April 29, 2014

Economics Group
Special Commentary

Jay H. Bryson, Global Economist

jay.bryson@wellsfargo.com (704) 410-3274

Strong U.K. Economic Recovery Remains Intact

Executive Summary
Real GDP in the United Kingdom grew 0.8 percent (not annualized) in Q1-2014, which lifted the year-over-year growth rate to a six-year high of 3.1 percent. Real GDP growth over the past year or so has been driven largely by the consumer, but there are reasons to believe that the recovery should start to broaden to other areas of spending. Despite strong GDP growth in recent quarters, monetary policymakers in the United Kingdom judge that there is still spare capacity in the economy. Consequently, we do not look for the Bank of England to begin tightening policy until next year.

Year-over-Year Growth Rate Rises to Six-Year High

Recently released data show that real GDP in the United Kingdom rose 0.8 percent (3.2 percent at an annualized rate) in Q1-2014 relative to the previous quarter (Figure 1). On a year-ago basis real GDP was up 3.1 percent, the strongest year-over-year growth rate in six years. A breakdown of Q1 GDP into its underlying demand-side components will not be available for another month. However, monthly data suggest that consumer spending continued to be an important driver of British real GDP growth as the volume of retail spending rose at an annualized rate of 4.0 percent in the first three months of 2014 relative to the last quarter of 2013. Figure 1
U.K. Real GDP
8%
6% 4% 2% 0% -2% -4% -6% -8% -10% -12% 2000 Compound Annual Growth: Q1 @ 3.2% Year-over-Year Percent Change: Q1 @ 3.1% 2002 2004 2006 2008 2010 2012 Bars = Compound Annual Rate Line = Yr/Yr % Change

Consumer spending has been the primary driver of GDP growth.

Figure 2
Contributions to U.K. GDP Growth
8%
6% 4% 2% 0% -2% -4% -6% -8% -10% -12% 2014 -8% 2007 2008 2009 2010 2011 2012 2013 -4%
Net Exports: 2013 @ 0.2% Government Spending: 2013 @ 0.2% Investment: 2013 @ 0.2% Consumption: 2013 @ 1.4% Year-over-Year GDP Growth: 2013 @ 1.7%

4%

4%

2%

2%

0%

0%

-2%

-2%

-4%

-6%

-6%

-8%

Source: IHS Global Insight and Wells Fargo Securities, LLC

Indeed, growth in real personal consumption expenditures (PCE) has been the primary driver of British economic growth over the past two years. Real GDP grew 1.7 percent in 2013, with 1.4 percentage points of this growth attributable to real PCE (Figure 2). Although investment spending, government spending and net exports all made positive contributions to the overall rate of real GDP growth in 2013, real PCE clearly was the main driver. Economic theory posits that growth in real disposable income should be the primary determinant of growth in real PCE, a hypothesis that generally is supported by empirical analysis. In 2013, real

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Strong U.K. Economic Recovery Remains Intact April 29, 2014

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP

disposable income in the United Kingdom fell 0.5 percent. Although employment growth was fairly solid in 2013it grew 1.5 percent over the course of the yearstubbornly high inflation, which we will discuss further below, eroded purchasing power. Despite the contraction in real disposable income, real PCE rose 2.2 percent in 2013. What kept growth in British consumer spending aloft? A decline in the savings rate has helped to support growth in consumer spending. British consumers were able to finance solid growth in PCE last year by allowing their savings rates to recede somewhat (Figure 3). The personal savings rate spiked during the global financial crisis due to the combination of a surge in precautionary savings and an apparent desire among British consumers to de-lever. Indeed, the debt-to-disposable income ratio, often considered to be a measure of leverage, has declined markedly over the past five years (Figure 4). British consumers apparently feel less need today to maintain elevated savings rates now that the immediacy of the global financial crisis has passed and some de-leveraging has occurred. Moreover, household balance sheets are in much better shape today than they were a few years ago now that net worth has risen to an all-time high.1 Figure 3
U.K. Personal Savings Rate
12%

Figure 4
U.K. Household & Nonprofit Debt
As a Share of Gross Disposable Income

Percent of Disposable Income, SA

Personal Savings Rate: Q4 @ 5.0%

12%

160% Household Debt/Disposable Income: Q3 @ 129.9% 150%

160% 150% 140% 130% 120% 110%

10%

10%
140%

8%

8%

130% 120% 110%

6%

6%

4%

4%

100%

100%
90% 80% 2000 2002 2004 2006 2008 2010 2012

2%

2%
90%

0% 90 92 94 96 98 00 02 04 06 08 10 12 14

0%

80% 1998

Source: IHS Global Insight and Wells Fargo Securities, LLC

Lower interest rates have also helped to support consumer spending.

