RBS Weekly economic update 27th July Eyes to the front

  • Whether it’s sunshine or showers for the UK economy depends on which way you look. Face backwards, as official measures do, and it’s a golden summer of strong economic growth, increased retail sales and a resurgent private sector. Yet the Bank of England, whose job it is to scan the distant horizon, sees dark clouds gathering.
  • The UK economy grew at the fastest pace in four years between April and June, soaring by 1.1%. This confounded expectations, which had estimated a robust, but less impressive, 0.6% rise. This is the preliminary estimate, so lacks detail, but the increase was due mainly to business services and finance, up 1.3%, and production, which grew at 1.0% for the second quarter in a row. However, the gold star for most improved sector goes to construction, which increased by 6.6% on the quarter, after having fallen by 1.6% in Q1.
  • Retailers too enjoyed a chirpy Q2, especially compared with a weather-beaten first quarter. Sales volumes (excluding fuel) in the retail sector rose by 1% on the month to June and were up 3.1% year-on-year. The growth in June was broad-based, although non-food stores did particularly well, with household goods, up 1.6% m/m and department stores up 1.5% m/m, reporting the strongest growth. As an aside, the internet continues to grow as a shopping-tool. Internet sales as a proportion of total sales rose to a record-breaking 7.9% in June.
  • A good data week inevitably heightens speculation that the Bank of England will tighten monetary policy sooner rather than later. However, the minutes from the July meeting of the Monetary Policy Committee (MPC) show that they again voted 7-1 in favour of keeping interest rates unchanged from their record low of 0.5%. If anything, the tone of the meeting was more dovish than in June, adding weight to the growing opinion that Q2 GDP will be the high water mark for UK growth - at least in the short term. The minutes stated that the prospects for GDP growth had ‘probably deteriorated a little’ over the month, with one member, Adam Posen, stating that the probability is marginally in favour of the next move being to loosen, rather than to tighten, monetary policy, adding that a double-dip recession cannot be ruled out.
  • The debate about the monetary policy and the timing of fiscal consolidation took an interesting turn last week. The MPC began to discuss whether it is necessary to embark on another round of QE (buying assets to lower yields). This is a significant shift in thinking. Earlier meetings had focused more on exit strategies and managing inflation expectations.
  • In addition, there were conflicting pronouncements from two of the world's most influential central bankers. US Fed Chairman Bernanke said that he favoured "a reasonable degree of fiscal support for the economy" in the short term, and that additional monetary policy measures remain on the cards. This was in stark contrast to ECB President Trichet, who argued in the Financial Times that the time has come to start tightening fiscal policy ("we have to avoid...unduly hesitant retrenchment"). This difference of opinion serves to underline the difficulty of the task facing governments and policy makers around the world as they struggle to balance fears about the longevity of the recovery and concerns about public sector balance sheets.
  • Yet both sides of the Atlantic share a rocky path to recovery. The US Federal Reserve has adjusted its US growth forecasts downwards. It now expects the economy to grow by 3-3.5% this year, which would still require an expansion from the Q1 rate of 2.7%. The Fed also expects labour markets to take longer to recover. Consequently, the Chairman reiterated that the economic conditions justify an “exceptionally low” federal funds rate for an “extended period”.
  • The Eurozone has a rather special set of challenges, manifested by a widening gap in the economic performance of the core countries and the periphery. The ratings agency Moody’s downgraded Ireland, who now sit alongside Italy, although above Portugal and Greece. Moody’s cited Ireland’s weakening growth prospects as a key driver of the downgrade. Meanwhile French and German firms reported more expansion in both the manufacturing and services sectors. The flash PMIs (as these preliminary surveys are called) showed services output at 56 (up from 55.5 last month) and manufacturing output accelerating to 58.3 (from 57.2). Most forecasters still expect growth in the Eurozone to slow through the second half of the year and it will take more than one month’s worth of surveys to shift that view.
  • Seven banks failed the EU’s stress tests, but there were no big surprises. Analysts poured over the results at the weekend and the market’s reaction will be closely watched over the coming days. Though some commentators are saying that the tests were too lenient, they have focused minds on the resilience of the banking system to prolonged downturn.