Contents Foreword Highlights Introduction Forecast in detail Fiscal policy Monetary policy Prices and wages Activity Consumer demand Housing market

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3 Contents EY is the sole sponsor of the ITEM Club, which is the only non-governmental economic forecasting group to use the HM Treasury model of the UK economy. Its forecasts are independent of any political, economic or business bias. Foreword 2 Highlights 4 Introduction 5 Forecast in detail Fiscal policy Monetary policy Prices and wages Activity Consumer demand Housing market Company sector Labour market Trade and the Balance of Payments 17 EY 1

4 Foreword Mark Gregory Foreword An uncertain outlook EY Chief Economist The economic news has been generally gloomy in recent months and it was no surprise to me that the EY ITEM Club Spring forecast suggests that the UK outlook has weakened significantly since the turn of the year. EY ITEM are now forecasting GDP growth of 2.3% for 216, compared to the forecast of 2.6% in January. Drawing on the public data and commentary, EY ITEM feel that business confidence has fallen as a result of concerns about the weakness of the global economy and the upcoming referendum of the UK s membership of the European Union (EU). UK exports have also disappointed in part due to the slowdown in emerging markets. Consumer spending continues to grow but the forecast reflects the fact the economy is running on this one engine and that there are a number of factors which will cause it to slow as we move beyond 216. but still time to think longer-term It would be easy for UK businesses to get caught up in the economic gloom and embark on very defensive strategies. However, there a broader set of economic challenges facing UK businesses which require attention. The most important of these are: A slowing in the rate of the increase of consumer spending as a result of a fall in the rate of growth of real disposable incomes and a likely reduction in the high rate of job creation seen in recent years, as the higher costs of employment start to bite; An increase in operating costs due to the combination of a declining pound which means import costs will increase, the return of inflation and, once again, the higher costs of employing people due to the introduction of the National Living Wage, the Apprenticeship Levy and the Single Tier Pension. In parallel, technology continues to develop meaning there is an increasing potential to use it to disrupt current business models. At EY, we continue to see technology deals as the largest category of M&A activity in both the UK and the global economy. With the consumer still likely to provide reasonable support to economic growth in 216, now is the time to look beyond short-term concerns and focus on positioning the business as effectively as possible for the long-term. about the business model. The UK recovery has been characterised by extremely high levels of job creation facilitated by increased labour supply and relatively restrained wage increases. With output growth increasing at a slower rate than the EY 2

5 Foreword Foreword workforce, productivity has fallen, leading to a view that labour may have been used to substitute for capital. With labour becoming relatively more expensive, it is time to evaluate the relative balance between capital and labour in the business model and work through the implications for capital investment. Enhancing operating efficiency is not the only way that investment can drive productivity. In a challenging economic environment, there is a need to look to new sources of revenue and here digital technology may have a positive contribution to make either in facilitating new forms of customer engagement or enabling the creation of new products and services. Looking to get more from the existing workforce by growing the top line rather than a focus on cost reduction could be a winning strategy. But be prepared for June 24th. The EY ITEM Club forecast, like that of the Office for Budget Responsibility, is constructed on the basis of unchanged government policies. It is therefore based on the assumption that the UK will remain part of the EU. This assumption sees business investment bouncing back after the EU referendum and therefore underpins growth of 2.6% in GDP in 217. Business investment alone is expected to add 1.2% to GDP in 217. The UK could choose to leave the EU on June 23rd at which point the economic outlook would be uncertain during the period of transition. I was struck by the wide range of outcomes for the key drivers of the UK economy outside of the EU and hence the large number of possible scenarios. Against this uncertain backdrop, it seems to make little sense for companies to undertake detailed planning now. It is better to wait for the vote and respond as the details of the future environment become clear. However, a sensible approach would be to have a short-term plan on how to manage through the initial period of a leave scenario. The focus should be on stabilising relationships with customers, partners, suppliers, employees and shareholders, buying time to develop more detailed plans over time. EY 3

