The Outlook for the UK Consumer Sector A Note. Gavyn Davies. 9 May Overview

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1 The Outlook for the UK Consumer Sector A Note Gavyn Davies 9 May 2018 Overview Consumers expenditure accounts for 66 per cent of GDP in the UK. There is therefore a huge variety of investment opportunities within the sector, and the rest of the economy is inevitably affected by consumer trends. There are few places to hide from the consumer: any recession in consumer spending would take the rest of the economy down with it. Growth in real consumers expenditure has slowed since the Brexit referendum in June, Real disposable income has been squeezed by higher taxes, reduced benefit payments and the rise in inflation that has followed the depreciation in sterling, which has raised import prices. In addition, there has been a drop in household confidence about the future of the economy. Nevertheless, households have dipped into their savings in order to cushion these effects, and prior to the start of 2018, real consumers expenditure had continued to rise at about 1.5 per cent per annum. The first quarter was, however, extremely weak. The worst of the squeeze on real household incomes is probably now over. Sterling has stabilised, and the pass-through into higher import prices is mostly complete. This means that the squeeze from higher inflation should begin to abate in the next few years. However, with the boost from declining savings also now over, the rise in real consumers expenditure is generally expected to be around per cent per annum. This is lower than the growth rates achieved in , but it is a long way from a consumer recession. The following graph shows the latest official projections for consumption from the Office for Budget Responsibility. Note that the scale shows quarterly, not annual, rates of growth:

2 Key Factors for the Consumer The following are key factors in determining the consumer outlook in coming years: 1. The labour market is still extremely strong, with unemployment now having fallen to the rate considered by the Bank of England to represent full employment. Wages growth is beginning to rise, but only very slowly. This should support consumer confidence and real incomes growth in the next few years. A reduction in inward migration will, however, cause recruitment problems for some low skilled consumer sectors, especially in London. 2. The housing market has been slowing lately, with house price increases now down to 2 per cent per annum, compared to 7 per cent two years ago. The house price/earnings ratio is back to the levels seen before the 2009 financial crash, implying that the market is expensive. In addition, household debt has started to rise again, after several years of deleveraging after the financial crash. These factors would make the consumer balance sheet vulnerable to a large rise in interest rates that could lead to a larger downturn in the housing market. But the good news is that there are no signs that the Bank of England intends to increase interest rates aggressively. 3. The Bank tolerated an overshoot of 1 per cent in inflation last year relative to the 2 per cent target because it believed that the overshoot would prove temporary, and did not merit taking risks with the economic recovery. This decision seems to have been justified. The dominant message from the MPC in recent months has been that households should expect a very gradual increase in the bank rate in coming years, possibly amounting to 1 percentage point over 3 years. However, even that now seems dubious, given the dip in GDP growth seen in the first quarter of A relatively dovish Bank for a long period ahead now seems probable.

3 4. Household disposable incomes will continue to be held back by further fiscal tightening in the rest of this Parliament. This will result in a freeze in household benefits for working age people, and a further rise in the real burden of income tax. Nevertheless, the buoyancy of the labour market is expected to result in annual growth in real disposable incomes of around per cent, slightly better than seen in Consumers expenditure has been boosted this decade by a continuous decline in the savings ratio as confidence has recovered from the crash. This was particularly important in and Forecasts suggest that the savings ratio will decline further, though not at the pace seen in recent years.

4 6. Brexit is likely to have a significant effect on the consumer outcome in the next 3 years at least. Confidence in the economy has been declining, but households continue to feel comfortable about the financial situation facing their own families. Prospects of a hard Brexit could lead to recessionary forces gathering momentum, and to a further depreciation in the exchange rate, in which case the outlook for the consumer would darken considerably. We assume, however, that a soft Brexit takes place, with a lengthy transition period (probably several years) before the final economic destination is reached. In such a soft Brexit scenario, sterling could rise, leading to faster growth in consumers expenditure than shown in the main case above.

5 7. Profit margins in the consumer sector have been hit recently by higher wages, rates and rents, and by the effects of devaluation on energy and other import costs. Furthermore, competition is fierce in some sub sectors (eg restaurants), following excessive expansion in capacity in In addition, technological change is clearly damaging the bricks and mortar retail sub sector. However, these changes simultaneously help other sub sectors such as tourism and internet retailing, and new entrants to some sub sectors will be helped by falling rents and occupancy rates. New opportunities will, as always, present themselves, even in a less buoyant backdrop for overall consumer spending.

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