UK Q2 GDP Contracts Far More Than Expected

A preliminary estimate from the United Kingdom's Office for National Statistics (ONS) indicates that GDP contracted 0.7% quarter-on-quarter (q/q) in the second quarter of 2012. This was a far deeper decline than anyone had expected and cemented the UK's return to recession as it marked a third successive quarter of contraction. GDP had previously declined by 0.3% q/q in the first quarter of 2012 and by 0.4% q/q in the fourth quarter of 2011. Furthermore, GDP was down 0.8% year-on-year (y/y) in the second quarter of 2012.

Although part of the GDP contraction in the second quarter can be attributed to lost activity from the extra day's public holiday resulting from the Queen's Diamond Jubilee celebrations and to the very wet weather hitting retail sales and construction output, the economy's weakness clearly runs far deeper than that. This is highlighted by the fact that this was the sharpest GDP drop since the first quarter of 2009. It also means that GDP is now 1.4% below the level seen in the third quarter of 2011 and 4.5% below its peak level in the first quarter of 2008.

Prior to contracting since the fourth quarter of 2011, GDP had been erratic around a modestly expanding trend last year as it grew 0.6% q/q in the third quarter, contracted 0.1% q/q in the second quarter, and expanded 0.5% q/q in the first quarter. This erratic performance was influenced by distorting factors, with growth in the third quarter containing a major element of catch-up after activity in the second quarter had been held back by a number of one-off "special" factors (including an extra public holiday resulting from the royal wedding, manufacturing supply-chain disruptions resulting from the Japanese tsunami, and maintenance work in the North Sea hitting oil and gas extraction). Similarly, growth in the first quarter of 2011 was also lifted by a catch-up effect after activity in the fourth quarter of 2010 was hit appreciably by severe weather in December. GDP expanded just 0.8% (revised up from 0.7%) over 2011 as a whole, which was down markedly from expansion of 2.1% in 2010.

Sharply Falling Construction and Manufacturing Output Drag Down GDP

On the output side of the economy, GDP contraction in the second quarter of 2012 was primarily due to sharp declines in construction output and industrial production. In particular, construction output plunged 5.2% q/q in the second quarter following a drop of 4.9% q/q in the first quarter, causing it to be down by 9.7% y/y. Consequently, construction output contributed 0.4 percentage point to the q/q GDP contraction in the second quarter, as it had done in the first quarter. Industrial production accounted for a further 0.2 percentage point of the second-quarter GDP contraction as it fell by 1.3% q/q. This followed a drop of 0.5% q/q in the first quarter and meant that industrial production was down by 3.2% y/y. Within this, manufacturing output contracted 1.4% q/q and 3.1% y/y in the second quarter after a drop of 0.3% q/q in the first quarter.

Completing the unhappy picture, output in the dominant services sector (it accounts for 76.3% of GDP) edged down by 0.1% q/q in the second quarter following modest expansion of 0.2% q/q in the first quarter. Consequently, services activity was up just 0.7% y/y. Output in transport, storage, and communications sank 1.4% q/q in the second quarter and was only flat y/y. There was also contraction of 0.4% q/q and 0.3% y/y in the output of the distribution, hotels, and catering sector. This outweighed modest expansion in business services and finance (up 0.1% q/q and 0.8% y/y) and in government and other services (up 0.3% q/q and 1.3% y/y).

Falling Consumer Spending and Negative Net Trade Likely to Have Hurt GDP

No details have been released on the expenditure side of the economy in the second quarter of 2012. It seems probable, though, that lower consumer spending and negative net trade contributed to the contraction. In particular, it looks highly likely that there was a clear decline in consumer spending given that retail sales volumes contracted by 0.7% q/q in the second quarter. Although employment rose in the second quarter and consumer price inflation moderated, thereby easing the squeeze on consumers' purchasing power, it is likely that consumers were still keen to limit their overall spending as a result of the still significant pressures on them stemming from muted wage growth, tight fiscal policy, elevated debt levels, and a very uncertain outlook. Furthermore, unemployment is still high and many of the job gains have been part-time or low paid.

Meanwhile, trade data for April and May were disappointing overall and indicated that it was more likely than not that net trade was negative in the second quarter. Weakened Eurozone economic activity is limiting UK exports, while survey evidence has indicated that there has been a slowdown in foreign orders from the United States and Asia.

