UK reaction: Robust Q2 GDP, but process of normalisation to begin
David Page, Head of Macro Research at AXA Investment Managers, comments on the UK’s latest GDP figures:
- UK GDP rose by 4.8% in Q2, excluding last year’s rebound the fastest rise since 1973.
- The strength of Q2 was driven by the re-opening of the wider economy, with large increases in household spending and services output.
- From here the pace of growth looks likely to slow, both mechanically and driven by rising headwinds, such as the delta variant resurgence and the unwind of the furlough scheme.
- We still forecast a robust H2 2021 delivering annual growth of 6.7%, but expect the pace of growth to be a little slower and a little more spread out than the Bank of England.
- As such, we continue to expect a slower tightening in monetary policy than markets.
- However, we bring forward our expectations of the first adjustment to Bank Rate to end-next year, and now forecast Bank Rate rising to 0.50% in Q3 2023.
UK GDP recorded a very strong Q2, rising by 4.8% on the quarter. This was its most robust expansion – excluding Q3 2020’s 17% re-opening surge – since Q2 1973. Q2 also benefitted from a re-opening surge, with restrictions from the January lockdown starting to be removed at the end of Q1, but continuing across this second quarter. However, it still leaves the level of economic activity some 4.4% below pre-Covid level of Q4 2019. The rise in quarterly GDP growth was in line with our own and market consensus forecasts, and only marginally lower than then Bank of England’s 5.0% expectation. That said, the monthly pattern of growth did show some variation with May’s expansion revised lower to 0.6% (from 0.8%) and June’s increase coming in up 1.0% (from an expected 0.8%).
A breakdown of UK GDP growth showed that, in keeping with the re-opening theme, household spending growth and services drove the Q2 rebound. Household spending rose by 7.3% on the quarter following a 1.7% drop in Q4 2020 and a 4.6% fall in Q1 2021. Government spending also surged by 6.1% - far exceeding the expected 1.8% rise. But total investment spending came in at a weaker -0.5% - compared to a 2.5% expectation - as business investment rose by a softer 2.4% and residential investment weakened. Net trade was also softer, with a disappointing 3.0% quarterly rise in exports, following the previous quarter’s 6.1% drop – a worrying trend in the post-Brexit environment. By sector, industrial activity rose by 0.5%, but was softer than the 1.7% underlying rise in the manufacturing sector – in turn hampered by a 16.5% drop in mining activity, itself reflecting another sharp reduction in North Sea Oil output in June (-16% m/m). Construction output rose on the quarter, up 3.2% - but this fully reflected the strong gains at the end of Q1, with output actually falling in each of the months across Q2, leaving the sector likely to contract over Q3 as a whole. Finally the largest sector, services, posted a large 5.8% quarterly rise, again reflecting the re-opening across the quarter.
The outlook for GDP growth from here remains highly uncertain. Qualitatively, a number of factors are likely to see growth begin to normalise from here. The large reaction to easing restrictions is now behind us and although we continue to expect buoyant activity over the summer, the scale should slow – reminiscent of last year’s pattern. Moreover, headwinds to growth have arisen for Q3: the emergence of the delta variant and the UK’s decision to plough on with re-opening led to the “pingdemic” in July, with many people asked to self-isolate and likely disrupting behaviour. Indeed, mobility, as tracked by Google, was effectively flat in July – the first month not to see a solid increase since January’s drop – and likely reflecting this disruption. We suspect that GDP will be similarly subdued. These pressures should ease with the further relaxation of restrictions in August, but a growing awareness that the virus is likely to remain endemic as we “learn to live with” it and that while vaccines are doing a good job of minimising severe cases of COVID, they are not perfect, is likely to see some precautionary behaviour creep back into vulnerable groups, which could weigh a little on both consumer and business spending.
Finally, the gradual winding down of the furlough scheme across this quarter could also add some uncertainty – albeit that evidence so far is of a significant and smooth unwind of the scheme. That said, restrictions have been lifted, a lot of households have excess savings and the full resumption of the services economy looks likely to be attractive to many. Quantitatively, we still expect a robust second half and pencil in 2.0% and 1.5% growth for the remaining quarters of this year. This would see GDP growth at 6.7% this year. This is broadly in line with consensus expectations of 6.8%, but softer than the Bank of England’s 7.25% forecast, with the Bank forecasting respectively stronger quarterly growth of 2.9% and 2.0% for the remaining quarters of this year. In part, this discrepancy is to our minds is one of timing, with our forecasts assuming a slower drawdown of households savings that continues to drive faster growth next year (we forecast annual growth of 5.7% vs 5.5% consensus, with quarterly growth remaining at an elevated 0.9% average pace, compared to the BoE’s 0.6%). However, we acknowledge significant uncertainty around how households will actually behave over this period.
This different outlook in terms of the pace of recovery is likely to prove important to the outlook for monetary policy. Our slower recovery forecasts UK GDP resuming its pre-COVID level in Q1 2022, slower than the BoE’s Q4. More importantly for monetary policy, the recovery of its post-COVID potential growth rate looks further off – although any precise estimate of that for now remains a judgement based on expectations for the longer-term supply-side impact of the pandemic – where hopes are rising that this may be smaller than first thought – and Brexit. We estimate this fuller recovery only occurring in H2 2022, but short-term supply disruption will likely reduce any excess supply in the intervening period. At its August Monetary Policy Report meeting, Governor Bailey stated that “some modest tightening in policy over the forecast horizon is likely to be necessary”. We concur, but see some difference in timing. Markets now fully expect the BoE to raise the Bank Rate from its 0.1% level by the middle of next year, before rising to 0.50% by mid-2023. Our own view is that such a cautious pace is likely, but we think that the BoE will move a little more slowly – as suggested by slower growth – and with a change in sequencing adding to our previous concerns about tighter financial conditions more generally rising from later this year. That said, given the BoE’s consistently upbeat outlook we bring forward our rate hike expectations to now consider the first modest adjustment of 0.15% to 0.25% in Q4 2022 and a further 0.25% hike to 0.5% by in Q3 2023.
Financial market reaction has been muted to this in line GDP print. Sterling is a little softer to the US dollar after the release at $1.386, but broadly unchanged to the euro at £0.8465. Gilts have opened, if anything a little softer, with 2-year yields at 0.12% and 10-year at 0.57% - although we not necessarily ascribed any modest adjustment to the domestic data.