The outlook for the UK Consumer – not that bad!

The outlook for the UK Consumer – not that bad!

by Ewen Stewart
article from Monday 1, May, 2017

NOTWITHSTANDING recent signs of slowing retail sales, the UK consumer has had a good financial crisis. While real wage growth has been consistently weak, since 2008, substantial cuts in the cost of borrowing, full employment, strong asset prices feeding through to a wealth effect, and modest aggregate tax cuts, for the below median earner, have offered a degree of income protection.

Moreover, over the last couple of years, real earnings growth has improved as wage inflation has for the first time picked up as inflation tended to zero. However, this is showing signs of reversal as inflation is now rising and real wage growth is again muted. Considering the outlook for the UK consumer in the light of rising inflation, is this as good as it gets?

What is the outlook for UK and global inflation?

Since 2008 inflationary trends have been volatile. Despite weak global demand CPI increased by 24.1 per cent between 2008 and 2016 with an annual peak of 4.4 per cent in 2011. Recent experience is of a much lower rate of inflation with near static prices in 2015 giving cause for concern, in some quarters, that the UK (and the world) was entering a period of deflation.

The chart below shows CPI for key nations since 2005 demonstrating that global inflation is now rising modestly, driven by resurgent commodity prices, with UK inflation expected to be the highest in the G10.

More recently global inflationary pressures have, however, been modestly building with expectations for the G10 of around 1.4 per cent in 2018 from parity in 2015. While this can hardly be a cause for alarm, and may even be a positive as a spur to global earnings growth, it is happening just as Sterling has depreciated materially post the EU referendum thus exacerbating the UK’s problem.

The chart below outlines Sterling’s value relative to key global currencies. Sterling had been sliding against the USD prior to the EU referendum falling from USD 1.65, in mid-2014 to USD 1.45 on the eve of the referendum. While Sterling has stabilised in recent months, the current level of USD 1.28 is some 12 per cent below the rate the day before the referendum and 23 per cent lower than mid-2014. The fall against the Euro while material, has been less spectacular, at 7 per cent, since June 2016.

The UK is one of the world’s most open trading economies highly dependent on imports. Further, with oil and major commodities all priced in USD any decline in sterling tends to feed thorough to domestic inflation relatively quickly. The fall, particularly against the USD, is thus obviously highly material to inflationary expectations.

It should be noted however that although Sterling had already fallen from USD 1.65 to USD 1.45 in the 24 months prior to the EU referendum there was no appreciable impact on inflation. Some of this can be explained by weakening commodity prices and a very subdued global demand environment and clearly there are also lead and lag effects – but while Sterling’s decline to the USD was more gradual and not as sharp as that in June 2016 inflation remained very low and some categories, food for example, was strongly negative. Thus there is clearly more to inflation than simply currency movements, important as that is.

I have argued that there are a number of factors at play here subduing inflation more profoundly than might normally be expected at a time of such a sharp currency depreciation. 

First, there is an abundance of global labour. The trend from countryside to city has decades to run with literally perhaps a couple of billion of ‘global poor’ still potentially available to enter the labour market. Thus the cost of producing ‘stuff’ is likely to be subdued for years and may well fall as capital replaces labour. 

Second, national labour supply has been replaced by relatively open global labour markets. This has actually been a fairly recent phenomenon as there was little intra-EU migration prior to 1997. While this dynamic, for the UK, may reverse post BREXIT should a future Government impose a more rigid migration policy, there will be no short term change in freedom of movement until the UK leaves the EU (not before 2019 at the very earliest and quite possibly 2022 if the muted transitional arrangements prove to be the chosen route). Post that we suggest change is likely to be only at the margin.

Third, global productivity gains continue to subdue inflation which, coupled with technology change (internet in particular), give ready price comparisons helping create more perfect competition adding to price deflation.

Fourth, consumers have become very ‘price aware.’ Vendors thus often re-engineer product, in an attempt to massage inflation, using cheaper substitute materials to hold prices down beyond what might be expected.

It is for these reasons that I have been and continue to be, relatively, an inflation dove. While expecting UK inflation to increase I think it will do so by less than the consensus. I forecast CPI of 2.5 per cent in 2017 and 2.6 per cent in 2018. Longer term I view the currency effect as a ‘one-off’ and expect inflation to subdue again (on the assumption of relatively open labour markets being maintained). 

I am aware this is slightly lower than consensus and a number of counter factors are at play, notably increasing commodity prices and a minimum wage rising well ahead of inflation, but nevertheless I believe we are in an era of structural low inflation.