It is also hard to see business investment being anything other than soft given the recent weakness of the economy and the worrying and highly uncertain outlook. Meanwhile, public spending clearly could not continue to expand at the 1.9% q/q rate seen in the first quarter given the planned fiscal squeeze, although it may not actually have contracted in the second quarter. It is also possible that stocks were run down further in the second quarter. In the first quarter of 2012, GDP had been dragged down by a sharp drop in stocks (which knocked 0.6 percentage point off q/q GDP). Negative net trade had knocked a further 0.4 percentage point off q/q GDP as exports of goods and services fell 1.7% q/q while imports declined by a lesser 0.3% q/q. Meanwhile, consumer spending edged down 0.1% q/q. These negative factors had outweighed a 1.9% q/q increase in total investment that had been underpinned by a decent pick-up in business investment (up 1.9% q/q) after a fall in the fourth quarter of 2011. In addition, public spending rose by 1.9% q/q in the first quarter despite the fiscal squeeze.

Outlook and Implications

The UK economy is battling against an extended squeeze on consumer purchasing power (although this has eased recently, inflation is currently still running above wage growth), elevated unemployment, a need for many consumers to deleverage, a reluctance on the part of business to invest in worrying and uncertain circumstances, relatively tight credit conditions, tightening public spending and investment, and muted global economic activity (particularly in the Eurozone).

IHS Global Insight expects the UK to return to clear growth in the third quarter of 2012, helped by the staging of the Olympic Games and the making up of some of the activity lost in the second quarter as a result of the extra day's public holiday for the Queen's Diamond Jubilee celebrations. We expect the economy to then continue to grow in the fourth quarter as it benefits from lower oil prices, which have reduced the squeeze on companies' margins and helped inflation come down, thereby easing the pressure on consumers' purchasing power. Ultra-accommodative monetary policy will also help matters, hopefully including emerging benefits from the "funding for lending" scheme aimed at boosting bank lending to businesses and households.

However, ongoing serious Eurozone problems and sovereign debt tensions will continue to hinder UK economic recovery by limiting exports and causing major uncertainty and concerns that will hit business and consumer confidence, so constraining their willingness to invest and spend. Meanwhile, public spending cuts will increasingly have an impact. Consequently, in our July forecast we projected GDP to be only flat overall in 2012. However, the depth of contraction in the second quarter means that GDP now looks set to decline by around 0.5% overall this year.

The economy is expected to continue growing in the first half of 2013, but it is seen coming under increasing pressure from an escalation of Greece's problems that we believe will lead to that country leaving the Eurozone around mid-2013. Although strong policy action from Eurozone policy-makers and the European Central Bank (ECB) is anticipated to contain the fallout from Greece's Eurozone exit, it seems probable that a still fragile UK economy will be unable to avoid limited contraction in the second half of 2013. Consequently, UK GDP growth is forecast to be limited to 1.0% in 2013. Hopefully, a more settled and cohesive Eurozone will help UK growth to pick up appreciably during 2014.

Pressure Mounts for Further Policy Stimulus

The depth of GDP contraction in the second quarter of 2012 intensifies the pressure on the government to come up with more measures to try to stimulate growth. For the time being at least, though, the government shows no inclination to relent on its fiscal austerity measures and is increasingly looking for measures that do not affect its budget deficit, such as underwriting risk on large-scale infrastructure projects and launching the "funding for lending" scheme with the Bank of England. The longer the economy fails to achieve underlying significant, sustainable growth, the harder it will be for the government to stick to its austerity plans. If the government does eventually relent on fiscal austerity, the most likely measures will be an increase in direct capital expenditure on infrastructure projects and, possibly, some near-term tax cuts. The government would be unlikely to ease back on its planned spending cuts.

Pressure will also mount on the Bank of England to find more ways to help the economy. For now, the Bank of England will press ahead with the latest GBP50-billion (USD77-billion) extension to its quantitative easing (QE) programme that was announced in early July. This is scheduled to last through to early November and will take the stock of QE up to GBP375 billion. Further QE is highly possible in the fourth quarter, particularly if consumer price inflation falls back further, as seems likely. It is also possible that the Bank of England could eventually cut interest rates from the current record-low level of 0.50% where they have stood since May 2009, although we remain dubious that the Monetary Policy Committee (MPC) will choose to go down that route given significant doubts about the net beneficial impact of such a move. We believe that it is more likely that the Bank of England will keep interest rates down at 0.50% deep into 2014, and very possibly beyond.