6 Highlights Highlights The forecast shows growth of 2.3% in GDP this year. This is in line with the latest estimate for 215, which was heavily dependent upon the consumer, supported by the strong labour market and low inflation. Although these tailwinds remain in place this year, households are unlikely to be able to sustain this drive for much longer as inflation and austerity progressively undermine the growth in real disposable income. Household spending has also been growing faster than income, cutting their saving ratio to an all-time low of 3.8%. The household financial deficit also reached a record 43 billion in 215. However, that reflects the high level of spending on housing rather than consumption. Households invested a record 95 billion in housing last year, 7.8% of their disposable income. In contrast, their investment in financial assets, net of sales, was just 28 billion, lower than at any time since this series began in It seems clear that the low interest rates and high equity prices engineered by central banks in response to the financial crisis have encouraged households to invest in housing rather than low-yielding financial assets. This is the main reason why their move into heavy financial deficit has not been accompanied by the surge in bank borrowing that we saw in the run up to the crisis in 27. On this analysis, the economy is less prone to a banking crisis than it was then. Nevertheless, in our view the high level of house prices relative to income does pose a risk to financial stability. Affordability also poses a risk to social cohesion, threatening to lock younger generations out of the housing market. Companies have been reluctant to follow consumers in switching from financial to real investment. They continue to run huge financial surpluses, amounting to 32 billion in 215. Companies hit the pause button last summer as risk appetite was undermined by uncertainty about the global economy and this year s referendum on EU membership. The forecast is constructed on the assumption that the UK remains a member of the EU following the referendum. On this view, we should see a rebound in investment following the vote, as spending held back by the associated uncertainty comes through. Profitability in most sectors is moving up to progressively higher levels, while the return on financial investments is progressively depressed. The cost of labour is also rising as the Living Wage is introduced and levies on businesses are increased. On this view, investment adds 1.2% to GDP next year, making up for the expected slowdown in the consumer sectors and pushing the growth rate up to 2.6%. However, that looks like the high point in this cycle as inflation progressively saps consumer spending power and austerity tightens its grip on consumers and companies alike. EY 4

7 Introduction Introduction The forecast shows growth in GDP of 2.3% this year, driven largely by the consumer and consumerfacing businesses, the main beneficiaries of the low inflation precipitated by the collapse in commodity prices. These sectors are expected to slow down next year as inflation begins to move back towards the CPI target and taxes and other levies on consumers and companies increase. The forecast is based on unchanged government policy, which means that the referendum is assumed to keep the UK in the EU. On this view, we should see a rebound in investment following the vote, as spending held back by the associated uncertainty comes through. Investment adds 1.2% to GDP next year, making up for the expected slowdown in the consumer sectors and pushing the growth rate up to 2.6%. The consumer remains in the driving seat The latest national accounts statistics suggest that consumers are on their own in driving economic growth at the moment, but raise questions about how long this drive can continue. Consumption grew by 2.5% in 214 and another 2.7% last year, helped by a recovery in real disposable income as wages picked up and price inflation fell back to negligible numbers. These tailwinds remain in place this year. Disposable incomes will be supported by the increase in the personal tax allowance and the introduction of the National Living Wage (NLW) this month. Surveys suggest that consumers are becoming concerned about the economic outlook but remain bullish about their personal financial situation, with a continued appetite for making large purchases. as companies hit pause last summer On the other hand, business investment stalled in the second half of last year. Industrial surveys have weakened further this year, suggesting that concerns about the strength of the global economy and the referendum on the UK s membership of the EU have undermined business confidence and held back the upturn in capital spending that we enjoyed until last summer. Exports, which were growing reasonably well until last summer, also stalled in the second half of 215, while import growth picked up. Overseas income was hit by the slowdown in the Emerging Markets in the final quarter of 215, making the current account deficit of 7% of GDP the largest on record. It is abundantly clear that the imbalances which have been a feature of the UK economy for the past two decades continue to widen. but how long can the consumer maintain this drive? The national accounts raise questions about the ability of households to sustain this expansion, suggesting that the household saving ratio dropped to just 3.8% in the final quarter of last year, the lowest since records began in Moreover, with household investment in housing now reaching 5% of GDP, the household sector ran a financial deficit of 41.3 billion in 215, 2.2% of GDP, well above any historical precedent. This deficit accounted for 42% of the 97.3 billion deficit that the UK ran with the rest of the world last year.. House prices have been moving up much faster than incomes. This sort of consumer-led expansion normally ends in tears, just as it did in 27, when the seizure of the international credit markets collapsed the Northern Rock and the value of the pound within weeks, leading eventually to the worst recession since the war. EY 5