Lower interest rates have also helped to support consumer spending. At the height of the British housing bubble in late 2007/early 2008 British households were devoting about 8 percent of disposable income to servicing mortgage debt (Figure 5). Not only were households highly indebted in 2007, but interest rates rose steadily from 2003 through 2007 due to policy tightening by the Bank of England. However, the mortgage debt-servicing obligations of British households tumbled sharply in 2008 as the Bank of England slashed its main policy rate from 5.75 percent in December 2007 to 0.50 percent in March 2009, where it has subsequently been maintained. Most households in the United Kingdom have floating-rate mortgages, and the sharp decline in interest rates has resulted in significantly lower monthly mortgages payments. Today, British households spend less that 1 percent of disposable income servicing their mortgage obligations. Lower mortgage payments have freed up income that households can use on consuming other goods and services. Looking forward, we forecast that the recovery underway in the British economy will remain intact. After growing by 1.7 percent in 2013, we project that real GDP will grow nearly 3 percent in both 2014 and 2015.2 As noted above, growth in employment remains solid, which should help to support growth in consumer spending. A widely-followed measure of consumer confidence has rebounded to levels that were last seen in 2006-07, which should lead to further declines in the
The plunge in asset prices during the global financial crisis caused household net worth to tumble 12 percent in 2008. Due to the rise in asset prices over the past few years, net worth at the end of 2012 (latest available data) stood at 7.6 trillion, which was 11 percent higher than the previous high in 2007. Net worth undoubtedly increased further last year due to the continued rise in asset prices. 2 For details see our Monthly Economic Outlook which is posted at www.wellsfargo.com/economics.
1

Strong U.K. Economic Recovery Remains Intact April 29, 2014

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household savings rate. Businesses expect that output will strengthen in coming months, which should support growth in business fixed investment spending ( Figure 6). Continued economic growth in the Eurozone, to which the United Kingdom sends about one-half of its exports, should lead to acceleration in British exports of goods and services. Figure 5
U.K. Household Financial Indicators
180%
170% 160% 150% 140% 130% 120% 110% 100% 90% 80% 1999
Financial Liabilities: Q4 @ 140.3% (Left Axis) Interest Expense: Q4 @ 0.69% (Right Axis)

Figure 6
U.K. Business Indicators
10%
9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Percent of Disposable Income

40%
30% 20% 10% 0% -10% -20%

Year-over-Year Percent Change; Volume Business Fixed Investment (YoY% Change): Q4 @ 8.7% (Left Axis) Expected Output in Next 3 Months: Q1 @ 23.3 (Right Axis)

40
30 20 10 0 -10 -20

-30%
-40% -50% 1996

-30
-40 -50 2014

2001

2003

2005

2007

2009

2011

2013

1998

2000

2002

2004

2006

2008

2010

2012

Source: IHS Global Insight and Wells Fargo Securities, LLC

Will the Bank of England Begin to Hike Rates Soon?

Despite the pickup in the British economy over the past year, the Bank of England likely will refrain from tightening policy this year. The government has given the Banks Monetary Policy Committee (MPC) the mandate to maintain 2 percent inflation in the medium term. As noted above, CPI inflation was stubbornly high throughout most of 2013, but it has receded below 2 percent in recent months (Figure 7). If the inflation rates of 2011, which were well above target, did not trigger rate hikes at that time, it is doubtful that the MPC would vote to tighten policy at present when CPI inflation is below target. There has not been a MPC member since July 2011 who has voted to raise rates. Beginning in August 2013 the MPC stated that it would refrain from hiking rates until the unemployment rate receded to a threshold of 7 percent. However, the unemployment rate fell much faster than the MPC expected in the second half of 2013, and it is now below 7 percent (Figure 8). Therefore, the MPC revised its forward guidance at the February 2014 policy meeting and now says that there is scope to absorb spare capacity further before raising rates. Indeed, with unemployment significantly above rates that prevailed before the onset of the global financial crisis, there seems to be a fair amount of scope to absorb spare capacity. In our view, the MCP will maintain its main policy rate at 0.50 percent until mid-2015 before commencing a gradual pace of tightening.3 Once the MPCs policy rate begins to rise, mortgage rates will increase as well, which will cause mortgage debt-servicing obligations to trend higher. At that time, growth in consumer spending could begin to downshift as households will need to commit a larger proportion of their income to servicing their mortgages. That said, this phenomenon likely is more of a story for 2016, which we do not currently forecast, than it is for 2014 or 2015. We do not look for rate hikes until next year.

