What a difference a year makes…
Former British Labour Prime Minister Harold Wilson famously said “a week, in politics, is a long time”. Well what a difference the last year has made to the economics of the UK.
At the beginning of 2013, the talk was of a triple dip UK recession and sterling was falling like a stone. But now barely twelve months later, we discover there was no triple drip, not even a double dip (thanks to data revisions) and the potential worry now, is of an overheating economy.
The chart I have put together highlights that the timing of this recovery was actually in the midst of this early year pessimism. Turning points are notoriously difficult to forecast and often it is when pessimism is at its highest that it occurs – contrarians are often the best investors. It also shows us why economists are likely to underestimate the recovery’s strength.
The horizontal axis is time, in quarter of a year increments going back to Jan 07 to now – Dec 2013. The vertical axis denotes GDP, forecasts for each year in coloured lines and actual GDP in the pink blocks (from August 2013). So at the beginning of 2007, the average forecast for GDP for that year was a 2.5% (blue line). The forecasts were gradually increased during the year – the blue line rises – to predict a 3.1% growth. The actual outcome was a 3.4% expansion, shown in the pink block.
The first thing this chart shows is that the financial forecasting profession were way too optimistic about the financial crisis, pretty much all the way through (with the exception of the temporary rebound in 2010). The severity and scale of the downturn took all by surprise.Moving on to 2008, the initial forecasts made midway through 2007, is for growth of 2.4%. Those forecasts were gradually reduced over the next 12months – the dark pink line slopes downwards – so that by the end of 2008, the average forecast was 0.8% GDP growth. The eventual outcome shown in the pink block was a contraction of almost 1%. That is a big change from expected growth of 2.4% to a contraction of 0.8% in just over a year. And 2009 was even worse as can be seen from the steepness of the green line sloping downwards. Initial forecasts for an expansion of 1.8% changed to an actual contraction of 5.2%. 2010 actually saw some upgrades to GDP forecasts with the purple line rising, although that is just a rebound from the severity of the downturn in 2009 – easy comparisons. Forecasts for 2011 in turquoise and 2012 in orange go back to being way too optimistic and both lines slope downwards showing cuts to expectations of GDP throughout 2010, 2011 and 2012.
Secondly, the turning point for the economy is right at the end of 2012, beginning of 2013, just when all the doomsayers were at their worst, talking triple dip and sterling crisis. Forecasts for 2012, after being cut many times, finally increase – the orange line turns up. The forecasts for 2013 GDP – the pale blue line – increase –and the forecasts for 2014 also increase (last pink line). Predicting a turning point in an economy is notoriously difficult – as Norman Lamont’s much derided Green shoots comment testifies – but this chart shows it well. The UK economy has now finally and firmly turned the corner.
Thirdly the chart enforces my belief that the financial forecasting profession always underestimates amplitude. In 2007, economists underestimated the strength of the last boom year. And in the years of contraction, economists underestimated the scale of the decline. So in the boom years, forecasts were too low, and in the crisis the forecasts were too high. This, combined with anecdotal evidence, is why I think the UK economy is much stronger than currently forecast. There will be upgrades and positive surprises to come.
Clearly a stronger UK economy should be beneficial to Sterling. Looking at a five year cable chart:
GBP/USD 5 years
In the last months, sterling has already strengthened relative to the dollar, as the UK recovery has gathered pace and Washington has been embroiled in its budget mess. However sterling may have a lot further to go as GDP surprises on the upside.
Sterling’s recent strength against the euro has been a lot less pronounced, because the story is also of a recovering Europe, albeit more slowly:
EUR/GBP 5 years
There have been a number of positive and important data releases this week for the UK. Nov CPI inflation fell to 2.1% the lowest rate in four years. Controlled inflation is a support for Sterling. Unemployment fell to 7.4% which if the trend continues is only months away from falling to the Bank of England’s target of 7%, where rate rises will be considered. And 3Q GDP was revised to 1.9% yoy up from 1.5% yoy (although the qoq figure was unchanged). The 2Q figure was also revised up. In an upturn, the strength of the recovery always tends to be under estimated, expect the same this time, although it may take many quarters of revisions to see the true figures.
In the Eurozone, the recovery is much more muted than the UK and at a much earlier stage. The ECB was comparatively slow to cut rates initially and still has one more potential rate cut left. The Federal Reserve announced QE tapering this week under the outgoing Bernanke, but under Yellen it remains to be seen how quickly the taper will occur. Some suggest it may take a whole year to withdraw the stimulus. Compare that to the UK, where if unemployment falls continue, the Bank of England will, in a matter of months, have to start talking about rate rises. All that argues for a stronger sterling relative to the dollar and euro.
However I doubt Mark Carney will want to raise rates ahead of the Fed. We know he was a political appointee charged with delivering strong growth ahead of an election. He must be nervous that the spectre of higher rates could choke off the recovery. And falling inflation gives him an excuse not to act. I think it is more likely that the target unemployment rate will be reduced from 7% to 6.5%, rather than raise rates. But even if the rate rise is postponed further into the future, sterling should still do well if the data continues positively. The 4Q GDP figure is likely to be strong with a 1% qoq forecast at the moment. 2014 is likely to be the first year where the increase in private sector wages is larger than the increase in prices, helping consumer spending. And although the most recent public sector borrowing figures were the highest on record it will not be long before stronger growth starts to impact the borrowing figures a lot more than most expect.
2014 could be a year for Britons to look forward to.
