SLI: First signs that the UK economy is weakening

It has now been a month since the referendum result on EU membership. We have written a good deal about how the large increase in uncertainty in the aftermath of the vote might feed through to activity – particularly through firms’ investment decisions and households’ spending on big-ticket items.

Slowly but surely, we are starting to get some early data, which is helping shed some light on the initial fallout. These data points have tended to be survey-based ‘soft’ data, rather than official
‘hard’ statistics, which will be released with more of a lag. However, in most cases we have seen clear signs of a sharp deterioration in activity. In large part, these indicators were on the B-list of most data watchers.

The Deloitte CFO survey showed a sharp fall in investment intentions; an Institute of Directors survey suggested likewise; consumer confidence dipped sharply; the Bank of England Agents survey was relatively sanguine. However, the release of a preliminary Purchasing Managers’ Index (PMI) for July provided more significant headlines.

These headlines were pretty sobering. The composite PMI registered its steepest fall over a single month on record to 47.7 – the lowest level seen since early 2009. The decline was particularly precipitous in the important services sector where activity and new business both fell sharply. This was severe enough for the sector to start cutting payrolls for the first time since late 2012.

Manufacturing was far from unscathed, despite a weaker sterling exchange rate boosting the competitiveness of more export corientated firms. Indeed, large declines in output and new orders more than offset the biggest increase in new export business in two years. How should we interpret the large deterioration in this survey? Traditionally, a reading below 50 is meant to signal recession, suggesting that the economy has started to contract markedly as we move into Q3.

In practice, this survey has a mixed record with regards to predicting growth rates and recessions. For instance, while it correctly identified the move into recession during the financial crisis, it overstated weaknesses in the domestic economy in the early 2000s.

The Bank of England (BoE) will be watching these data with interest. While initial readings are worrying, it is important to note that uncertainty over the impact of EU exit remains acute. Survey data can sometimes be erratic and overreact to short-term shocks.

Moreover, the Bank is currently looking at just one month’s worth of data in the immediate aftermath of the result. However, this persistent uncertainty should not be used as an excuse for inaction. Indeed, former MPC member Blanchflower, who has experience of seeing shocks hit the economy, has warned that it is no use waiting for the house to be engulfed by flames before
calling the fire brigade.

The BoE’s own empirical work on uncertainty shows that this can have severe and lasting impacts on growth. Initial data, while limited, corroborates this. Finally, the more limited reaction in financial markets, particularly equity and credit markets, likely reflects the expectation that material monetary loosening is coming. Accordingly, we would argue for a forceful package of easing in early August, including a rate cut, credit easing and asset purchases. If the Bank does not deliver this strong response, and opts to wait for more data, it risks further entrenching the downturn.

James McCann, European economist at Standard Life Investments 

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