December 2015

UK Economy: Ready for a Year of Divergence?
Before it gets underway, 2016 is already being dubbed as “the year of divergence”; one in which sustained economic growth enables the US to slowly, but steadily nudge rates higher while they remain at practically zero in Europe.

In the most recent stimulus update, European Central Bank (ECB) president Mario Draghi was judged to have promised more than he delivered. A modest further reduction was announced in the (already negative) deposit rate paid on reserves held by the central bank, from -0.2 percent to -0.3 percent, as well as a six-month extension to the banks €60 billion per month programme of quantitative easing (QE), taking it to March 2017, but the package was overall regarded as a disappointment - a modest stimulus rather than a major boost

Those analysing the UK economy have also been wrong-footed in recent weeks. Ahead of the spending review announced by chancellor George Osborne on November 25, predictions centred on how the austerity regime would deepen with major reductions expected for a number of budgets and deep cuts to tax credits.

In the event, the latter policy was scrapped and the axe fell less heavily than expected in a number of areas. The change of policy was helped by the Office for Budget Responsibility (OBR) - a body set up to provide the government with independent economic forecasts - revising its forecast for tax receipts upwards, which provided Osborne with an extra £27 billion of anticipated revenues.

What was a major policy U-turn by the UK government should have provided the opposition parties with considerable ammunition. However, internal divisions in the Labour Party since its controversial new leader, Jeremy Corbyn, took over this autumn, has blunted its effectiveness.

Instead, Prime Minister David Cameron has been further helped by a surprisingly effusive report from the International Monetary Fund (IMF) in its latest assessment of the British economy.

The IMF noted the country’s “strikingly large” current account deficit as well as continued uncertainty on whether the forthcoming referendum on continued membership will result in the UK pulling out of the European Union, aka a ‘Brexit’. In all other respects the report was highly positive. “The UK authorities have managed to repair the damage of the [2008-09] crisis like very few other countries have managed,” commented IMF head Christine Lagarde.

Steady as she goes

Meanwhile, first projections for the fourth quarter of 2015 suggest that UK economic growth continues to be steady, if unspectacular. Think-tank, the National Institute of Economic and Social Research (NIESR) estimates growth at 2.4 percent year-on-year in 2015, dipping only slightly in 2016 to 2.3 percent.
  Departing more from general consensus, the NIESR also suggested that the Bank of England (BoE) will raise its benchmark rate as early as next February from the record low of 0.5 percent at which it has remained since March 2009.

The central bank’s governor, Mark Carney has been dropping strong hints that the first post-crisis increase could come in 2017 rather than 2016. UK inflation provides no incentive for the BoE to yet start tightening, with the consumer price index (CPI) measure again at zero in August before again dipping into negative territory with a -0.1 percent rate in September and October.

Continuing weak commodity prices, particularly oil, and retailers maintaining a fierce price war suggest that inflation will remain subdued going into 2016.

The NIESR’s forecast for UK economic growth next year is more optimistic than that for the Institute of Chartered Accountants in England and Wales (ICAEW), which has downgraded its projection from 2.6 percent to 2.1 percent.

The ICAEW’s downgrade follows figures suggesting that a strong pound and weaker global growth are undermining efforts to improve the UK’s trade performance; in particular to build exports and reduce the country’s persistent large deficit in manufactured goods.

The latest figures, for October, showed the total deficit in goods and services widening to £4.1 billion. They heightened concerns that the trade balance for the final quarter of 2015 will be even more heavily in the red as the UK’s deficit with the EU, still its largest trading partner, reaches record highs.

The mixture of good news and bad means that the UK’s prospects for 2016 defy easy summary. Although the country is growing at a faster pace than its fellow G7 members, the recovery is unbalanced.

While the manufacturing sector dipped back into recession for much of the year, the ongoing strength of the UK’s services sector provided the economy’s continuing momentum. The Times of London concluded recently that “a stronger Eurozone is needed for Britain’s recovery to be extended in 2016”.

Fortunately, there are reasons to believe that this strengthening could come about. Despite the recent anaemic growth figures for the UK’s continental neighbours - and the likely impact on France’s economic growth following the November 13 terrorist attacks in Paris - Europe has come through several dramas this year (the election of a far-left government in Greece; the summer’s stock market jitters emanating from China).

Eurozone monetary policy is significantly less tight than it was when the region’s first crisis broke back in 2009-10 and the ECB can, and likely will, take further measures to accelerate recovery in its member countries.

FX Risk Management in Uncertain Times
Percentage of UK businesses

Source: East & Partners UK Business FX Markets Program, December 2015

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