The Honeymoon is over - Are we already heading towards a divorce?

Oh dear oh dear!  After a short recession at the end of last year and with uncertainty causing a depressing start to the year we were, in July, full of hope.

A new stable government that recognised it is businesses that deliver economic growth and which appeared keen to work with them to deliver the growth that would create the funds desperately needed to improve our public services.  A great message! And looking at the graph of your optimism, things started well.

But now look! The sharpest drop in confidence amongst you business leaders we’ve seen to date!

It seems you (in general) didn’t much like Rachel Reeves first budget!

Maybe they (them - the political classes - the Labour leadership) knew that would be the case.  Maybe they decided to get the bad news out of the way early so they can later build momentum for the election in 2029.

Not sure that was the right tactic.  I think they might have forgotten the Franklin D Roosevelt mantra when talking about the 1920s depression: ““We have nothing to fear but fear itself”.

Or maybe they’re planning to move to playing “Things can only get better”.  Or perhaps that’s too touchy a subject.

We’ll see! Whatever the rationale, it’s bad news for now.  The winter is coming.  That’s what the graph says and what I am feeling through the conversations I’m having.

It will genuinely be interesting to see how this pans out.

I can be optimistic.  It might be that the significant investment in public services drives economic growth - after all the public sector is a very large part of our economy today - and that growth creates a virtuous circle of enhancing growth for consumers and businesses too. It might also be that the cost of labour forces businesses to invest in productivity improvements.  And in an economy that is 70% services it’s not difficult to identify a technology that might help that.  Assuming the measures pick that up. (I’m not sure they will but that’s another very complex story I need to investigate further)

But I can also be pessimistic - and that’s the view the straw poll is indicating. The ‘dead hand of government’ taking money in taxes reduces business confidence, reduces investment and the economy gets into the mud.  Which reduces tax take and requires more public spending and the vicious circle entrenches.  I was only a child in the 1970s but I am so old that I was actually around then and I remember the feeling in the country then. Let’s hope that’s not where we are heading!

I genuinely have no idea which way it will go.  “You pays your money and takes your chance”.  All I can do is listen, survey and replay!

So let’s see your comments below: What scenario do you see playing out?

And to help you in answering, and more importantly in making the best decisions for your business, the remainder is my neutral, balanced (as far as I can) summary in plain English (as far as I can) of what the Bank of England Monetary Policy Committee (MPC) the NIESR and a variety of other mainstream forecasters think is going on.

Summary: A balanced recovery with a little optimism

The UK economy is navigating through a period of slow growth, with a mixed set of challenges and opportunities. While the first half of 2024 saw strong performance, the second half is expected to see a deceleration, with growth expected to stabilise well below the long-term trend of 2% for the year as a whole. Forecasts for 2025 point to a slight improvement in growth to 1.2%.

GDP Growth

• Growing - but slowly without much momentum

The UK economy grew at 2% pa in Q2 and is thought to have been slowing since then.  The budget is though expected to add about 0.5% to growth over the next year or two. As a result whilst economic growth for 2024 is forecast to remain close to 1%, an uptick to 1.2% in 2025 is expected.

• Balanced across sectors Monthly GDP data indicates modest growth across all major sectors—production, services, and construction.. 

Inflation, Monetary policy and Interest rates

• Infllation is low but is likely to bounce back temporarily The headline rate is 1.7%, helpfully just below target 2%, is expected to increase towards 3% over the next year as the energy price cap and bus fares increase before returning to target. So all sounds good!  But watch out.
• Services inflation is quite persistent:

The headline figure hides a concerning variation.  Goods price rises have virtually stopped and energy costs are now below those of a year ago. A dramatic contrast to services inflation which has dropped a little but is still running near to 5%. Add in the energy price cap and bus fare increases and then consider that businesses are likely to pass on some of the cost of the increased living wage and employers NI.  This could create significant upward pressure which causes the Bank of England some concern leading them to be cautious about reducing interest rates.

• Interest rates being reduced slowly Despite this, the low headline rate has given the Bank of England the confidence to reduce rates by 0.25% this month to 4.75%.  Unless something goes wrong (see above on the components of inflation and below for the employment and global risks) interest rates are expected to fall slowly and hopefully stabilise (He dreams). My very rough guess is that they will stabilise around 3.75%.