8 Introduction UK: Savings ratio % of disposable income Headline savings ratio 14 Discretionary saving Source : Haver Analytics UK: Personal sector saving % of disposable income Savings ratio 14 Net acquisition of financial assets Source : Haver Analytics It is hard to see how regulators can keep the financial system and the economy safe in the face of such exposure to global shocks. However, lessons were learned from the last crisis, and it seems unlikely that borrowers, lenders and their regulators will be prepared to run risks with bank credit again. Certainly, households are a lot less dependent upon credit than they were in the run up to the crisis. Household borrowing, net of repayments, was remarkably flat in the five years following the crisis, reflecting the poorly functioning credit market. Borrowing only began to recover after the Chancellor s move to revive the mortgage market with his Help to Buy schemes in the 213 Budget. The saving ratio is at an all-time low So how have people been able to drive this recovery without resorting to bank credit? The clue is provided by the behaviour of housing equity withdrawal (HEW). This is the difference between the figures for mortgage borrowing and investment in housing shown in the next chart. Before the credit markets collapsed in 27, mortgage borrowing was running well ahead of housing investment because people were using equity release as a major source of cash. There was a lot of speculation at the time about what people were doing with this money. UK: Housing equity withdrawal bn Housing investment HEW Mortgage borrowing Cash injections Source : Haver Analytics UK: Financial investments and housing equity withdrawal bn Financial investment -2 Equity withdrawal Source : Haver Analytics However, HEW is now heavily negative: cash injections are pushing housing investment up much faster than borrowing. Low interest rates have encouraged existing homeowners to pay down the mortgage rather than invest in low yielding financial assets. Cash buyers have been selling financial assets and more recently some retirees have apparently been cashing in their pension pots to become buy-to-let landlords. The bank of mum and dad has also been raided to help the children get their feet on the EY 6

9 Introduction housing ladder. The boost to equity prices provided by Quantitative Easing has facilitated this massive portfolio reallocation. but so far, housing investment has been financed by cash Financial and housing investment must be financed by saving or borrowing. In other words, financial investment is the sum of saving, housing equity withdrawal and unsecured borrowing. This relationship is shown in the second chart above. It suggests that one way or another the surplus cash from HEW before the crisis found its way into ISAs and other personal financial investments. These investments were very buoyant at the time. Now, once sales are deducted from purchases, these investments are running at much lower levels as home owners and landlords raise cash to invest in real estate instead of borrowing. This should make the economy less vulnerable to a future banking crisis, although the elevated level of house prices remains problematic. UK: Household debt-to-income ratio % of disposable income Source : Haver Analytics UK: House prices to income ratio Index, 2 = Source : Haver Analytics rather than borrowing This time, bank credit is the dog that has not barked. Arguably, another reason for this is that people have turned to the labour, rather than the credit, market to support their spending. Indeed, although the credit market has functioned abysmally in this economic cycle, the labour market has performed amazingly. Employment held up relatively well during the recession, as workers opted for cuts in real wages to preserve their jobs. Between the end of 29 and 215, employment increased from 7.6% of the population of working age to 74.1%, while average hours, which usually trend down over time, increased from 31.5 to 32.2 a week. In contrast, the employment rate remained flat at around 72.8% between the end of 21 and end 27, while average hours fell from 32.5 to 31.9 a week. These jobs-rich, wage-weak trends help explain why employers took on more staff rather than investing, weakening productivity growth. They are however likely to be slowed by the introduction of the NLW this month, as well as the single-tier pension, which will cost employers and employees that were contracted out of the second state pension an estimated 5.5 billion a year. Employers also need to finance the auto-enrolment of pensions and the apprenticeship levy that comes into effect this time next year. They will surely be looking for efficiency gains to offset these increases in labour costs. The forecast The forecast shows growth in GDP of 2.3% this year, driven largely by the consumer, the main beneficiary of the low inflation precipitated by the collapse in commodity prices. It is assumed that the MPC continues to look through these low inflation numbers and focus on the outlook for 217 and beyond, which depends on wage inflation, productivity and the strength of the economy. It will be difficult to justify an increase in interest rates while inflation remains so low and we do not expect an EY 7

10 Introduction increase in base rates until the spring of 217. However, fiscal policy is already tightening and inflation will begin to move back towards the 2% CPI target as oil and other commodity prices stop falling. The forecast is constructed on the assumption of unchanged government policies which means that the referendum is assumed to keep the UK in the EU. On this view, we should see a rebound in investment following the vote, as spending held back by the associated uncertainty comes through. The EY ITEM Club forecast for the UK Economy, Spring 216 % changes on previous year except borrowing, current account and interest & exchange rates GDP Domestic Demand Consumer spending Fixed investment Exports Imports Net Govt Borrowing(*) Current account (% of GDP) Average earnings CPI Bank Rate Effective exchange rate (*) Fiscal years, as % of GDP Source: EY ITEM Club sees the consumer in the driving seat this year The GfK survey indicates that although consumers have become less confident about the future of the economy, they have become more upbeat about their personal finances. This reflects the growth in real incomes, which the forecast sees continuing. Average earnings are forecast to increase by 2.9% this year and 3.3% in 217, helped by the introduction of the NLW in April, while the CPI increases by.5% and then 1.4% respectively. Household disposable income increases by 2.9% in 216 and 3.1% in 217, a real terms increase of 2.4% this year and 1.7% next. Real income grows at a similar rate over the remaining years of the forecast, remaining supportive throughout. The forecast sees real household consumption increasing by 2.5% in 216 before slowing to 2.1% and 1.7% in 217 and 218 respectively. The saving ratio moves up from 4.2% in 215 to 4.6% this year, and around 5.3% in subsequent years. This is consistent with a household debt to income ratio that is increasing, but much more slowly than it was before the financial crisis. EY 8

