Our Opinion: 2018

UK growth better than expected in 2017

The UK economy outperformed consensus last year, with growth looking set to finish at around 1.5%. While better than expected, it still marks a slowdown, and is noticeably lower than the average of the previous three years.

The slowdown – in real income and rates of business investment – is likely to persist for some time. Additional headwinds for households are also likely to emerge. The impact of higher interest rates following the recent Bank of England hike is likely to hit first, followed by the ability to smooth consumption from other income sources, especially in light of the current low savings ratio.

Nevertheless, these obstacles should fade. With inflation gradually trending back toward the 2% target this year, the pressure on real income growth should ease. And though it is too early to be certain, some tentative evidence suggests that tight labour markets and domestic skills shortages might be leading to higher wage settlements.

As for business investment and hiring, the progress made on Brexit negotiations will likely have lessened uncertainty. The UK looks set to enter a transition agreement with the EU from the March 2019 exit date through the end of 2020. During this time, little should change operationally for most firms (subject to negotiation of course), which will ease the adjustment. Unquestionably, uncertainty about a final agreement will linger, so it too early for a rebound of business investment. Still, the threat of a sharp near-term slowdown should diminish.

Another positive to consider is the external sector. The rising broad-based global economic growth we forecast, along with an under-valued pound, should enable net exports to boost domestic GDP expansion over the next couple of years.

In sum, this points to an economy muddling through as it adjusts to a new trading relationship with the EU and the rest of the world. But, as always, there are risks. Most are likely to centre on how the government negotiates the next phase of Brexit.

With phase one of the talks complete, attention now turns to the transition and to trade. Political negotiations are always difficult to forecast. And Prime Minister Theresa May faces many challenges in trying to come to a transition arrangement with the EU that is acceptable at home, especially to some factions of her own Conservative party. A deal, however, is likely to be concluded as it is in both sides’ economic interests to ensure a smooth transition.

Once it is agreed, talks about the future trading relationship will return to the fore. They are likely to be as bruising as phase one was and generate plenty of media attention. If the government sticks to its current red lines, the only reasonable conclusion is that the UK will eventually leave the single market and the customs union. This initially suggests that the type of trade deal it can reach with the EU will resemble the Comprehensive Economic and Trade Agreement (CETA) that the EU has with Canada. This agreement only covers goods and crucially excludes services, an area where the UK excels. Of course, much can change during negotiations, but this cloud of uncertainty is likely to hang over business and consumer sentiment until the final terms are known.

Weaker growth, falling inflation, a softer labour market and uncertainty about the Brexit outcome are not an ideal backdrop for tighter monetary policy. So, for now, the Bank of England is likely to keep rates on hold through this year and next.

Despite an 8% rate of return last year, the UK equity market was one of the worst regional performers globally as its defensive sector make- up didn’t keep pace with more cyclical markets. This year could produce further gains, with a likely increase in volatility. Sterling has been the main conduit for Brexit risk, and this has offset some of the concerns about the future of the financial services industry which has a sizeable weight in the equity market index. As the deadline for leaving the EU approaches, volatility could increase in these areas, but, ultimately, global growth is likely to fuel the UK equity market, since 70% of its revenues are generated outside British borders.


13thh January 2018