Can the UK economy complete its recovery in 2021?
Hopes for a fast recovery are rising, but fragilities will mean policy support will be required for some time.
It has been a tough start to the year, but as the first quarter draws to a close, we examine the progress made in tackling the Covid-19 pandemic, and the prospects for a strong economic recovery. This note builds on the details of the forecast presented in the March Economic and Strategy Viewpoint.
Vaccines offered hope, speedy inoculation will solidify the recovery
A year on from the start of the pandemic, the UK has generally underperformed its peers on most measures. It has had one of the highest infection and fatality rates, one of the worst recessions, and has been one of the countries with the most days lost to lockdowns.
These facts will hurt the government’s standing in the eyes of the public when the time comes to pass judgment. However, its success so far in rapidly vaccinating its population will help not only to aid the UK’s economic recovery, but also help the government’s popularity rating.
The UK now has one of the lowest numbers of confirmed Covid-19 cases as a share of its population in the advanced world (using a seven-day moving-average, see chart 1). This has partly been down to the strict restrictions imposed, but also the vaccine programme. According to ourworldindata.org, 37.2% of the UK population has received one of two doses, while 2.6% is now considered fully vaccinated (chart 2).
The UK government’s decisions to place early and large orders across many manufacturers, along with spreading the stock thinly through the population to improve overall immunity, appear to be paying off. By comparison, the US has a higher share of its population that is fully vaccinated, but a lower share has received its first dose.
The UK’s progress will slow in the coming few weeks as supply issues delay first jabs. Priority is being given to giving people their second jab on time. Meanwhile, Europe’s progress is woefully behind, which is already leading to lockdowns being extended well into the second quarter, and perhaps even into the third.
What does the “road to freedom” mean for the economy?
On 22 February prime minister Boris Johnson, outlined a “one way road to freedom”. Schools reopened earlier this month, with non-essential retail expected to re-open from 12 April. Hospitality is likely to follow from 17 of May, with remaining restrictions on social contact and high risk activities removed from 21 June. This is somewhat slower than we had expected, but despite this, we upgraded our UK growth forecast at the end of last month.
We now forecast Real GDP growth to rise from -9.9% in 2020 to 5.3% in 2021. This compares to our previous forecast of 5%, and consensus estimate of 4.2% (Consensus Economics February survey).
The first quarter of the year is likely to see a larger contraction than previously expected. Indeed, monthly GDP data showed a contraction of 2.9% in January compared to December, but the economy should more than offset this in the following quarters as restrictions are lifted.
We have also revised up our forecast for growth in 2022, from 4.5% to 5.1%. This is partly due to improved businesses confidence, which should help lift capital expenditure as spare capacity is utilised. But it is also driven by an upward revision to our estimate of household savings, which provides more room for a spending recovery.
Our forecast is for the economy to complete its recovery - that is, the level of GDP to rise back above its pre-pandemic peak - in the second half of 2022 (chart 3). This is a little later than the Office for Budgetary Responsibility’s (OBR) forecast of Q2 2022 (as published alongside Budget 2021). And much later than the optimistic forecast from the Bank of England (BoE) that it will recover by the end of 2021. The latter is important for monetary policy, which we will return to later.
As for inflation, we have revised our forecast up for this year largely due to a sharp rise in wholesale energy prices (chart 4). Compared to our November forecast, the price of a December 2021 contract for Brent Crude has risen by over 30%, and more since we finished the forecast.
As we approach the anniversary of the pandemic and the collapse in oil prices last year, the annual comparison of prices spikes up due to base effects. The contribution from energy inflation to headline CPI is forecast to rise by a full percentage point by May compared to the end of last year. The impact would have been larger had we not seen the recovery in sterling against the US dollar in recent months.
Core inflation (excluding energy, food, alcohol and tobacco), is also due to rise as the effect of several fiscal initiatives fade. These include the “eat out to help out” scheme, along with the VAT reduction on hospitality services.
Importantly, though headline inflation is forecast to rise above 2% in the near-term, by 2022, inflation is expected to moderate and fall back below 2%. Ultimately, though there are some sectors that face cost pressures that will pass those on to consumers, the majority of firms are likely to now have considerable spare capacity, and potentially face weaker demand, culminating in a deflationary backdrop over the forecast horizon.
Two vulnerabilities to watch
Why is the Schroders forecast less optimistic on the speed of the recovery? We think there are two key areas of vulnerability that are less well understood:
1. The build-up of inventories
Brexit has not helped matters through this period. The latest trade release brought to light the extent of the disruption to businesses and trade in goods. The value of exported goods to the European Union (EU) in January 2021 - the first month since the end of unfettered trade – fell by £5.5 billion or 40.5%. Meanwhile, imports from the EU were down £6.6 billion, or -28.9%. Though the fall in the UK’s trade deficit with the EU will be celebrated by Brexit supporters, it only unwinds the sharp increase in the deficit seen at the end of last year – almost 20% between October and December.
It appears that firms on both sides of the channel had been stockpiling goods and supplies, possibly as insurance against a failure by authorities to agree a trade deal, though data clearly shows that UK companies imported more than they had exported.