It should be noted however that CPI pressures have been highly directional with a large divergence around the mean. Primark may well sell clothing ever cheaper, but Saville Row inflation has been high. The same is true for top hotel room prices, theatre tickets, school fees and generally domestically handcrafted specialist products and the like. 

Further, although not picked up by CPI, the cost of property and rent has also greatly exceeded CPI. Contrast that, for example, with deflation in electrical products, basic clothes and food. 

Real wage growth – tending to zero

Notwithstanding my comments above, after a brief bounce into positive territory, post a record four years of negative wage growth, real wage inflation is back to flat and may be about to turn marginally negative, as can be seen from the chart below.

Indeed it would seem to me as close to inevitable that in real terms there will be a few quarters of marginally negative wage growth thus causing some to argue ‘it is all over for the consumer.’ 

I believe this is too simplistic a measure, however, to give the true underlying position as I shall later explain.

GDP, employment and consumption trends are broadly helpful

The labour market has been extremely buoyant in recent years absorbing a large growth in the workforce. Employment has been plentiful with minimal unemployment and total employment increasing from 70.4 per cent of the workforce in 2012 to74.6 per cent today. Further the improvement in total employment is exhibited across a wide range of sectors.  

Average earnings growth may have moderated to 2.3 per cent, although I believe the official ONS statistics underestimate the true position due to the probable under-reporting of earnings from the increasingly large ‘self-employed’ sector (now  over 15 per cent of the workforce) and the tendency for migrant labour, which is growing as a proportion of the labour force, to be  relatively lowly paid. 

Overall consumption has been slightly positive.  The general trends described above are illustrated by the two charts below.

The yield curve and the cost of borrowing remains supportive

Critical to the consumer is the cost of borrowing.  While the post referendum £60bn QE shot and rate cut has worked through, bond yields are marginally lower than they were 12 months ago. The 10-year benchmark gilt yield of 1.02 per cent, at the time of writing, compares with the pre-referendum rate of 1.4 per cent.

Mortgage borrowing costs have also marginally trended downwards. A 50bp decline might not sound much but on a £100,000 mortgage it equates to £500pa extra income.  Average borrowing spreads are indicated by the chart below and continue to compress at the margin.

Money Supply, commodities and other factors

The chart below suggests inflationary pressures may well be on the rise and not just down to currency. M4 growth has started to rise and is at its strongest since the credit crisis. I view this as broadly positive for growth albeit it with the caveat of possible amber light warning of inflationary pressure further down the road.

Of further concern is commodity prices that, as can be seen from the two charts below, have shown a sustained rally from very depressed levels. The Sterling impact is even more profound as commodities are generally priced in USD. However I remain of the view that a substantial rally in commodity prices is unlikely from here albeit it remains one of the largest swing factors.

Summary

I would therefore draw the following broad conclusions:

  • Headline real wage growth is tending to zero and may move slightly negative in 2017 and 2018. I am an inflation dove and see inflation as a modest spike rather than a structural issue, with the caveat that the UK continues to adopt a fairly open migration policy post BREXIT.
  • The underlying consumer position is not as bad as it looks as I believe underlying wage growth is slightly stronger than the official statistics, employment remains full and increases in statutory minimum wages could ripple upwards at the margin.
  • Further continuing very depressed borrowing costs, an asset wealth effect and marginal tax cuts at the bottom end should ensure real disposable income remains slightly positive.
  • Caveats to this include a political status quo and continuing reasonably open labour markets.
  • My household spending model suggests a marginally positive disposable spending environment over the next two years.
  • I believe it is consensual to be negative on UK domestics and the consumer in particular partially down to ‘BREXIT concerns’ and partially down to a concern on rising inflation.
  • My judgement would be, that while 2017 will be a tougher year than the previous two it may surprise slightly on the upside against weak expectations.
  • I expect the yield curve and borrowing costs to remain at very low and accommodative levels. I remain of the view that the Bank of England is on a treadmill it cannot easily get off. Low rates are embedded. This is the core assumption behind my relatively benign forecast.
  • Looking at the principle consumer sectors I remain broadly positive on the housebuilders, building and domestic financials. I also believe the real estate yield arbitrage has someway further to run. 
  • I am be more cautious on general retail and travel where technology change and supply issues could continue to disrupt. 
  • The key risks are a shift in the yield curve or a political earthquake either in the UK (unlikely) or France (also very unlikely) spilling over to currency and Euro stability questions.
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