XpertHR economic commentary August 2011: An absence of decent growth

Drought.jpgThe August 2011 XpertHR economic commentary assesses just how long the age of austerity might last as the UK endures a protracted and painful recovery.

The UK is now a little over one year into the age of austerity. Chancellor George Osborne’s high-risk strategy to tackle the UK budget deficit – described by some as “Osbornomics” – is well underway, and economic recovery is ongoing.

But what we are seeing is – to paraphrase one commentator – an “absence of decent growth.”

Osborne gave his assessment of the UK economic situation, in his annual Mansion House speech. He said that “stability has returned. Britain is on the mend. But it is taking time.”

There is widespread conjecture among official bodies and economic commentators as to exactly how much time economic recovery might be expected to take. For example, the CIPD argues that Osborne’s unswerving commitment to his economic strategy “risks crippling the economy for years to come and will make the task of deficit reduction even harder.”

There is consensus, however, that UK economic recovery is likely to be painful and prolonged. David Cameron has stated that the UK’s “path back to growth will be a difficult one.”

At the same time, concern is mounting about the global economic situation, with the euro area and the US experiencing crises (indeed, the IMF warns that the US crisis risks plunging the global economy into what it terms a “mega recession”). The extent of uncertainty is perhaps most simply illustrated by the record highs achieved by gold prices (the ‘flight to gold’ being a traditional response to economic hard times).

Here, we consider some of the arguments around the type of recovery that might be in store for the UK. We also report on the latest key economic indicators for HR professionals and employment practitioners.

UK economy grew by 0.2% in the second quarter of 2011

Economic recovery is ongoing, but extremely weak in 2011.

Eagerly-awaited preliminary figures on UK economic growth from the Office for National Statistics (ONS) reveal that growth in gross domestic product (GDP) ran at 0.2% in the second quarter of 2011.

This is down when compared with the latest revised estimate of 0.5% GDP growth in the first quarter of this year.

‘Events, my dear boy, events.’

The ONS suggests that second quarter GDP growth could have come in at 0.7%, had it not been held back by a number of “special events.” These “special events” comprise the following:

The additional bank holiday for the royal wedding; The royal wedding itself; The after-effects of the Japanese tsunami; The first phase of Olympic ticket sales; and Record warm weather in April.

ONS stresses that its estimates regarding the impact of these “special events [...] must be regarded as broad brush and illustrative.”

Macmillan cph.3b40592It might be argued that growth in any quarter of any year will always be subject to what Harold Macmillan termed “Events, my dear boy, events.”

However, Chris Dillow of Investors Chronicle contends that it might pay to take ONS’ views on the impact of these “special events” seriously.

Dillow says that “these one-off factors should [...] cause growth to bounce back in Q3 and Q4.” But Dillow also identifies further factors, which could serve to constrain growth in the latter half of 2011, including public spending cuts, rising utility bills and the possible impact of a euro area slowdown on UK exports.

Protracted and painful recovery in prospect

While a double-dip recession might have been avoided thus far, concerns are mounting that even the feeble levels of growth achieved in the second quarter of 2011 could be hard to sustain. Simon King of HSBC says:

It’s not so much the double-dip concern that we’re worried about, it’s much more the absence of decent recovery.

A protracted and painful recovery could well be in prospect for the UK.

The UK is currently enduring “an uncomfortable period” of necessary “adjust[ment] to the consequences of the financial crisis and the macroeconomic rebalancing,” according to Bank of England Governor Mervyn King. King also acknowledges that UK households are experiencing “a very substantial squeeze on real living standards” as a direct result of “uncomfortably high” inflation.

The Bank of England would appear to be of the view that growth will weaken further in the current quarter. The minutes of the July 2011 Bank of England Monetary Policy Committee (MPC) meeting noted “early indications that underlying growth might soften in the third quarter, in both services and manufacturing.” More clarity on the Bank of England’s expectations for growth will be set out in its latest quarterly Inflation Report, to be published next week (Wednesday 10 August 2011).

Other bodies have also expressed a view that growth is likely to weaken further:

  • The CBI publishes its latest economic forecasts today (Monday 1 August 2011). It expects UK GDP growth for 2011 to come in at 1.3%. This is down from 1.7% in its May 2011 forecast. The CBI expects GDP growth to accelerate to 2.2% in 2012.

  • The CIPD has revised down its UK GDP for 2011 from 1.6% to 1.4%, “because of the impact of higher than expected price inflation on real disposable incomes and consumer spending.”
  • The Ernst & Young ITEM Club has downgraded its forecast for UK GDP growth in 2011 from 1.8% to 1.4%. It notes that the UK recovery is “delicately poised,” with growth set to be “well below trend this year as inflation continues to squeeze household disposable incomes.”

Is permanent austerity in prospect (at least in our lifetimes)?