11 Introduction supported by low inflation and the buoyant labour market Although there is evidence that higher rates of stamp duty are depressing transactions and prices at the top end of the market, other housing market indicators have recovered nicely since last year s slowdown. Mortgage rates hit an all-time low in February, while the proportion of borrowers opting for fixed-rate mortgages reached an all-time high. Mortgage approvals in January recovered to their highest level in two years, with the pace broadly maintained in February, spurred by buy-to-let landlords anticipating the higher stamp duty rate effective in April. With mortgage interest tax relief being reduced, we expect to see this segment of the market pause for breath over the summer. We see house prices increasing by 6.2% this year, before easing back to 4.6% in 217 and 4.5% over the remaining years of the forecast. The growth in housing investment recovers strongly, from 3.9% in 215 to 5.7% this year and 8.2% in 217. while business spending has stalled UK: House prices & transactions Prices, % year 15 Recent surveys point to a significant easing of the pace of growth in the business sector. The average manufacturing PMI for the first three months of this year was the lowest since the beginning of 213 when worries about the Euro eased, suggesting that manufacturing output growth remains stalled. Output in the service sector, which now accounts for 8% of GDP, remained firm over the New Year, growing at an annual rate of 2.8% in January. However the average service sector PMI in the first quarter was the weakest since the first quarter of 213. The first quarter composite PMI, weighted by each sector s share in the economy, fell to a three-year low. Surveys of company executives suggest that concerns about the emerging markets and global growth have now been overtaken by worries about the June referendum on the UK s membership of the EU. The appetite for risk-taking seems to have suffered as a result and the forecast sees the year on year growth in business investment slowing to 2.1% by the April-June quarter of this year. Companies should drive the pace of the economy next year However, on the assumption of a referendum vote to remain in the EU, the forecast sees a recovery in business investment in the second half of the year, gaining further momentum next year. The growth of US, European and other export markets should be enough to underpin capital spending over the rest of the forecast period. Financial conditions strongly favour investment, while rising labour costs and falling energy costs now favour energy intensive plant and machinery at the expense of labour. The forecast suggest that business investment will grow by 3.2% this year, 7.8% in 217 and 6.9% in 218. With housing investment also expected to recover and public investment holding up until the later years of the forecast, total investment accelerates from 3.% in 216 to 6.7% and 5.5% respectively in the following two years. Investment adds 1.2% to GDP in 217, similar to the contribution it made in Transactions, s 5-1 Transactions (RHS) Source : EY ITEM Club Prices (LHS) Forecast EY 9

12 Introduction UK: Exports & world trade % year World trade Exports Forecast UK: Business investment & GDP % year Business investment Forecast GDP Source : EY ITEM Club Source : EY ITEM Club External trade continues to disappoint. Export volumes grew by 5.1% last year but with consumption continuing to advance, import volumes increased by 6.3%. The big disappointment came once again on investment income. This showed signs of improvement over the first three quarters of 215, but deteriorated badly again in the fourth quarter, apparently hit by investments in mining companies and Emerging Markets. Net exports subtracted.5% from GDP in 215, following similar negative figures in the previous three years. However, with our major markets in North America and Europe continuing to recover and longer-term prospects for the Emerging Markets remaining positive, we expect the poor fourth quarter performance to be temporary. The current account deficit gradually falls, from 5.2% of GDP in 215 to 2.5% by 22. But the risks remain on the downside Although the financial markets may have recovered their poise, questions about the Emerging Markets and the global economy remain unresolved. Moreover, this forecast assumes that the June referendum keeps the UK in the EU. If that proves wrong, the fundamentals would remain in place during the two year transition period and in that sense nothing would change. We would still have access to the single market, subject to EU regulations. However, uncertainty about the eventual settlement is likely to hit business confidence and investment and probably sterling, the gilt market and consumer confidence too. Survey evidence suggests that uncertainty has already hit the corporate appetite for risk, and in the event of Brexit we think this would be unlikely to rebound over the next year or two in the way the present forecast suggests. EY 1