Interestingly, the build-up of inventories helped the UK avoid a technical recession, as it boosted GDP growth at the end of last year (chart 5). However, it now means that inventory levels are very high, and UK companies will probably reduce production, and possibly even discount stocks, in order to clear excess inventories. This would suggest downside risk to growth ahead.
2. Furlough dependency
The second cause for concern is the high dependence of both households and firms on the government’s furlough scheme.
Despite attempting to improve its efficacy last year by asking firms to pay part of the contribution for furloughed staff, chancellor Rishi Sunak backtracked on the move as the nation returned to lockdown. The full cost of the scheme was again shouldered by the exchequer, and he even asked firms to re-hire staff made redundant, just to make them eligible for the furlough scheme.
Latest figures show that the official unemployment rate was 5.1% in the three months to December 2020, but this excludes the 4.7 million employees that have been furloughed (13.8% of the working population), the 2.2 million self-employed workers receiving aid (6.4%), or the or the estimated 3 million self-employed that have been “excluded” from receiving any help from the government (8.8%).
As chart 6 shows, the true unemployment figure is likely to be closer to 20% - a record high during peace times. But this is already lower than its peak last year. Less restrictive lockdowns have helped reduce the impact this time around.
As the economy opens up, and support is withdrawn, we do expect the official unemployment rate to rise to over 6%, but the re-opening of businesses is likely to help most of those currently furlough back to some form of employment.
Policy response: spend, spend, tax?
Given the number of updates, you would be forgiven for thinking that Rishi Sunak has been holding the nation’s purse-strings for years. However, in only his second annual Budget, the chancellor decided to extend most pandemic related support measure to September – understanding that it would take time for companies to get back to normal activity. The cost of the various measures would raise borrowing by a further £67 billion (3.4% of GDP) over this financial year and next (chart 7).
Virus-related support measures would then be reduced in 2022-23, as fiscal consolidation begins. This starts with the freezing of uplifts for personal tax allowances, along with other smaller measures. This has the effect of capturing more tax as people’s incomes grow, moving them into higher tax brackets.
The other major tax change announced was the increase of corporation tax, where it will rise from 19% to 25% by April 2023 for companies that report profits of more than £250,000 per year. Smaller companies with less than £50,000 in profits, will continue to enjoy the 19% rate, with the remaining seeing a tapered rate between the two thresholds.
The increase in the corporation tax rate will at the margin make the UK a less appealing base for companies. But the government argues that at 25%, the UK will still have the lowest corporation tax rate in the G7. However, when considering exemptions and reliefs, this claim does not hold. The chancellor did though concede that the extra levy on banks would have to be reviewed (and most likely lowered) in light of the increase in the headline tax rate.
The hike in the corporation tax rate is the first since 1974. It is a major reversal of policy from a government that lowered the headline rate from 28% to 19%, and has always believed in a having a low tax economy. Overall taxation as a share of GDP is set to return to highs also not seen since the mid-1970s.
There were, however, plenty of incentives to help boost business investment, including the creation of free-ports, but the one that caught our attention was the super deduction on investment costs, where companies will be able to reduce taxable profits by 130% of the cost of investment projects. The incentive will run from April this year to March 2023.
Unfortunately, this has only been introduced for investments on plants and machinery, and is to be capped at 25% of profits. So, while it will help boost demand for construction projects and for manufacturers, its excludes the biggest part of the economy, which has also taken the largest hit during lockdown: the services sectors!
Overall, it is clear that the chancellor is willing to continue to support the efforts in tackling the virus. However, the lack of economic recovery measures is a little disappointing, and the rush to re-introduce austerity seems odd.
BoE: optimism returns, but no rush to raise rates
Getting public finances back on track was the other main theme of the budget. The UK’s budget deficit for financial year-to-date (February) stands at £261.4 billion – 80% higher than at the same time as 2009/10, during the height of the global financial crisis.
The chancellor warned on the impact of a rise in interest rates, and how a 1 percentage point rise in the benchmark 10-year gilt yield would result in £25 billion of extra borrowing. Since the start of the year, the same benchmark yield has risen by 0.66 percentage points.
The stronger-than-expected global recovery, particularly in the US, has driven borrowing rates for governments higher (prices lower). This is as demand from investors for safe haven assets has shifted towards riskier equities, among other asset classes.
In addition to the stronger recovery, markets had priced in the possibility of the Bank of England cutting interest rates below zero earlier in the year.
The Bank had been investigating negative interest rates as a new policy tool, but February’s monetary policy meeting may have put paid to that.
The committee had concluded that it could not be introduced without proper notice to commercial banks, which would take at least six months. Given most investors expect the economy to pick up sharply over the summer, that effectively ruled out any further cuts to interest rates. This resulted in bond yields rising.
At its March monetary policy meeting, the committee kept rates and asset purchases unchanged. It cited better news on vaccinations, the plan to re-open the economy, stronger than expected growth and higher inflation in the near-term. Despite this, the Bank was at pains to stress that more stimulus would be provided for the economy if required. It would not “…tighten monetary policy at least until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably.”
We continue to expect the BoE to keep its main interest rate at 0.1% until 2023, and to maintain current asset purchases until the end of this year. The Bank’s ultra dovish stance suggests that it will look through the spike up in inflation in the near-term, and only really begin to worry if there are signs of second round effects. That is, wage inflation rising in response to higher inflation, which in turn could drive inflation even higher.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.