As noted above, the age of austerity recently notched up its first year. But could permanent austerity be in prospect, at least in our lifetimes?

The age of austerity may need to be prolonged and intensified in order to deal with the consequences of rising life expectancy, the Office for Budget Responsibility’s (OBR) Fiscal Sustainability Report suggests. The OBR finds that further cuts to public spending and further hikes in taxes could be required to offset the economic burden of providing for the UK’s ageing population.

The report includes economic projections for the next 50 years, which “suggest that the public finances are likely to come under pressure over the longer term, primarily as a result of an ageing population. [T]he Government would end up having to spend more as a share of national income on age-related items such as pensions and healthcare. But the same demographic trends would leave government revenues roughly stable as a share of national income.”

The report suggests that – if no action is taken – Government debt could be running at 107% of gross domestic product (GDP) by 2060/2061. The OBR concludes that “future governments are likely to have to undertake some additional fiscal tightening beyond the current parliament in order to address the fiscal costs of an ageing population.”

While it is not necessarily probable that economic austerity measures will remain a permanent fixture during our lifetimes, it is certainly possible.

The UK economy’s walking dead (1): Zombie companies

The Observer’s William Keegan argues that the UK economic situation is “grave.” But some other commentators have gone one step further.

Zombies NightoftheLivingDeadA recent spike in the use of zombie metaphors suggests that conditions in some areas of the economy might already have moved “beyond the grave.” They argue that the UK is plagued by “zombie companies” and “zombie households,” which threaten to pull weak growth back down toward zero (or beyond).

First, let’s take a look at the phenomenon of “zombie companies.”

New research from KPMG defines “zombie companies” as follows:

Businesses with low or no profitability which are accordingly unable to generate sufficient cash flow to repay borrowings. [...] Zombie businesses are stuck in a kind of corporate purgatory, unable to live and unable to restructure and move on.

The problem of “zombie companies” stems from banks artificially prolonging the life of companies that otherwise would have failed, via the practice of forbearance.

Forbearance is defined by the BBC’s Robert Peston as “vary[ing] the terms of a loan, when a borrower can’t keep up the payments or breaches the conditions, rather than pulling the rug.” The banks’ use of forbearance might be serving to conceal “hidden domestic threats to the UK’s financial sector,” in the view of the Financial Times.

Indeed, the latest Bank of England Financial Stability Report argues that the resilience of the UK economy might have been overestimated, and identifies forbearance as a potential medium-term risk to the UK banking system. It says that levels of forbearance could be “significant,” and that its use might explain the comparatively low level of company insolvencies in the UK. The report says:

Market contacts remain concerned that a deterioration in income streams, or increases in interest rates, could reduce borrowers’ ability to service their debts, reducing banks’ willingness and ability to continue to show forbearance”

So how significant a threat might be posed by forbearance? The Bank of England says:

A survey by De Montfort University suggests that, at end-2010, 12% of commercial property loans were in breach of financial covenant but had not been declared in default. This may, however, understate the number of loans in breach of their original terms.

The UK economy’s walking dead (2): Zombie households

The second type of “walking dead” that might pose a threat to UK economic recovery is “zombie households.”

The term “zombie households” was coined by Fathom Consulting’s Danny Gabay. Gabay defines “zombie households” as “[t]echnically insolvent but stumbling onwards.”

The ongoing squeeze on real incomes is only likely to exacerbate the economic threat posed by “zombie households.” As the Financial Times notes, many UK “households [have] had to dip into their meagre savings even to maintain their falling level of consumption.” The FT believes there is “no end in sight” to this trend for salary stagnation among “those around and below the middle of the income distribution.”

It is consequently likely that the number of “zombie households” in the UK will only increase. As economist David Blanchflower warns:

Life in Britain is about to become very tough.

Inflation falls back, but continues to outpace pay awards

Economic growth may be stagnant, but inflation has fallen back slightly, according to latest official inflation data from ONS:

  • Retail prices index (RPI) inflation rose by 5.0% over the 12 months to June 2011. This is down 0.2 percentage points from 5.2% a month ago. But while RPI has shown a slight fall, it remains 3.0 percentage points above the headline pay award of 2.0% (see below).
  • Consumer prices index (CPI) inflation – the Government’s target measure – rose by 4.2% in June 2011, down 0.3 percentage points on the previous month’s figure (4.5%). CPI consequently remains at a level that is more than double the Government’s target rate of 2%.

The fall in inflation reflects tough trading conditions for the UK’s high street retailers, the Financial Times notes:

[T]he reasons for [the fall in inflation] are not good news. We are now spending so much on things we need to buy such as food and fuel that retailers have had to lower the prices of things we want to buy like recreation and computer games.

This fall in inflation could prove short-lived – at least in the near term.