13 Forecast in detail Forecast in detail 1. Fiscal policy Deficit reduction continues to be a slow process. And while the Government officially remains on course to meet its objective of a budget surplus by the end of the decade, it will not take much to knock that target off course, including an acceptance of the implausibility of current plans. To some surprise, the OBR used the March Budget to cut its forecast for public sector net borrowing in to 72.2bn. But borrowing in the first 11 months of the fiscal year already amounts to 7.7bn, leaving very little leeway to achieve the forecast. Indeed, meeting the OBR s projection would require the smallest March deficit since 21. Granted, there are a number of factors which should depress borrowing at the end of the fiscal year, including base effects boosting SDLT receipts and a fall in payments to the EU. And the OBR s forecast is based on final outturn data for , post-any future revisions. But the Budget forecast could prove to be holed fairly quickly. If that happened and the deterioration is not corrected in subsequent years, this would narrow the already slender 1bn margin by which the Chancellor is forecast to meet his mandate of a budget surplus in That margin has already been eroded since the Budget by the Government s climb down on cuts to disability benefits. And the Chancellor s statement was lacking in detail on some of the measures to cut borrowing, notably 3.5bn of further cuts to departmental spending in via as-yet unidentified efficiency savings. In pursuit of meeting the surplus goal the Chancellor engineered some significant re-profiling of tax receipts and public spending over the next few years. This included bringing forward capital spending from to earlier years and deferring a policy announced only last summer of bringing forward corporation tax payments by the most profitable companies. This delivers a tax cut of 6bn and 3.9bn in and respectively, but then a tax rise of almost 6bn the following year. As a result, the drag on the economy from fiscal policy is a touch looser in the three years from than previously planned. But is now intended to see the largest fiscal tightening of any year since the programme of deficit reduction began a decade earlier 1½% of GDP or 32bn. That the Government would undertake such a major fiscal squeeze the year before a general election is implausible. The Budget represents the fourth significant shift in fiscal plans in 18 months. Another equally sizeable shift in the not-too-distant future would come as no surprise. 2. Monetary policy UK: Public sector net borrowing * bn, cumulative 1 * excluding public sector banks Forecast assuming 1 same improvement as YTD Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar March 216 saw the seventh full year pass with Bank Rate unchanged at.5%. And with the MPC recently shifting in a more cautious direction, there is a good chance that the UK will see another full year with rates remaining at a record low Source : Haver Analytics, EY ITEM Club, OBR OBR forecast for = 72.2bn EY 11

14 Forecast in detail The most obvious sign of that shift was the action of external MPC member Ian McCafferty. Having voted for a hike in rates for six consecutive months, Mr McCafferty fell back in line with the majority view in February 216. Meanwhile, Mark Carney has backtracked from some of his more hawkish statements of 215 where he hinted at a rate rise in the near future. Indeed, he has arguably moved more than 18 degrees, speaking in February of the considerable room available for additional monetary stimulus should the economy need it. New external member, Gertjan Vileghe, has also intimated that looser policy may be on the cards in the event of further downside surprises for the economy. Avoiding adding to the potentially adverse effect of uncertainty surrounding June s Brexit referendum points to the MPC maintaining a dovish countenance over the next few months. And with the Committee downgrading its forecasts for growth and inflation in February s Inflation Report the economic outlook does not scream of the need for tighter policy. Indeed, our own forecast shows CPI inflation struggling to reach 1% even by the end of this year. With inflation so far from the MPC s 2% target, this would rule out a rate hike in 216. With inflation then forecast to see a more meaningful pick-up, a rise in Bank Rate in the second quarter of 217 is possible, although the risks suggest that an even more prolonged period of record low rates is not out of the question. But subsequent rises in interest rates are set to be slow and gradual, with Bank Rate predicted to reach only 1% by the beginning of 218. Sterling has weakened significantly in recent months, reflecting lower interest rate expectations, tighter US policy and Brexit-referendum induced uncertainty. Assuming a vote to remain, sterling is likely to see a relief rally, but, longer-term, interest rate differentials suggest a decline in the value of the pound, particularly against the dollar. UK: Bank Rate & 2-year bond yield % Source : EY ITEM Club 2-year government bond yield Bank Rate Forecast 3. Prices and wages Having bumped around close to zero throughout 215, CPI inflation has started to gradually edge upwards in early-216, reaching.5% in March. This increase was largely due to base effects, as the impact of the sharp falls in food and petrol prices in late-214 and early-215 dropped out of the yearon-year calculation. But while we have now passed the trough in inflation rates, we are still a long way below the MPC s 2% target and we expect it to take several years to get back there. Though base effects have started to reduce the drag from some of the more volatile components, the food, petrol and energy categories are all still reporting falling prices on a year-on-year basis. And it is not just the more volatile components which are keeping inflation subdued underlying pressures remain weak. With the oil price having rallied over the past couple of months, petrol prices are now starting to pick up. However, given that there was a similar rally in the spring and summer of 215, rising pump prices are unlikely to put any meaningful upward pressure on inflation in the near-term. Meanwhile, the big six energy suppliers have announced cuts to domestic gas prices in the region of 5%, so this will renew the downward pressure on inflation from this source. As a result, CPI inflation is likely to remain in the -.5% range until the autumn, requiring Mark Carney to write a further series of explanatory letters to the Chancellor. EY 12

