDP growth as a whole contracted by 9.9% in 2020, its worst annual contraction since 1709.
• December’s GDP was firmer than expected, up 1.2% on the month with an upward revision to November (-2.3% from -2.6%), with services delivering the biggest boost to activity.
• Household spending contracted by 0.2% in Q4 and remains the most significant laggard on the economy, still down 8.4% from its pre-Covid level and contributing 5.2% to the total economy shortfall of 7.8%.
• Brexit also left its mark in Q4, with UK imports surging despite flat exports and consumption, as firms built inventory – likely to offer some protection from the change in UK trading arrangements with the EU. This likely added to GDP on balance in Q4.
• Uncertainty around the outlook remains high. We expect a 3.5% drop in quarterly growth in Q1, followed by two successively strong quarters growth in Q2 and Q3 as pandemic restrictions are eased.
• We forecast GDP growth of 4.6% in 2021 and 7.5% in 2022.    

UK Q4 GDP recorded growth of 1.0% q/q, stronger than our own and market expectations (0.4% and 0.5% respectively). The expansion of growth in Q4 – unexpected a couple of months ago – should see the UK avoid a double-dip recession, even as we expect a quarterly contraction in the current quarter. Once again, the economy appeared to perform better in the final months of the quarter than feared. December saw monthly GDP rise by 1.2%, better than our fears of a smaller 0.5% rise. The release also included an upward revision to November’s already surprisingly resilient drop to -2.3% from -2.6%. Services again outperformed expectations, output recorded 1.7% firmer in December (consensus 1.0%) and November was revised up to -3.1% from -3.4%. Industrial production managed a small gain in December, up 0.2% on the month, driven by a 0.3% rise in manufacturing – both were a little softer than consensus hopes (0.5% and 0.7% respectively), but both also saw revisions to November’s estimates to 0.3% from -0.1% and 1.1% from 0.7% respectively. The only outlier from this positive trend was construction output which fell back by 2.9% on the month (consensus +0.5%), with November also revised lower to +1.7% from +1.9%. The construction sector has been one that has benefitted from a sharp rebound in output relative to other sectors and is considered to have seen output just 0.6% below its pre-Covid February level in November (from a 43% nadir in April), before falling back in the last month of the year.

Q4’s release shows GDP to have fallen in the UK by 9.9% in 2020 as a whole, making it the worst year’s contraction in over 300 years – just worse than the worst of the successive brutal contractions the UK economy faced in the three years after World War I. Such a contraction still leaves the economy 7.8% lower than its pre-Covid (Q4 2019) level. Unsurprisingly, renewed social restrictions over the quarter led to a contraction of household spending– albeit down just 0.2%. The household sector still faces the most significant shortfall relative to pre-Covid levels – the sector is still 8.4% lower than before the pandemic, contributing 5.2% of the total economy shortfall. Other sectors fared better in Q4, again unsurprisingly with government spending leading the way with a 6.4% rise recorded in Q4, taking the level of government spending to +0.5% on a year ago. Investment spending also recorded a 2.1% gain on the quarter, with business investment up 1.3%. Total investment is still 3.5% lower than its pre-Covid level. However, Brexit was also an obvious dynamic in the final quarter’s data. UK export growth in Q4 edged higher, up 0.1% on the quarter still leaving UK exports a disappointing 23.6% lower than a year ago. However, imports surged again up 8.9%, leading to the second successive large net trade drag, -2.5ppt in Q4 (-4.2ppt in Q3). However, this time the surge in imports looks likely to have been was motivated more by a rise in inventory, not by the revival of domestic consumption, with inventory (and other acquisitions) rising sharply on the quarter. Most of this likely reflects companies protecting themselves from the expected disruption of trade with the EU after the end of transition, which was fully expected even with a then best case scenario of a trade deal. On balance, it appears that this inventory build added to UK GDP growth in Q4, even allowing for the import rise. The combination of an unwind of this inventory build and the impact that the actual disruption of leaving EU trading arrangements has had on UK exports is likely to add to a significant contraction in Q1. The effect will be difficult to isolate amidst the bigger disruptions that the pandemic has wrought, but the Bank of England estimates a 1% impact on GDP reflecting this transition and our estimate is for a marginally bigger 1.5% over H1 this year.

Significant uncertainties still surround the outlook for UK activity in 2021. This not only includes the short-term path of the virus – how quickly do schools return, restrictions ease and lockdown ends – and the broader scale of impact and revival of the NHS’s vaccine roll out, but also gauging the impact of this on economic activity, with recent month’s showing the impact of an economy that is adapting to social restrictions, but should also benefitting from different methods of accounting for output as activity recovers. In the short-term, we estimate a sharp contraction in Q1 GDP of 3.5%, allowing for some adaptivity in the economy relative to our expectations of lockdown duration, but also a negative contribution from the UK’s shift from EU trading arrangements. Q2 should see a large rebound in activity. With vulnerable sectors of society protected by first doses of the vaccine, we expect restrictions to be easing from the start of Q2 and gathering pace as more and more people are protected by the vaccine. We pencil in a 3.5% rebound in GDP growth in Q2 and a further 4.6% expansion in Q3 as we anticipate the UK achieving herd immunity in this quarter and a more material relaxation in restrictions. In total, we forecast growth of 4.6% for the UK as a whole in 2021 and, in part because of the pattern of quarterly growth, we forecast an even stronger 7.5% for 2022, even as we anticipate quarterly growth slowing to more usual rates across that year. However, even that pace of growth would only leave the UK achieving pre-Covid levels of activity by mid-2022, and we suggest that spare capacity will only be removed from the economy by late 2022, assuming a significant permanent loss in supply capacity, not least reflecting the UK’s withdrawal from the EU. The Bank of England now expects a similar growth outlook, forecasting 5% and 7¼% growth in its latest Monetary Policy Report, however, it expects to see spare capacity all but withdrawn by the end of this year with a somewhat more pessimistic assessment on the impact on the UK’s supply potential.

Financial markets posted only a modest reaction to today’s data. 2-year and 10-year gilt yields edged modestly higher relative to comparable benchmarks after the data, both up 1bps to -0.04% and 0.48% respectively (versus flat bunds). Sterling also rose by 0.1% to the euro, although held steady to the US dollar.