The gloom starts to lift ?

Posted on: May 1st, 2018 by Rob Orme

Economic commentary

25 April 2018

Figures released last week show that earnings growth is catching up with inflation. This means that the squeeze on real incomes, and hence on living standards, is coming  to an end, which in turn means that the pall of gloom that has been hanging over the retail and consumer landscape should soon start to lift.

Pain on the high street

British consumers have been in retrenchment mode since the end of 2016. At a time when the retail trade is still in the midst of a shift from ‘bricks to clicks’, the pain has been all too evident, and the news headlines in recent months have been full of stories about high street chains closing outlets, or firms being forced into administration.

It’s also been a tough time for some other consumer-facing sectors, such as estate agents and motor dealerships. In the housing market, affordability constraints and tax changes affecting the buy-to-let market have dampened demand and price growth, while in the motor trade the long-running trend towards financing purchases through Personal Contract Plans (PCPs) has run its course.

For economists, who have complained incessantly about the penchant of the British for retail therapy and property investment, last year marked something of a return to virtue. With shoppers and house-buyers taking an enforced breather, economic growth in 2017 was instead driven by fixed investment and net trade (the difference between growth of exports and imports). In particular, the depreciation of sterling immediately after the EU referendum, coupled with the strengthening of the global economy, meant that exports expanded at a faster pace than imports for the first time since 2011.

Nonetheless, the retrenchment by households was such that the rate of real GDP growth (i.e. after adjusting for inflation) slowed a touch, coming in at a modest 1.8% in 2017. In itself, this was no disaster. During the present long, but slow, cyclical upswing many advanced economies would be quite happy with that pace of expansion. But it’s still the slowest annual growth since 2013, and the deceleration contrasted with the quickening pace of growth seen in almost all other advanced economies during 2017. The slowdown was particularly marked in the household sector, where spending expanded by just 1.7% in 2017, compared with 3.0% the previous year.

A minor inflation surge

The retrenchment wasn’t unexpected, and so ought not to have come as a surprise to retailers and motor dealers. The fall in the value of pound that was triggered by the vote to leave the EU in June 2016 resulted in a sharp rise in the cost of imports in sterling terms, and this eventually generated a minor surge in inflation: having been close to zero throughout much of 2015, the annual rate of consumer price inflation peaked at 3.1% in November 2017.

This might not sound like much to write home about, especially for those of us who remember the inflation horrors of the 1970s, but it’s quite enough to cause problems at a time when earnings growth was pegged at around 2%. It meant that real disposable incomes (the gap between earnings growth and price increases) once again turned negative. While some people may have been protected by career progression or bigger bonuses, or by the more generous increases applied the statutory minimum wage, many have not been so fortunate, with the result that the general standard of living has edged down.

Household finances under pressure

Consumers did put up some resistance, spending a higher proportion of their disposable income in 2017 than at any time since records began in the early 1960s. This is another way of saying that the savings rate fell, coming in at just 4.9% in 2017 compared with 7.0% the preceding year. But given that the burden of debt remains at a historically high level, it was never likely that households could plough on regardless through the present income squeeze.

Back in the autumn of 2016 the volume of retail sales was expanding at a dizzy annual rate of nearly 6%. But an atmosphere of gloom descended early in 2017, with the annual growth of retail sales reported as being just 1.2% in the first quarter of this year. The figures for March were especially weak, showing a decline from the previous month of 0.5%, although the wintry weather at the start of the month clearly kept some shoppers away and caused people to delay re-stocking their wardrobes for the spring and summer.

The malaise extends to cars and housing

It’s been a similar story as regards demand for new cars. After six years of continuous expansion, new registrations started to fall in April 2017, after a last hurrah as people rushed to beat the changes to Vehicle Excise Duty (VED) which took effect in that month. In the first quarter of 2018 total new car registrations were 12.4% down from the previous year, with sales to private buyers declining by 13.8%. The malaise in the housing market has a wider set of causes, including of course the more hostile tax regime faced by the buy-to-let (BTL) market. According to UK Finance, demand for BTL mortgages has fallen by around a third in the wake of the tax changes introduced in 2016. Across the wider housing market, the present income squeeze hasn’t helped, with figures from the Nationwide showing that the average purchase price of a house is now more than five times average income, a ratio which has historically caused the market to cool or contract.