15 Forecast in detail Thereafter, we expect inflation to gradually accelerate, eventually breaching 1% by the end of 216. Again base effects will be important, with the late-215 collapse in the oil price set to fall out of the calculation towards the end of this year. The influence of a weaker pound which has depreciated by around 8% against the dollar since the middle of 215 will also have an effect by putting upward pressure on the cost of imported goods. UK: CPI inflation % year Forecast However, with underlying inflationary pressures likely to remain muted this will preclude a more aggressive pickup in price pressures. While we expect a steady recovery in earnings growth, it should be offset in part by an improvement in Source : EY ITEM Club productivity. And the degree of spare capacity in the economy is unlikely to diminish quickly, preventing firms from doing much to improve their profit margins. Therefore, after averaging just.5% in 216, we expect CPI inflation to remain some way short of the 2% target, at 1.4% in 217 and 1.7% in 218. RPI inflation will be higher over the forecast period, reflecting the so-called formula effect (i.e. the different methods of aggregation between the RPI and CPI measures which place an upward bias on RPI), our expectation that house prices will rise more quickly than general prices and, from mid-217, the impact of interest rate hikes on mortgage interest payments. 4. Activity 215 delivered a so-so growth performance with the rise in output a touch below the long-run trend. This year looks like delivering a very similar performance with the expansion remaining a largely domestic affair. Q4 s National Accounts revised up growth in Q4 215 from.5% to.6%. With growth in Q1 also pushed up, output in 215 is now estimated to have risen by 2.3% (previously 2.2%), slightly below the post average of 2.5%. The expenditure breakdown showed an economy heavily dependent on the consumer. Consumer spending accounted for two-thirds of the rise in output in Q4. Government spending and inventories also made positive contributions. But net trade dragged on growth for the second consecutive quarter. And investment made a negative contribution to GDP for the first time in almost three years. Business investment dropped 2% q/q, although this appeared to partly reflect unusually large disposals of transport equipment, so this may have unwound in Q The trends evident in Q4 are likely to remain broadly in play over the course of 216. Consumer spending will benefit from a number of tailwinds including continued very low inflation and interest rates, depressed unemployment and the National Living Wage coming into effect. A healthy consumer environment will bolster firms confidence to invest. However, that confidence may UK: Contributions to GDP growth % year 4 Domestic demand Net exports GDP growth 3 Forecast Source : EY ITEM Club EY 13

16 Forecast in detail be hindered by uncertainty surrounding the referendum on EU membership on 23 June. And Q4 s drop in business spending provides a weak launchpad for growth in 216, pointing to the rise in investment falling short of 215 s 4.1% pace. On the external side, demand from the US and Eurozone is now forecast to strengthen more modestly than was previously anticipated, reflecting a weaker expansion in both economies. That said, supported by the sterling s recent sizeable depreciation, we still think that net trade should provide a modest spur to growth this year. Overall, we expect GDP to increase by 2.3% in 216, broadly in line with last year s rate of growth. So the norm in previous expansions of several years of rapid, above-average growth, will continue to be absent. 5. Consumer demand The environment for consumer spending should remain bright this year, with a variety of tailwinds supporting households spending power. Although consumer spending accounted for the bulk of GDP growth in Q4, the UK is some way from a consumer boom. A quarterly rise in consumption of.6% was unchanged from Q3 s pace and well below the.9% averaged in the decade prior to the financial crisis. However, this rise was still sufficient to push the household saving ratio down to 3.8%, the lowest since records began in Moreover, households ran a financial deficit of 2.6% of GDP in Q4, also another record-breaker. And consumer credit has continued to rise at a rapid pace. Unsecured lending rose by 9.3% year-on-year in the three months to February, a ten-year high. Whether these trends are sustainable in the long-term is debatable. But alongside evidence of robust consumer confidence, they suggest that consumers appetite to spend will remain robust this year. Consumption should benefit from continued very low interest rates and a pick-up in pay growth, reflecting in part the introduction in April of the National Living Wage (NLW). While rising inflation will erode some of the gain in real incomes, the CPI measure is forecast to end 216 at just 1%. Moreover, household balance sheets are looking in increasingly good shape, notwithstanding recent falls in equity prices. Household wealth (including housing and financial assets) reached almost 74% of household incomes in Q4 215, above the pre-crisis peak and close to a record high. That said, the effect of lower unemployment in spurring pay growth appears to be more modest than in the past. And the NLW is not a free lunch. Part of the gain to individuals will be lost in higher tax payments and withdrawn benefits. And to the extent that the NLW causes employers to cut headcount or hours worked, this will mitigate the benefit to incomes and spending. On balance, these factors point to a modest slowdown in consumer spending growth this year, from 2.7% in 215 to 2.5%. But beyond 216, as inflation picks up further and fiscal austerity bites, growth in spending is set to slow to rates more in line with the post-financial crisis norm. UK: Real household income and spending % year Household spending Source : EY ITEM Club Household income Forecast EY 14