We forecast that the MPC will raise its main policy rate to 1.50 percent by the end of 2015. See our Monthly Economic Outlook for details.
3

Strong U.K. Economic Recovery Remains Intact April 29, 2014

WELLS FARGO SECURITIES, LLC ECONOMICS GROUP Figure 8

Figure 7
U.K. Consumer Price Index
6%
Year-over-Year Percent Change

U.K. ILO Unemployment Rate

6%

8.5%
8.0%

Seasonally Adjusted Unemployment Rate: Feb @ 6.9%

8.5%
8.0% 7.5% 7.0% 6.5% 6.0%

CPI: Mar @ 1.6%

5% 5%

7.5%
4% 4%

7.0% 6.5% 6.0%

3%

3%

2%

2%

5.5%
1% 1%

5.5%
5.0% 4.5% 1999 2001 2003 2005 2007 2009 2011 2013

5.0%
0% 1997 0% 1999 2001 2003 2005 2007 2009 2011 2013

4.5% 1997

Source: IHS Global Insight, Bloomberg LP and Wells Fargo Securities, LLC

Conclusion
Economic activity in the United Kingdom accelerated last year, and recently released data show that real GDP growth remained strong in the first quarter of 2014. The overall rate of real GDP growth has been driven in recent quarters by real personal consumption expenditures, and monthly data suggest that growth in consumer spending remained solid in the first three months of the year. We look for the expansion to remain intact for the foreseeable future, and the drivers of economic growth should broaden as investment spending and exports accelerate. If, as we forecast, real GDP grows roughly 3 percent per annum in both 2014 and 2015, it would mark the strongest two-year period of British economic growth since the onset of the global financial crisis. Although real GDP growth in the United Kingdom has been and should continue to be solid, the MPC likely will keep its main policy rate at only 0.50 percent, where it has been maintained for more than five years, throughout 2014. Indeed, we forecast that the MPC will refrain from hiking rates until mid-2015. The MPC judges that there still is spare capacity in the economy, and it desires that some of this excess capacity is absorbed before it starts to tighten policy. With CPI inflation currently below the MPCs target of 2 percent, policymakers can afford to wait before hiking rates. What would induce the MPC to tighten policy earlier than most investors expect? 4 In our view, one of the main indicators to watch is the monthly series on average weekly earnings. Growth in earnings has generally been running below two percent for more than two years. Not only would wage acceleration indicate that spare capacity is being absorbed, but it could also put upward pressure on CPI inflation. Stay tuned.

According to the Bloomberg consensus forecast, most analysts do not expect a rate hike until Q1-2015.

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Diane Schumaker-Krieg John E. Silvia, Ph.D. Mark Vitner Jay H. Bryson, Ph.D. Sam Bullard Nick Bennenbroek Eugenio J. Alemn, Ph.D. Anika R. Khan Azhar Iqbal Tim Quinlan Eric Viloria, CFA Sarah Watt House Michael A. Brown Michael T. Wolf Zachary Griffiths Mackenzie Miller Blaire Zachary Peg Gavin Cyndi Burris Global Head of Research, (704) 410-1801 Economics & Strategy (212) 214-5070 Chief Economist Senior Economist Global Economist Senior Economist Currency Strategist Senior Economist Senior Economist Econometrician Economist Currency Strategist Economist Economist Economist Economic Analyst Economic Analyst Economic Analyst Executive Assistant Senior Admin. Assistant (704) 410-3275 (704) 410-3277 (704) 410-3274 (704) 410-3280 (212) 214-5636 (704) 410-3273 (704) 410-3271 (704) 410-3270 (704) 410-3283 (212) 214-5637 (704) 410-3282 (704) 410-3278 (704) 410-3286 (704) 410-3284 (704) 410-3358 (704) 410-3359 (704) 410-3279 (704) 410-3272 diane.schumaker@wellsfargo.com john.silvia@wellsfargo.com mark.vitner@wellsfargo.com jay.bryson@wellsfargo.com sam.bullard@wellsfargo.com nicholas.bennenbroek@wellsfargo.com eugenio.j.aleman@wellsfargo.com anika.khan@wellsfargo.com azhar.iqbal@wellsfargo.com tim.quinlan@wellsfargo.com eric.viloria@wellsfargo.com sarah.house@wellsfargo.com michael.a.brown@wellsfargo.com michael.t.wolf@wellsfargo.com zachary.griffiths@wellsfargo.com mackenzie.miller@wellsfargo.com blaire.a.zachary@wellsfargo.com peg.gavin@wellsfargo.com cyndi.burris@wellsfargo.com

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