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Tailwinds remain in place

Businesses to ‘pick up baton’ from consumer

Princes St shoppingConsumers will continue to be the main driver of economic growth this year, but businesses will pick up the baton next year as investment levels are expected to rebound, according to the EY Item Club’s spring forecast.

It says the tailwinds that consumers have been enjoying over the last year – low inflation, a strong labour market, and rising incomes following the increase in the personal allowance and the introduction of the National Living Wage – will remain in place for the rest of 2016.

Against this backdrop, real household incomes are forecast to increase by 2.4% this year and 1.7% in 2017. The forecast sees consumer spending increasing by 2.5% in 2016. In contrast, in 2017 rising inflation and a renewed fiscal squeeze will see consumer spending slow to 2.1%, before dipping further to 1.7% in 2018.

However, the forecasting group says that as uncertainty from domestic and overseas factors eases, growth in business investment will accelerate to 7.8% in 2017 from a modest 3.2% in 2016.

As a result the Item Club expects GDP growth to reach 2.3% this year. In 2017, overall investment is expected to add 1.2% to output, more than making up for the expected slowdown in the consumer sector and pushing growth up to 2.6%.

The club forecast, like that of the OBR, is constructed on the basis of ‘unchanged government policies’. It is therefore based on the assumption that the UK will remain part of the EU.

Consumer to remain in the driving seat this year

Peter Spencer, chief economic advisor to the Club, said: “As inflation starts to move up and the effects of the fiscal tightening are increasingly felt, consumers will take the back seat.

“At the same time, with the recent drag from uncertainty assumed to fade, companies are likely to resume their investment drive, putting their healthy balance sheets and high profits to good use. This bounce back in business investment should more than offset the slowdown in the consumer sector.”

Is the UK facing a consumer credit fuelled boom?

2015 saw the household saving ratio drop to just 3.8% in the final quarter, the lowest since records began in 1963. But according to the EY ITEM Club, this does not point to a debt-fuelled consumer boom.

Instead, prompted by ultra-low interest rates, households have been shifting cash from low-yielding financial assets to housing.

Households invested a record £95 billion in housing last year, 7.8% of their disposable income. In contrast, their investment in financial assets, net of sales, was just £28 billion, lower than at any time since records began in 1987.

Mr Spencer adds: “Households are a lot less dependent upon credit than they were in the run up to the last financial crisis, making this a cash-fuelled rather than a credit-fuelled expansion. As a result the UK economy is less exposed to another banking crisis.

“Nevertheless, in our view the high levels of house prices relative to incomes driven by inflows of savings into housing could pose a risk to financial stability in the longer term. Many of the older generation are becoming buy-to-let landlords, which pushes house prices up and ultimately risks locking younger people out of the market.”

Business investment bounces back

The EY ITEM Club forecast sees a recovery in business investment in the second half of the year, which is expected to gain further momentum in 2017, as the uncertainty surrounding the outcome of the EU referendum fades and the UK’s main export markets in the US and the EU continue to grow.

With housing investment also expected to recover and public investment holding up until the later years of the forecast, total investment growth accelerates from 3.0% in 2016 to 6.7% and 5.5% respectively in the following two years.

Mr Spencer says: “UK companies continue to run substantial financial surpluses, amounting to £32 billion in 2015. They have been reluctant to invest in tangible assets such as plant and machinery. Conditions from the second half of this year should strongly favour investment.”

Mark Gregory, EY’s chief economist, comments: “Businesses should look beyond the short-term noise and focus on positioning themselves for the long-term. So far, cheap labour has led to unprecedented levels of employment, but productivity has fallen. With labour becoming relatively more expensive, business will have to reevaluate the balance between capital investment and further expanding their workforce.”

Moving parts mean risks remain

Mr Spencer concludes: “Although the financial markets may have recovered their poise, questions about emerging markets and the global economy remain unresolved. At home uncertainty surrounding the outcome of the EU referendum may hit business confidence and corporate appetite for risk.

“We are at a tipping point and, if the predicted growth in business investment doesn’t come through, the long term sustainability of an economy running on a single engine fuelled by consumer spending will look increasingly doubtful.|”

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