17 Forecast in detail 6. Housing market Analysis of housing market trends has been complicated by the distortions caused by April s increase in stamp duty on buy-to-let properties and second homes. With the change announced well in advance, there has been a degree of forestalling, with buyers rushing to complete their transactions before the increase came into effect. We believe that this effect accounted for the bulk of the increase in mortgage approvals for house purchases from 7,5 in November to nearly 74, in February. The pickup in activity does not appear to have caused a corresponding increase in house price inflation, with the ONS series slowing from 2.6% to 1.4% on a three-month-on-three-month basis between October and February, although the Halifax series does point to stronger price trends. In addition to the stamp duty changes, buy-to-let investors will also face more stringent underwriting standards following a review by the Prudential Regulatory Authority. Together these moves should cool demand in the sector a little. Elsewhere in the market, the RICS survey has reported a modest pickup in new buyer enquiries in early-216. And with household incomes set to continue to grow strongly and interest rates likely to be on hold for some time yet, demand for housing should remain well supported. There has been some more encouraging news on supply, with the number of housing starts in England reaching a seven-and-a-half year high in the year to Q4 215 and the RICS survey reporting a pickup in the number of new sellers. But these developments have done little to alter the broader picture of UK: House prices supply remaining very constrained, particularly in % year 2 London and parts of southern England. This fundamental imbalance between supply and demand should ensure that house prices continue to rise, with our forecast showing growth of 6.2% this year, only a little short of the 215 pace. However, the growing unaffordability of property the Halifax reported that the price-to-income ratio was 5.7 in January, the highest since late-27 combined with weaker household income growth and rising interest rates should cause house price inflation to slow to around 4½% a year in 217 and Company sector Growth in business investment has outpaced rises in overall GDP in each year since 21. While this should remain the case in 216, the gap is likely to narrow on the back of domestic and global uncertainties. The first three quarters of 215 saw business investment increase at a rapid pace, with growth averaging 1.6% per quarter. This took business investment s share of GDP to almost 1%, the highest since mid-21. But investment then dropped sharply in Q4, falling by 2% q/q, the weakest performance in seven quarters. That said, this may prove to be a temporary set-back, with the ONS attributing the drop to a relatively large volume of asset disposals. So investment may bounce back in Q Healthy growth in consumer spending should encourage in by firms. Moreover, the return on capital employed offers further incentive the rate of return enjoyed by UK corporates has reached 13%, a rate not exceeded since Source : EY ITEM Club Forecast EY 15

