UK GDP – is it downhill from here?

The UK economy expanded as expected at 0.8% in Q3 led by strong gains in the service sector, which expanded by 0.7%. However, overall growth was fairly board-based with increases in each of the four main economic sectors. Output increased by 1.4% in agriculture, 2.5% in construction and even production expanded 0.5%, with manufacturing increasing by 0.9%, even though August industrial production fell 1.1% on the month and manufacturing fared worse dropping 1.2%. This suggests there may have been a strong rebound in the final month of the quarter.

Keep the champagne on ice…

These numbers are the best we have seen since 2010, but now is no time for celebration. From peak to trough in 2009 the economy shrank by 7.2%, it has been a steep uphill climb since then, and although the worst leg of the journey may be behind us we still have further to go: the UK economy remains 2.5% below the peak in Q1 2008. This should be concerning for the UK government, with only 2 years to go until the next election. It is easy to see how the opposition Labour Party could use this fact to damaging effect in a bitterly contested campaign.

Weak foundations: UK economy is too reliant on a fragile consumer

Although it is good news that the UK growth was broad based in Q3, it is still uneven. As the ONS says, although the service sector has seen activity expand to above levels last reached in 2008, activity in the industrial sector remains below the trough recorded in 2009, thus the increase in GDP since 2009 is “overwhelmingly attributable to services”. This is concerning for a few reasons: 1, wage growth remains weak and real wage growth is still negative. In September real average annual wages were -2% when adjusted for inflation. 2, the consumer in the UK is only going to suffer further constraints after the UK’s major energy providers announced inflation-busting price increases that will come into effect from next month, adding roughly GBP 100 + to the average annual household energy bill. Thus, it’s going to take a robust consumer, especially during this holiday season, to prop up growth in the final three months of the year.

Can production step up to the plate?

Looking ahead, the bright spots include the housing market – prices are expected to continue rising across the country, particularly in London, which could boost consumer confidence. However, the savings rate has started to rise again, which, along with the rise in energy costs, could limit the scope of discretionary spending at the end of this year. We also need to see industrial production notch up a gear so that it could pick up some of the slack if the consumer starts to falter. Thus, going forward it’s easy for the service sector to do well and continue to rise, what is more of a challenge, and more important for discerning sterling traders and small cap UK equity traders is the production side. If its tentative recovery stalls it will be very hard for the UK economy to get back to pre-2008 levels, which could weigh on GBO asset markets.

What this means for the pound?

After initially jumping to 1.6240, GBPUSD is back below 1.6200 as we progress through the London morning session. GBPUSD has been stuck in a range since the US resolved its debt ceiling issue, and has remained above 1.60 since then, however the upside has been capped at 1.6260 so far.

The fact that GBP did not jump above this level on the back of the GDP data suggests that it could be a stretch too far and the good economic news in the UK is fully baked into the cable price. Thus, going forward we believe that GBP will be sensitive to any UK data misses, however we think that downside could be limited as the market concentrates on 1, the weak tone to US data and 2, the relative interest rate differential, which remains pound positive, as the market concentrates on the BOE’s sanguine stance after the market successfully challenged the Bank’s dovish forward guidance. So GBPUSD could be range bound for some time.

From a rate perspective, EURGBP is more interesting as the ECB remains unlikely to loosen policy any time soon. From a technical perspective it looks ripe to outperform the pound if it can get a weekly close above 0.8535 – the 200-day sma. Above here opens the way to 0.8600 – the high from the end of August. If the UK starts to see economic data start to slip then economic fundamentals could also start to support EURGBP.