Many analysts expect inflation to begin to rise once more over the next few months, before reversing its trajectory to fall back sharply during 2012. For example, Telegraph Emma Rowley predicts that CPI “should hit 5% within months,” as planned utility price rises take hold. But she also notes that “supporters of the Bank say that inflation should drop back next year as the impact of this year’s VAT rise, recent spikes in energy prices and the fall in the pound wanes.”

Below-inflation pay awards mean recovery is more painful than recession

[W]e are in a topsy-turvy period. For most people, recovery is proving far more painful than recession. Real incomes held up surprisingly well in the recession but are falling sharply in the recovery.

This is according to Sunday Times Economics Editor David Smith. The fall in inflation noted above means that the gap between pay awards and inflation has narrowed slightly. But the headline pay award remains subdued for now.

The median whole-economy pay award was worth 2% (subscription required) over the three months to 30 June 2011, according to latest readings from the XpertHR pay databank. XpertHR pay editor Sheila Attwood writes (XpertHR subscription required):

For the time being, employers are unable to respond to high inflation by paying matching increases in employees’ wage packets. Instead, company performance/ability to pay is one of the most important influences on pay settlements, according to the latest XpertHR research.

The squeeze on UK workers’ pay packets is, if anything, likely to intensify further, argues the Ernst & Young ITEM Club. It says:

Workforce flexibility, while preserving jobs during the recession and keeping unit labour cost inflation down in the face of these import cost pressures, has hit real wages hard.

The Ernst & Young ITEM Club predicts that disposable incomes will fall by 1.4% in 2011 (following the 0.8% fall recorded for 2010). This trend is set to continue over the next two years, with disposable incomes remaining depressed into 2013, as “public spending cuts will [...] the pressure on the labour market and disposable income, while the reform of the benefit system will have additional effects on families dependent upon welfare.”

Are record-low interest rates here to stay?

An immediate interest rate increase would more than likely help stabilise inflation. But the MPC is unlikely to take such action.

Once again, the MPC voted to hold UK interest rates at the historic low of 0.5% in July 2011. And once again, the date at which the inevitable rate rise might be expected to appear has shifted further into the future. The minutes of its July meeting suggest that the case for a rate rise continues to weaken, as “recent developments had reduced the likelihood that a tightening in policy would be warranted in the near term.”

The current consensus among economic analysts is that an interest rate rise might be expected “well into 2012.”

But, as noted above, many analysts expect that inflation could have fallen sharply below current levels by that time. This could obviate the need for a rate rise, meaning that record-low interest rates might be here to stay for a still more extended period.

Euro area interest rate rise: ‘A classic policy error’?

In contrast to the Bank of England’s ongoing “wait and see” policy, the European Central Bank (ECB) has taken action to combat high inflation. The ECB raised the euro area interest rate to 1.5% (an increase of 0.25 basis points) in July 2011. ECB President Jean-Claude Trichet stated that euro area inflation is “clearly” going to remain above target over the coming months, with upward pressure coming “mainly from energy and commodity prices.” He said that it is of “paramount importance” that rising inflation “does not translate into second-round effects in price and wage-setting behaviour and lead to broad-based inflationary pressures.”

Economist David Blanchflower dismissed the ECB’s July 2011 rate hike as “a classic policy error,” which “will exacerbate the growth problems experienced by all countries.”

Unemployment falls slightly

Latest unemployment data brought some positive developments:

  • The headline unemployment rate (on the ILO definition) stood at 7.7% over the three-month period from March to May 2011, down by 0.1 percentage point when compared with the previous rolling three-month period (7.8%).
  • The number of people unemployed for more than 12 months was 807,000 over the three months to May 2011 (representing a fall of 37,000 on the quarter).
  • The youth unemployment rate was 19.7% in May 2011, down from 20.4% in the previous rolling quarter.

Despite this good news on falling unemployment rates, the UK labour market remains distinctly below par. The Observer’s Phillip Inman comments:

[T]he situation is dire for anyone without a job. Employers are biding their time, waiting for signs of an upturn before taking on full-time employees.

Inman’s view is borne out by ONS data revealing a record high in the numbers of people forced into part-time work “because they could not find a full-time job.”

The CIPD believes that unemployment will peak at 8.7% in mid-2012 (revised down from its previous estimate of 9.5%). The CIPD’s John Philpott argues that potential rises in unemployment have been limited by the ongoing weakness of pay awards. He says:

Just as pay freezes and pay cuts protected jobs in the recession, the ongoing pay squeeze is helping our anaemic economy support employment. This is clearly preferable to a further very sharp rise in unemployment. But a combination of falling real wages and the likelihood of unemployment well above the pre-recession level for several years to come represents an equivalent amount of labour market distress.

Osborne’s view that UK economic recovery is “taking time” is certainly accurate. But it remains to be seen just how protracted (and, in all probability, painful) recovery will prove to be.

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