The UK economic outlook continues to deteriorate. Second quarter growth (GDP) was revised down to zero. This reflects the sharp fall in investment, which is primarily due to the fall in residential property investment. The UK consumer is still resilient – in July retail sales growth was 3.9% per annum. This factor explains the continuing high UK balance of payments deficit, which is running at over £4 billion per month (goods and services). This equates to nearly 4% of UK gross domestic product. The deficit is exerting downward pressure on sterling: the trade weighted index fell below 90 in late August, the lowest level since Autumn 1996. The decline in the sterling trade weighted index exacerbates the Bank of England’s inflationary challenge. CPI rose in July to 4.4% - more than double the government’s 2% target and well above the 1-3% operating range. The upturn in inflation has not yet translated in a higher level of average earnings. Underlying average earnings have remained in a narrow 3.4% to 3.9% range since late 2005 – the June figure was 3.7% pa. Unemployment did rise by 0.2% in June, to 5.4%, although this level is still within the 5.1% to 5.6% range of the past three years. The current malaise of the economy primarily reflects the downturn in the UK housing market, which represents fall out from the international credit crunch. We expect UK growth to remain close to 0% in 2008, recovering in 2009 to 2% per annum, rising just above trend (2.7% per annum) in 2010.
Target inflation (CPI) rose to 4.4% in July, more than double the 2% target rate of inflation, and well above the government’s 1-3% operating range. The most recent Bank of England Quarterly Inflation Report predicts that CPI will peak at just over 5% per annum, despite the weakness of UK growth. The Bank predicts that growth will remain around zero until Summer 2009. This slowdown, in the Bank’s view, should enable CPI to return to target over the Bank’s 2 year forecast horizon. This should provide room for at least one 0.25% base rate cut in the first half of 2009. There is one proviso – if sterling continues to depreciate, base rate will remain on hold. The Bank of England is walking a monetary policy tightrope, and is unlikely to reduce the base rate until there are clear signs that inflationary pressures are easing. One positive development is the reduction in period rates. 2 year plus rates have fallen by an average of 0.25% in the past month, in response to the slowdown in the global economy and the consequent reduction in commodity prices. This has enabled many lenders to reduce fixed term mortgage rates. There is probably scope for a further modest reduction in period rates in the coming weeks, although we expect the period rate trend to reverse around year end, in anticipation of an upturn in global growth in 2009.
The UK mortgage market is probably at a cyclical low point. The most recent data from the Council of Mortgage Lenders indicates that the level of advances stabilised in July. We expect to see a similar picture from August and September data. Thereafter mortgage lending is likely to be on a gradual upward path. The prime reason for the downturn in the housing market is the international credit crunch, itself the product of a severe downturn in the US housing market against a background of excessive lending. The financial problems associated with the US mortgage market are steadily being resolved, and we expect liquidity to improve in the Autumn. In the absence of any improvement, there is likely to be a significant co-ordinated injection of liquidity by central banks. Within the next two months, there is a strong possibility of a significant UK fiscal stimulus package that may well include a reduction in housing transaction stamp duty. In our view, any change would need to be permanent in order to have a discernable impact on the housing market. Currently, our view remains unchanged. The volume of mortgage lending is expected to be at a low point this quarter and gradually recover to a monthly average of £20 billion gross in fourth quarter 2008 and to an average of £25 billion per month in the first half of 2009.
The August Nationwide survey was far worse than expected. Average prices, based on the Nationwide index, fell by 1.9% in the month to an annual figure of minus 10.5%. This year there has been a significant correlation between reductions in house prices and reductions in the volume of net lending. Our current view is that we have seen the trough in mortgage lending, and therefore the low point in house price inflation is imminent. Our view remains that the average house price (mortgaged properties) is approaching a low point of minus 12% per annum. If, as we expect, mortgage lending volumes improve in the fourth quarter, and stamp duty is reduced, then average house price inflation may gradually recover in the Autumn and Winter months. We expect the annual rate of house price inflation to reach zero in Spring 2009, recovering to 5% per annum by the end of next year. Forecast risk is high. There are many reputable analysts who predict that the decline in house prices in the coming months will be severe. It is also important to emphasise that average house price data hides numerous regional and locality variations. Housing market sentiment is likely to remain uneasy for several months – with recovery dependent upon effective action by financial decision makers.
This document is the property of Bank of Ireland Global Markets UK (GMUK). The content may not be reproduced, either in whole or in part, without the express written consent of a suitably authorised member of GMUK staff. Any information presented within this document is only an opinion and is based upon current understanding. It is not advice.
