Chancellor has thrown down the gauntlet to UK businesses, says EY ITEM Club


20-07-2015

The Chancellor’s fiscal medicine for the UK economy will be hard to take and its success depends heavily on whether businesses will rise to the challenge, according to the EY ITEM Club’s summer forecast.

 
The EY ITEM Club says that against a background of tax rises and a sharp squeeze on welfare spending, reconciling the Chancellor’s fiscal goals with maintaining healthy growth in the economy will require businesses to step up their investment and export plans. Otherwise the adjustment will come through slower growth and imports. 

The forecast predicts that companies will respond positively to the Chancellor’s challenge. Business investment is expected to accelerate to 7.4% in 2016, from 5.1% this year, and 7.1% in 2017. An improvement in the UK’s overseas investment income and exports of services will also provide some of the room needed for the Chancellor’s budget surplus and help to rebalance the economy away from the consumer spending-led growth of this year. However, investment and exports are unlikely to go far enough to prevent growth slowing over the next few years. As a result the EY ITEM Club expects GDP growth to reach 2.7% for 2015 and 2016 before it slows to 2.4% in 2017 and 2018.

Chancellor’s risky strategy

Peter Spencer, chief economic advisor to the EY ITEM Club comments: “The Chancellor has thrown down the gauntlet to businesses in a risky strategy that will require them to rise to the challenge and respond positively to his Budget announcements. Companies will have to invest in plant and skills to boost productivity and allow them to pay higher wages. However, we expect this strategy to be only partially successful and we are likely to see growth and imports slow down as well.”

Stuart Wilkinson, Partner at EY in Cambridge adds: “Businesses will have to dust down their export and investment plans and increase spending and borrowing levels. As labour is becoming more expensive, following the Chancellor’s announcement for the introduction of a living wage, investment levels should increase. This could be the time for businesses to consider investing in technology as a way to reduce labour costs.”

Strong services exports should help smooth the path to prudence

The EY ITEM Club forecast sees the trade deficit widening, but the continued success of the UK’s services exports means that this increase will be outweighed by an improvement in the balance of trade in services.

Meanwhile the recovery in European markets should improve the returns on UK investments there. As a result, EY ITEM Club expects to see an improvement of £34 billion in the balance of payments, from £100 billion in 2015 to £66 billion by 2020.

Peter Spencer adds: “In this race for exports there will be some winners. The success story of our financial services sector exports is expected to continue and they will lead the race. Exports of branded consumer goods are also expected to be amongst the winners.”

MPC unlikely to be in a hurry to raise interest rates

The US Federal Reserve is expected to raise interest rates this September, but the EY ITEM Club expects the first increase in UK interest rates to come a year later in Q3 2016, two quarters later than in its previous forecast.

The change in the forecast reflects the need to offset further fiscal tightening against a backdrop of a large amount of spare capacity in the UK economy.  The forecast predicts that the subsequent normalisation of monetary policy will be slow. As a result, interest rates are expected to end 2016 at 1% and 2017 in 1.75%, while they are unlikely to move above 3% until the fiscal adjustment is finally accomplished in 2019.

Peter Spencer comments: “With inflation floored this year and the Chancellor’s fiscal changes still to bed in, the MPC will have to be very cautious. Despite the rebound of both the US and the UK economy and the revival in earnings, the resemblance between the two economies stops there. The MPC knows that they can’t follow the Fed any time soon.”

Consumers not likely to be hogging the fast lane for much longer

The UK consumer, having been lashed by rising fuel and food prices for so long, is currently enjoying a ‘welcome break’ according to the EY ITEM Club.

The tightening labour market is at last pushing wages up, while the weakness of commodity prices and the strong pound has crushed inflation. The EY ITEM Club forecasts that real disposable incomes will increase by 3.5% in 2015 and 2.2% in 2016.

The forecast sees consumer spending increasing by 3.2% in 2015 and another 2.5% in 2016. However, the growth in real disposable income then slows as the Budget squeeze, in particular the sharp cuts to in-work benefits, begins to take effect. The forecast predicts that growth in real disposable incomes and spending is going to fall back to around 2% a year from 2017-19.

Peter Spencer adds: “UK consumers have been the boy racers in the fast lane and consumer confidence is running at record levels. While this heady pace is set to continue for the next few months, the boost from low inflation is likely to fade as we move into next year and the effects of the Budget begin to weigh on household incomes. However, these factors should be partly offset by a further pick-up in pay and continued growth in employment.”

Is this summer’s sunshine strong enough to help with the extensive roof repairs needed?

Peter Spencer concludes: “While the UK is set to have one of the strongest economies in the G7 this year, considerable risks still remain. The economy continues to be buffeted by world events, with developments in Europe and China providing the most recent worries. The Office for Budget Responsibility has assumed that the higher living wage will do little damage to employment levels and will largely offset the impact on household incomes of the cuts to welfare spending. However, there is a risk that the damage to household incomes and therefore consumer spending turns out to be greater.

“Whether this summer’s sunshine is strong enough to help with the extensive roof repairs the Chancellor is planning remains to be seen.”

 

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