18 Forecast in detail And having been firmly in saving mode for a long period, UK corporates have shown signs of shifting their position. The corporate sector ran a financial surplus of only.1% of GDP in Q4, the second smallest since 27. But against these positives, uncertainties are likely to constrain growth in investment in the shortterm. Domestically, the referendum on EU membership on 23 June is one source, with firms exposed to the EU market likely to hold back spending until the outcome is clear. And a troubled global economy, reflected in the recent volatility in financial markets, offers further cause for exporters, in particular, to exercise caution. Meanwhile, resources for investment will face competition from other demands. The National Living Wage came into effect in April and will put upward pressure on pay bills, while for large companies, the Apprenticeship Levy, due to be introduced in April 217, represents another new burden. Overall, these headwinds lead us to expect business investment to rise by 3.3% this year down on 4.1% in 215 and representing the slowest increase since Labour market UK: PNFC net rate of return The jobs market has been fairly becalmed recently, with unemployment stabilising at a low level. But the low level of joblessness has continued to exert little upward pressure on pay growth. These trends are unlikely to see a dramatic change this year. Having seen a steep drop over the course of 214 and much of 215, the LFS unemployment rate has stabilised in recent months, recording a rate of 5.1% in the three months to January 216, a decadelow. Meanwhile, the employment rate ran at a record high of 74.1% in the same period. But there is still no sign of a surge in pay growth on the back of healthy demand for workers. In fact, while the start of 216 saw the unemployment rate back to the average observed from 21-27, annual pay growth was little more than half the 4% recorded over that pre-financial crisis period. Compositional effects, in the form of a shift towards lower-skilled and lower paid jobs, may explain part of this development. But there may also be structural explanations, including an increasingly flexible labour market and a tightening up of eligibility criteria for out of work benefits. These factors, along with continued strong growth in the supply of workers from migration and more participation by older people, will constrain pay growth. The ongoing struggle to gain traction on a recovery in productivity will have a similar effect; having risen in the first three quarters of 215, output per hour plunged in Q4 at the fastest rate since late 28. % Source : Haver Analytics Total Manufacturing Services EY 16

19 Forecast in detail Granted, April s introduction of the National Living Wage has pushed up the pay of low earners. And our expectation of a further decline in the unemployment rate to 4.7% by the end of 216 should mean that a tighter labour market eventually makes its presence felt. Overall, we expect average earnings to rise by 2.9% in 216, up from 2.6% a year earlier. But this will still be well below the pre-crisis norm of 4½%-5% growth. The UK jobs market appears to have moved to a jobs-rich but relatively pay-poor equilibrium, bad news for individual workers but good news for the economy s potential to continue growing without inflation taking off. 9. Trade and the Balance of Payments UK: Unemployment There are substantial question marks over the quality of the official trade data; it has shown substantial volatility and reported movements in the real and price data which are hard to reconcile. In particular, the apparent strength of export volumes in 215 which were up 5.1% according to the official data was at odds with all of the survey evidence, which suggested that exporters struggled in the face of the strong pound and subdued demand from the Eurozone. % ILO Claimant count Source : EY ITEM Club Forecast Recent survey evidence has been mixed. However, there are reasons for optimism for exporters, with the pound forecast to depreciate by around 5% on a trade-weighted basis in 216. This will offer a much needed boost to competitiveness, although subdued global demand will restrain growth in exports and ensure that net trade only offers modest support to GDP growth in 216. UK: Sterling effective exchange rate Jan 25 = Forecast The current account deficit widened to a record 7% of GDP in Q4 215, following a slump in returns on 85 UK investments abroad. However, with our key 8 trading partners forecast to enjoy stronger economic growth over the coming years, the 75 performance of UK investments abroad should improve and, eventually, move the primary income Source : EY ITEM Club balance back into surplus. This should enable a gradual narrowing of the current account deficit from a record high of 5.2% of GDP in 215 to 4.5% this year and, ultimately, 2.5% by EY 17

20 EY Assurance Tax Transactions Advisory Ernst & Young LLP About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. About EY ITEM Club EY ITEM Club is the only non-governmental economic forecasting group to use the HM Treasury s model of the UK economy. ITEM stands for Independent Treasury Economic Model. HM Treasury uses the UK Treasury model for its UK policy analysis and Industry Act forecasts for the Budget. ITEM s use of the model enables it to explore the implications and unpublished assumptions behind Government forecasts and policy measures. Uniquely, ITEM can test whether Government claims are consistent and can assess which forecasts are credible and which are not. Its forecasts are independent of any political, economic or business bias. The UK firm Ernst & Young is a limited liability partnership registered in England and Wales with Registered number OC31 and is a member firm of Ernst & Young Global Limited Ernst & Young LLP, 1 More London Place, London, SE1 2AF. ITEM Club Limited Published in the UK. All Rights Reserved. All views expressed in the EY ITEM Club Spring 216 forecast are those of ITEM Club Limited and may or may not be those of Ernst & Young LLP. Information in this publication is intended to provide only a general outline of the subjects covered. It should neither be regarded as comprehensive or sufficient for making decisions, nor should it be used in place of professional advice. Neither the ITEM Club Limited, Ernst & Young LLP nor the Ernst & Young ITEM Club accepts any responsibility for any loss arising from any action taken or not taken by anyone using this material. If you wish to discuss any aspect of the content of this newsletter, please talk to your usual Ernst & Young contact. This document may not be disclosed to any third party without Ernst & Young s prior written consent. Reproduced with permission from ITEM Club Limited