While house prices are still rising at a modest pace (4.4% in the year to February), activity has fallen back again in the past year or so, with figures from the Bank of England showing that mortgage approvals for house purchase are running in the low 60,000s per month. Activity has been depressed ever since the onset of the financial crisis, the number of loans approved each month prior to that often being in excess of 100,000.

The consumer squeeze: retail sales and new car registrations suffer

The tide turns?

But recent data from the Office for National Statistics (ONS) suggest that the pall of gloom will soon begin to lift. On 17th April it was reported that the annual increase in total pay (i.e. regular pay plus bonuses) had held steady at 2.8% during the three months to February, while the measure of underlying, or regular, pay growth rose from 2.6% and now also stands at 2.8%. The unemployment rate has also ticked down again, to reach 4.2%, while the number of registered vacancies remains at over 800,000. The latter is a little lower than in recent months but is still high by historical standards. In other words, despite the more subdued economic landscape the labour market remains tight, with mounting evidence that employees are having some success in bidding up their wages.

The following day brought the news that the annual rate of consumer price inflation had fallen sharply again in March. Having peaked at 3.1% last November, it declined from 3.0% in January to 2.7% in February, and then to 2.5% in March. While it was generally expected that the peak of the recent spike had passed, the scale of the latest falls have taken most pundits by surprise. Clothing prices were partly responsible for the decline in March, which may reflect discounting by retailers to shift spring lines in the face of unusually cold weather.

Oil prices could still be a risk

In any case, the figures are prone to bobble about from one month to another, so it wouldn’t be a huge surprise if the inflation rate holds steady, or even rises a little, in the coming months. Moreover, the speed at which inflation ebbs away could be dampened if the price of crude oil continues to hold at over $70 a barrel. HSBC now expects that the annual rate will have declined to 2.2% by the end of this year, easing very gradually to stand at 2.0% at the end of next year.

The upshot of this latest crop of earnings and inflation data is that the decline in the ‘real’ income of households, which has depressed overall economic growth during the past year or so, is coming to an end. Nit-pickers will point out, perhaps with some justification, that since the earnings data cover a three-month period, the inflation rate used for comparison should cover the same three months, rather than simply taking the latest monthly reading, as is conventionally done. On this basis, real earnings still fell very slightly during the period from December to February, with consumer price inflation averaging 2.9%, against an increase in total pay of 2.8%. But, with March’s inflation rate coming in at 2.5%, it’s pretty clear which way the wind is blowing.

A better outlook for household finances

A rate rise in May?

The easing of inflation and the weakness of retail sales in March have prompted speculation that the Bank of England could hold off from raising Bank Rate at its next policy meeting, which is due to take place on 8-9 May, with the announcement being made at noon on 10 May. That speculation was fuelled further by the cautious tone of comments made by Mark Carney at the IMF’s spring meeting in Washington: those comments contributed to sterling falling by more than two cents against the dollar as markets re-priced the probability of a hike at the upcoming MPC meeting.

HSBC is sticking with its long-held view that there will be one increase in Bank Rate this year, and that it will take place in May. But the snowy weather earlier in the year and Mr Carney’s recent comments have muddied the waters somewhat. In the past, spells of wintry weather have subtracted 0.2-0.3 percentage points from quarterly growth of GDP; on this occasion however the disruption was short-lived (and, moreover, not all parts of the country were badly affected) meaning that a reduction of 0.1 percentage point is more likely. HSBC expects that the initial estimate of first-quarter growth, which will be published on 27th April, will therefore come in at just 0.2%. Provided that it’s no worse than that, and that there is no collapse in the readings from April’s Purchasing Managers’ Index (PMI) surveys, then an increase in Bank Rate of 25 basis points to 0.75% is still on the cards for May.

A gradual process

Whatever the Monetary Policy Committee decides to do, the good news is that the conditions are now in place for a modest revival of the UK’s consumer sector. It’s important, however, not to get carried away, as real incomes will be growing at only a modest pace: what we’re seeing is a gradual lightening of the gloom, rather than a sudden emergence from darkness to sunlight.

Finally, it’s still possible that the Brexit process could yet get in the way of a consumer revival. The start of this year brought a period of relative calm on the Brexit front, but the issue of whether the UK should remain in some sort of customs union with the EU is about to come to a head.

Mark Berrisford-Smith
Head of Economics, UK Commercial Banking
HSBC Bank plc

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