Chief Economist's Weekly Brief – 18 May 2009

Slowing pace of decline

Noises from the OECD last week that we are past the worst of the downturn will have been met with sighs of relief from the euro area where Q1 output plummeted at never before seen rates. This doesn’t mean a recovery is in sight, just that the pace of decline is slowing. For the time being, “less rapid contraction” is the new “green shoots”.

The Bank of England remained reluctant to buy into any building wave of optimism. During the press conference to present the latest Quarterly Inflation Report, Governor Mervyn King, emphasised that any recovery from the current “unprecedented recession” would be sluggish. The projected growth trajectory was more pessimistic than the one presented three months ago, showing a likely contraction of around 4% this year, before approaching positive territory next year. However, King also acknowledged that any forecast of growth and inflation at this point in the cycle carried an unusual degree of uncertainty, meaning that both upside and downside surprises are possible in the months ahead.

We saw a glimpse of the two sides of the UK housing market last week. “Green shootists” will take heart from the renewed signs of buyer interest reported by the Royal Institution of Chartered Surveyors (RICS). Enquiries by prospective buyers have risen for six months on the trot, and agreed sales have also started to increase. Unfortunately, the number of distressed borrowers is rising too: 12,800 properties were repossessed in Q1, 23% more than in Q4. The buy-to-let segment, which sprung up only in the last decade, is particularly concerning. The number of buy-to-let borrowers more than three months in arrears has trebled in the last year. House prices are unlikely to stabilise until demand and supply find an equilibrium. As distressed sales rise, this remains some way off.

The latest news from the UK labour market was unexpected, as much because it was leaked a day early as for the figures themselves. The unemployment rate rose 0.4 percentage points to 7.1% in March, driven by the highest quarterly increase in the number of people looking for jobs since 1981. New entrants to the labour market accounted for roughly a third of the increase in unemployment; the rest was due to redundancies and voluntary leavers. Other job indicators looked equally dire: wages declined 0.4% compared to last year- the first decline on record - as vacancies plummeted further.

After proving surprisingly resilient at the beginning of the year, US retail sales fell for a second month in April. With unemployment rising rapidly and households focusing on saving, the data did not come as a surprise. The outlook for consumer spending remains lacklustre. Meanwhile, the trade balance deteriorated in March, but by less than anticipated. This could mean a slight upward revision to Q1’s 6.1% annualised drop in GDP. The monthly trade deficit of $28 billion still compares very favourably to a four-year average of $60 billion. A big part of the improvement has been due to a sharp fall in the price of oil imports, now two-thirds below their mid-2008 level.

It is an anomaly of the current recession that core consumer price inflation refuses to come down. Headline CPI recorded its biggest decline since 1955 in the US in April (-0.7%), as core inflation (which excludes food and energy) climbed to 1.9%. In the euro area inflation was unchanged (at 0.6%), yet core prices rose 1.8% on the year, up from 1.4% in March. It seems deflationary pressures have abated in early 2009 versus late 2008. We will see whether the UK follows suit later this week.

The global recession has turned the world on its head in the euro area. Characteristics that were strengths are now weaknesses and vice versa. Germany’s reliance on trade was its greatest strength, now it is its Achilles’ heel. The erosion of its exports contributed to a massive 3.8% q/q decline in GDP in the first three months of the year. Its poor performance in the Eurovision Song Contest will have further depressed German spirits. A large public sector and highly regulated economy weighed heavily on growth in France during the global boom. Now the best performer in the euro area (just 1.2% q/q GDP decline), these characteristics have acted as safety nets, bolstering the economy’s automatic stabilisers.

In China, as the global recession takes its toll on exports and related industries, the fiscal stimulus is buoying domestic growth. In the year to date, investment in fixed assets (factories, property etc.) was up 31% compared to last year, boosting 2009 growth prospects from 5% to 7%. Even deflation is not enough to derail the recovery: declining consumer and producer prices are the result of cheaper food and oil, not a shortage of demand. This was reflected by strong retail sales, up 15% in April, the strongest growth since January. The economy may be reliant on government-led spending, but this is a popular club to be in right now.

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