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UK Growth Sails Through Brexit … For Now

Before the EU referendum, the Treasury, the Bank of England and the IMF warned that the economy could fall into an immediate recession if the vote was No. This morning, the Office for National Statistics said that the UK economy grew in the fourth quarter, by 0.6% qoq for the third quarter running.

Annual growth was 2.0% in 2016 after 2.2% in 2015 and 3.1% in 2014. This confirmed that the UK was the fastest growing G7 economy in 2016. The figure is provisional but revisions are usually modest.

What Was Driving Growth? In a word, services. The service sector comprises 79% of the economy: growth of 0.8% qoq accounted for the entirety of fourth quarter UK growth. The ONS pointed in particular to a “strong contribution from consumer-focused industries”. Beyond services, manufacturing grew by 0.7% and construction by 0.1% but mining (which includes North Sea oil) tumbled by 6.9%.

Where Is Growth Going? With hindsight, the economics fraternity should have seen the robust growth in the second half of 2016 coming. It was not a case of a “crisis in economics”, as the Bank’s chief economist, Andy Haldane, suggests, but rather failing to see signs that were there.

The chart shows one unfashionable example. Few economists look at money supply figures nowadays but M1 has been a reasonable predictor of real GDP growth since the turn of the decade, with a two to four quarter lead. M1 growth has picked up from 5.3% yoy in late 2015 to 11% in late 2016 so it is no great surprise that real GDP growth has also accelerated. Another couple of oft-ignored indicators – the CBI trends survey and the OECD leading indicator – also heralded firm second half growth.

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Even so, economic logic points to a slowdown ahead. Faster inflation due to the weaker pound will squeeze real incomes and slow consumer spending. Uncertainty about the UK’s future relations with the EU should deter capital spending by both domestic and foreign firms. In particular, there may be a move to consolidate supply chains within the EU. The budget deficit is still too high which will discourage government spending and so on.

However, the key question is how big a slowdown and how soon. Our guess – no more than that – is that there will be a distinct slowing but no recession. The first and shorter slowdown will be over the next six to twelve months, as weaker real incomes hit retail spending. The second and longer deceleration may come as Brexit talks proceed and likely turn nasty.

The other major question is how current buoyancy and future headwinds blend into the outlook. The first and maybe the second quarter of 2017 should print reasonable growth numbers. Thereafter, look for weaker data to emerge.

Market Implications. In the near term, firm economic numbers should support UK equities and the pound, while rising inflation will keep gilt yields under upward pressure. Farther ahead, say from the second quarter onwards, signs of modest economic weakness may reverse those trends.

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