Wage Growth and Living Standards

• Wage rises have slowed but are still high Wage growth, especially in the services sector, a key contributor to inflation, have slowed a little. In Q3 2024, services sector wages grew by 4.1%, down from an average of 5.6% earlier in the year. If this downward trend continues it may help alleviate inflationary pressures.
• Real wages are growing With nominal wages rising by nearly 5% and low inflation, real wages are projected to rise by 0.7% in 2024 and be followed by a stronger 2.2% increase in 2025. This strong real wage growth is expected to continue suggesting a continued recovery in living standards, as workers benefit from higher pay in real terms.
• Households could spend but are saving 

With nominal wage rises at approaching 5% and inflation around 2% real wages are currently increasing at around 3%. This means there is capacity for consumer led economic growth; capacity which is not currently being realised as uncertainties and higher interest rates cause households to save (or rebuild) for rainy day.

Labour Market

• Unemployment and Job Creation: Unemployment rose to 4.3% in recent data, and the employment rate showed a slight increase to 74.8%. However, labour market data remains volatile and unclear, and the actual trend could vary. Employment is expected to continue growing modestly, but the rise in employer National Insurance contributions (NICs) is likely to weigh on job creation.
• Employment may slow down The government’s decision to raise employer NICs by 1.2 percentage points is expected to generate up to £25 billion in additional tax revenue annually over the next five years. While this will increase public funds, it, combined with the increases to the national living wage could lead to a slowdown in hiring and a gradual rise in the unemployment rate over time.
• THe labour market is returning to a more normal balance The vacancy-to-unemployment ratio has now returned to pre-pandemic levels, signalling a cooling in labour demand. As job vacancies decrease, wage pressures are also expected to moderate, which could contribute to a reduction in inflationary pressures in the labour market.

Business profitability, investment and productivity

• Some businesses might face a difficult time The growth in real wages combined with the increase in employers NI and the increases in National Living Wage will increase labour costs. That, the shortage of staff for difficult to fill vacancies and continued low productivity could cause difficulties for some businesses.

Other businesses may benefit

• This may in turn have other benefits.  In the short term it may free up the labour market which remains tight.  In the long term that, and the high cost of labour may, with lower interest rates and a stable period of government policy, encourage investment in plant and in technologies such as AI and we may finally begin to see some improvements in productivity.  (He dreams again!)

Productivity remains a real challenge

• Whether it is the mechanical lack of recognition of the value created by investing in assets or simply political choices it seems that  the lack of both public and private investment in the UK is holding us back.  This lack of investment in assets like infrastructure (particularly transport), machines and people is likely to be key, alongside regulation, in influencing the continued failure to improve productivity. This low productivity growth is leading to stagnant GDP / head and the relatively low growth of overall GDP.

Government policy and debt

• Using a new measure to borrow more
• The chancellor has revised the fiscal rules but has chosen a new measure (called public sector net financial liabilities or PSNFL) that does not take into account the value of investment in real physical infrastructure.  I do not understand why. It seems to me to be simply an accounting change that enables the Chancellor to borrow more (an extra £49Bn)

The new measure still does not recognise the value of investment in assets

• It still limits public investment as it does not allow the government to recognise and potentially leverage the value of fixed assets on its balance sheet.  Maybe that is too complex and she needs more time to work that through.

Investing in the hope of creating growth As largely expected the new government has shifted the balance towards higher taxes and greater public investment.  The goal is clearly to promote increased growth which would be good for business.  On the other hand the majority of initial taxes do seem to be likely to hit businesses which may have negative implications for business confidence and then to long-term economic growth.

Global outlook

Wars continue and governments change

All of the above can be thrown in any direction by the current significant global uncertainties with new governments in the UK, Germany and US.  Whilst less politically important than Ukraine and the Middle East, the potential trade tensions resulting from President Elect Trump’s commitment to 20% tariffs on imports to the US could affect UK businesses negatively, or, if they result in a free trade deal as some wish for, they could give the UK an advantage over the EU.

Conclusion: A Cautiously Optimistic Outlook

The UK economy is showing resilience, with moderate GDP growth, improving real wages, and a gradual decline in inflationary pressures. However, risks remain, particularly from higher energy costs and fiscal measures like the increase in employer NICs, which could dampen job creation. The economic outlook for 2024 and 2025 suggests a balanced recovery, but much depends on the government's ability to foster business confidence and navigate inflation risks while managing public finances effectively.