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What is going on with the UK economy?

By Economic Strategist, Hottinger Investment Management  

According to the Office for National Statistics, the UK grew its economy by 0.6% in the period between July and September, the fastest pace of quarterly growth for two years and a rate that would correspond to 2.5% if applied across the calendar year. This announcement came a day after the European Commission produced its forecasts for 2019 economic growth, with the UK at the bottom of its European league table tied with Italy. An annual expansion of just 1.2% is expected in both countries. Meanwhile, Ireland sits near the top of the Commission’s league table, with 4.5% growth anticipated. Political posturing aside, what is going on?

During Q1 and Q2 this year, the British economy grew by 0.2% and 0.4% respectively. If we include the Q3 figures, that means the economy has expanded by 1.2% in the first three quarters of 2018. This compares with just 1% in the Eurozone, 0.8% in France and 1.1% in Germany (based on a +0.2% Q3 estimate). Third quarter growth itself in the UK exceeded that of France and Italy – and most likely Germany too. Part of that is because of the recovery of activity lost during the first three months of the year due to the exceptionally cold weather, with construction (+2.1% QoQ) and manufacturing (+0.6% QoQ) up during the summer months, the latter on the back of strong performance in the export of cars and machinery.

The UK has been gaining momentum over the year while the rest of Europe has been losing it after its stellar performance in 2017, yet pessimism over the future for the UK is proving so hard to shift. Brexit is part of the explanation, but only part. As long as there remains uncertainty over the UK’s trading status with the countries which constitute over 40% of its exports, businesses will hold off from making long-term investments, and we see this in the data. The chart shows that the UK is an outlier among G7 nations in investment spending both over the last quarter and over the last twelve months. British businesses haven’t felt confident enough to take part in the global growth story of 2017.

Trade complexity matters, and the complacency with which some Brexit-supporting politicians treat the issue presents a risk that is now materialising to the British economy. Global supply chains get more complex each year. We realise this from time to time, whether it was how the Fukushima nuclear disaster of 2011 in Japan created delays in the supply of components for car companies and smartphone manufacturers across the region, or – closer to home and nearer in time – the situation earlier this year in which KFC, the fast-food chicken franchise, ran out of chicken. The pressure for ultra-lean inventory and fast delivery creates conditions for dramatic stories like these. But it also potentially makes Brexit Britain a less attractive place for international businesses that want to sell into Europe competing with firms that benefit from lean supply chains elsewhere. That’s what matters, not tariffs (which can be mitigated to some extent by a currency devaluation and countervailing tax measures), but regulatory frictions that cause material delays, and the EU knows it. It’s not clear, however, that the people with whom they are negotiating with do.

Business will continue to fight for a Brexit deal that keeps in place that all-important just-in-time (JIT) supply chain infrastructure. But without greater strategic awareness from the government, Brexit will look like an expensive and reckless experiment in de-globalisation.

But there is a wider problem with the British economy that means one cannot lay blame wholly at the door of Brexit. The UK has consistently lagged other G7 countries when it comes to productivity, defined as output per hour of labour, and growth in productivity (see table). An hour worked in the UK in 2017 yields 80% of an hour worked in Germany and France. We like to mock the French for their employment attitudes and general sense of joie de vivre but the fact is that if they worked as many hours each day as the British, they could afford to take Friday off and be just as well-off per capita.

The culprit is decades of underinvestment as the second chart shows; since 1979, with the exception of a brief period in the late 1980s, the UK has consistently had one of the lowest rates of investment as a share of its GDP in the G7. Business investment has remained low for decades as banks have diverted funds towards mortgage lending over productive enterprise.

The table shows that compared to its G7 peers the UK hasn’t done badly in terms of real GDP growth since the end of 2007, before the Great Recession; only the US, Canada and Germany have grown by more. The countries however are ranked according to growth in labour productivity in the first column, where the UK only marginally beats Italy in the fight to avoid the wooden spoon. If we accept that GDP is basically the sum of productivity and labour input, what this means is that the UK has relied disproportionately on labour input to deliver growth. The UK is the only country that has seen an increase in labour hours per employee since the Great Recession, and it shares a high rate of employment growth with Germany and Canada, two countries that have seen significant immigration in the last decade.

The UK has relied on three unsustainable sources for its recovery. The first is a rise in the employment rate above its pre-crisis trend, as a result of government policies that encourage work. The second is a rise in hours worked per employee, most likely in response to negative real earnings growth during much of the period of interest. The third, and most important, is immigration. The UK population has increased by almost 8% (or 4.7 millions) between 2008 and 2017; official net migration in that period was just under 2.5 million (or 53% of the total rise in population). Immigrants are significantly more likely to be of working age; EU migrants (but not non-EU migrants) are more likely to be employed than natives. But even assuming they are equally as likely in both categories means that a very substantial chunk of the 2.48m rise in employed persons between 2007 and 2017 consists of immigrants.

And this brings us back not so much to Brexit but instead to the causes of Brexit. If Brexit is about reducing immigration then the UK is going to need a new economic model and it has to revolve around raising the investment rate in order to replace the economic growth provided by recent immigrants. At some point the economic debate will have to turn to this and there are two clear models: the Conservatives favour a low tax and business-friendly approach, while the Labour Party wants to use the resources of the Bank of England and the Treasury to get things going. Without an investment strategy for after Brexit, the growth outlook for the UK is justifiably poor.

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