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Has the UK economy really recovered?

In the UK, the crisis in the cost of living is back, as inflation, coming in at 2.9% in the year to August, has again risen above wage growth. The Bank of England says a major factor is the fall in the value of the pound since the EU referendum result, which has increased the costs of imports – in particular energy. Wage growth, up 2.1% in the year, hasn’t kept up. Adjusted for inflation, real incomes fell by 0.4% in the three months to July 2017.

Meanwhile, unemployment at 4.3% is now at a 42-year low, continuing to confound observers about the strength of the UK recovery as wage growth remains weak.

It may not feel like it but it is now over ten years since the financial crisis began, and we are nine years into a bull-run in equity markets in most major markets. Formally, the economy is said to have recovered. Unemployment is below its long-term trend of around 5%. Growth has been positive for many years, despite severe headwinds from years of fiscal consolidation. Inflation is rising.

Yet there is one highly abnormal feature of the British economy that could explain the weak growth in real wages. For the best part of a decade, the productivity gains that have driven rising living standards in the UK since the start of the industrial revolution have stalled, at least according to official data. Much of the increase in GDP since the crisis has come from ‘labour input’ – more people in work (often supported by high levels of net migration), people working longer hours, and more people returning to the workforce.

Low growth in labour productivity has meant that ordinary people in the UK have felt next to no benefit from the recovery of the economy in the form of rising wages. The return of high inflation threatens to put any gains they did see into reverse.

But is this the full story? Our research suggests that the productivity slowdown seen in the UK has been seen to varying degrees in all other G7 countries, but the performance of the UK should be an additional cause for concern. The UK has done particularly poorly due to unique frictions within its economy that have emerged post-crisis.

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Figure 1 shows how the evolution of labour productivity, measured in terms of output per head, was faster in the UK between 1970 and 2008 than in other G7 countries. Starting from a lower level in 1970, productivity in the UK grew on average by 2.3% per year and by 2.0% in the other countries (weighted by share of total GDP), which included technological leaders such as the United States and Germany.

However in 2008, productivity decoupled from its trend in all advanced economies, with the biggest deviations in the UK. One would expect this at the beginning of any recession as weak demand creates ‘spare capacity’ in labour and capital. But this phenomenon should not last. In all other recessions since 1970, productivity soon returned to trend.

The impact can be seen in Figures 2 and 3, where we see the deviation of output per hour from the level implied by trend for the UK compared to the world’s technological leader, the United States, and then compared to all other G7 countries.

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The UK and other G7 countries continue to deviate from their trend rates but to vastly different degrees. The US has also experienced low productivity growth in the last 5 years causing it so far only to revert back to its long-run trend level after a decade of rapid growth. But if the US continues to underperform on official measures, as seems likely, it too will slip below its pre-2008 trend in the coming years. The UK, however, appears to have done especially badly. Productivity (and therefore real wages) in the UK is 20% below where it should be based on recent trends, compared to just 10% below-trend for rest of the G7. More on the UK’s problems later.

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The productivity slowdown across the G7 suggests one or more of four things has happened. Either demand remains too low in all industrial economies; the pre-crisis trend rate has fallen across the G7 due to structural changes in the economy; the pressure to deleverage in the wake of the crisis has reduced the willingness for firms to invest in products and processes that increase productivity; or productivity gains have not been picked up by the statisticians.

The demand explanation cannot account for a decade-long trend, and apart from a short policy-induced scare in 2015-16 in the Eurozone, deflation has not been a major issue in most of G7. It is possible, however, that delivering more robust and sensibly designed fiscal action sooner would have sped up the recovery ameliorated some of the productivity problems we now face.

While we are sceptical that the long-term trend that has driven growth in the United States and its trading partners for up to 150 years should be revised fully downwards to meet the most recent trends, we think a moderate deterioration in trend growth is a possibility. Mainly this is due to a decline in secular returns from a range of general purpose technologies – such as electric power and mass production – and the growth in the share of the low-productivity services sector in all G7 economies. The financial crisis may have simply exposed these underlying changes.

It is also plausible that as a result of the financial crisis and the experience of deleveraging, firms have increased their risk aversion and are reluctant to invest in the emerging general purpose technologies in nanotechnology and biotechnology, which promise a step change in industrial activity. This would also suggest a reduction in the trend-rate of growth, at least in the short term, across the whole of the G7, meaning lower growth can be consistent with full employment.

The fourth reason – that productivity gains have been hidden – we believe explains a significant proportion of the shortfall in all G7 countries including the UK. The emergence and growth of the Information Technology sector have hidden real productivity gains that have been realised since 2008.

A smartphone today, for example, has taken the place of a number of other devices such as cameras, GPS, audio players and games machines; and to a more limited extent they have substituted for personal computers altogether. Despite this, the cost of smartphones has fallen. Product consolidation in consumable electronics and IT sectors means that the formal measure of GDP understates the true level of output, adjusted for quality, and goes some way in explaining why productivity is low relative to the level of employment.  Further, GDP statistics do not account for non-monetary transactions, such as content produced on social media or the services provided by free app technologies that underpin the ‘sharing economy’.

But for the UK economy, further underlying aspects can be highlighted, as pointed out in 2014 in a paper from Bank of England’s Monetary Analysis Directorate. They suggest that low interest rates have increased  forbearance from banks on the debts of firms that in normal conditions would have been allowed to fail. Moreover, credit frictions have prevented funds from being matched with new profitable opportunities, and a sustained fall in real wages relative to the price of capital has encouraged firms to delay investment by expanding employment.

So while a global phenomenon of depressed productivity growth exists, the problem seems particularly acute for the UK. Our research suggests that the UK has suffered a decade of lost productivity growth but that it is closer to full capacity than implied by its pre-crisis trend. This means that the country may face a period of stagflation – weak growth and high inflation – that will create a dilemma for a Bank of England that is committed to keeping inflation at 2%. As inflation rises, real interest rates fall and sterling continues to weaken, the UK economy could begin to overheat. At which point, the Bank will be encouraged to raise base rates. But this could reverse efforts to raise productivity and if markets have little tolerance for higher interest rates could create more adverse macro effects.

This is the near-term outlook, However if, as the technologists suggest, we really are on the cusp of a new industrial revolution, which promises to offer quantum leaps in productivity and living standards, the long-run prognosis for the UK and indeed the rest of the G7 need not be so bleak.

Our investment strategy committee, which consists of seasoned strategists and investment managers, meets regularly to review asset allocation, geographical spread, sector preferences and key global market drivers and our economist produces research and views on global economies which complement this process.

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