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Economics Weekly - UK manufacturing to avoid recession; Weekly economic data preview - UK inflation data key this week

Economics Weekly

UK manufacturing to avoid recession

Manufacturing activity has fallen in the last three months…
Despite a boost from the fall of 12% in the UK’s tradeweighted Index (TWI), manufacturing output fell by 0.5% in May and industrial production dropped 0.8%. A fall in UK energy output is understandable, however, as North Sea oil and gas extraction is dropping fast, even as prices rise, because of the difficulty of getting to the reserves that are left. Production from these fields is down by 40% from the peak in 1999, with a fall in 2007 alone of 3½%. But the critical question is why manufacturing output is also down and what this may mean for economic growth in the wider economy. If manufacturing output is flat in June, output would have fallen by 0.5% in the second quarter, after rising by 0.3% in Q1, taking 0.1% off overall gdp growth in the period.

…and the implication is that alongside the construction and services sector it is headed for recession…
It appears from the current weakening bias of the UK Purchasing Managers Indices (PMI) that manufacturing is slowing as much as the services and construction sectors and this could threaten growth in the whole economy further at a time when it is rising by just 0.3% a quarter. Chart a shows, however, that the PMIs would have to fall even further below 50 to suggest outright recession - in 2001 the composite index was below current levels and yet the economy still expanded by 2.4%. But the worry has to be that manufacturing activity slips back even further, alongside weaker economic activity in the US and Europe - its key overseas markets - and because of the higher financing costs and lower supply of funds associated with the credit crisis. This would certainly be a fair inference to draw from recent data, with manufacturing export prices up 11% in the year to May and almost offsetting the boost from a 12% fall in the TWI.

Further, the index of manufacturing production is lower than it was 8 months ago, with most of the weakness associated with consumer related sectors, likely due to the housing market slowdown in the UK. Chart b illustrates this point, with consumer durables and non durables posting a big slide in the last three months. But intermediate goods output has also slid, alongside that of capital goods production, though the latter is still showing positive growth. Taken on this basis, there is little prospect of any boost to the wider economy from the manufacturing sector, even though economic growth in Europe is relatively holding up, expansion in the emerging markets is still in high single figures and the pound has become more competitive overseas than at any time since 1992.

…but, we would urge caution in being too dismissive of manufacturing’s prospects for this year and next
With UK manufacturing jobs still being lost by 2-3% a year, productivity is rising by a similar amount and unit labour costs - a key measure of international competitiveness between firms - was up by only 0.8% on an annual basis in the three months to April. This means that manufacturing industry is still competitive – even though it is not as large as it once was as a share of gdp (down to 14% in 2007) or contributing as much to exports. As a result, the surprise would be if there were no rise in manufacturing production in the near future to reflect the rise there has been in export volumes, see chart c. However, it is the case that new export orders have taken a tumble, see chart d, perhaps reflecting the rise in export prices which in turn implies a desire by firms to boost profits rather than increase overseas sales volumes (though the level of export orders remains high). Chart e suggests that manufacturing orders in general are the best since 2004, although domestic orders have moved back into negative territory after being slightly positive in recent months.

A more powerful point about the current weakness of manufacturing output is that the experience of the 1992 devaluation suggests that it is still too soon to be sure that there will be no increase in output. Chart f shows that there has been the sort of fall in the UK’s TWI that is usually associated with a subsequent rise in manufacturing output. However, chart g shows that this response can take some time. The experience in 1992 was that manufacturing output remained weak for many months after the TWI initially fell and export prices rose, but then a fall in export prices occurred and manufacturing output rose quite rapidly. While not expecting an exact repeat of that this time round, it does seem too soon to suggest that manufacturing output will not grow more rapidly in response to gains in UK TWI competitiveness - especially if allied with the productivity gains that UK manufacturing is currently enjoying.

In summary, UK manufacturing is poised between boosting the overall economy and going into recession
The key message from our analysis is that it is too soon to expect the fall in the UK’s TWI to boost manufacturing output and that in 1992 output continued to slide after the initial fall in the currency. However, output eventually responded quite powerfully. This rise in manufacturing activity occurred despite initially higher export prices, which then fell back. The key seems to be about whether the rise in competitiveness is judged by firms to be sustainable or not. With monthly manufacturing production data volatile, it is likely that there will be a recovery in manufacturing output in the months ahead and the sector will boost the economy rather than help to drag it into recession. However, this will not be enough to prevent a sharp slowdown in overall economic growth from taking place.
Trevor Williams
Chief Economist, Corporate Markets

Weekly economic data preview W/c 14 July 2008

UK inflation data key this week

The UK, the US and the Eurozone (final) CPI inflation data are likely to highlight the monetary policy dilemma facing central banks. The Bank of England kept base rates steady at 5% at last week's MPC meeting, despite CPI inflation running well above the 2% target and projected at 3.6% in May, and there is clear evidence that Q2 growth slowed further from 0.3% in Q1, preventing a rate hike. This week's publication of a fifth consecutive rise in claimant count unemployment may exacerbate economic concerns. Since raising interest rates by 0.25% to 4.25% on 3 July, the ECB has adopted a neutral position on future interest rates, but there is still a possibility that it will do another 0.25% hike by the end of the year should CPI inflation surprise on the upside (expected to be confirmed at 4% in June) and/ or economic growth proves more resilient. The Fed publishes the minutes of its 24-25 June meeting, and Bernanke's semi-annual Monetary Policy testimony to the House Financial Services Committee will outline the Fed's latest projections for GDP growth, employment and CPI inflation in 2008-10. The Bank of Japan and the Bank of Canada are likely to hold interest rates at 0.5% and 3%, respectively.

• The UK has a busy economic calendar, featuring CPI inflation, producer prices, BRC retail sales and the labour market report. CPI inflation has risen from a low of 1% in September 2002 to a peak of 3.3% in May, see chart 1. Our forecast for June is a rise to 3.6%, therefore, the second consecutive month that CPI inflation has exceeded the BoE's 3% upper limit. We forecast RPI at 4.1% (4.3% in May) and RPIX unchanged at 4.4%. Higher RPI growth may not feed through to stronger earnings growth, however, as employment and earnings growth are both falling as the economy slows. Jobs data are likely to show a fifth consecutive monthly rise in claimant count unemployment , while average earnings growth on a 3-month rolling average basis may have slowed to 3.7% in May from 3.8% in April. However, growth of producer input prices reached 30.3% in June, underpinning the BoE's concerns about near term inflation risk. BRC retail sales survey data will be interesting given the fact that the official numbers surprised to the upside in May. Finally, UK money supply growth and public finance data for June should be supportive of close to trend rather than falling GDP growth.

• Fed Chairman Bernanke's semi-annual testimony on the state of the economy is likely to include upward revisions to its 2008 PCE inflation projections, last made in April, of 3.1 to 3.4% and 2.2 to 2.4% for core inflation. 2008 GDP growth and employment may be revised from 0.3 to 1.2% and the unemployment rate from 5.5 to 5.7% of the workforce. In terms of data releases, consumer price inflation may have risen to 4.5% in June, from 4.2% in May, while core prices, excluding food and energy, may have risen from 2.3% to 2.4%, see chart 2. Producer prices may have risen by 8.6% in June (7.2% in May), highlighting the potential upward risk to consumer prices. Another key data release published this week is advance retail sales for June - we expect growth of 0.4% on the month, another strong number following 1% growth in May, reflecting household tax rebates. Key housing market data includes June housing starts and building permits. In addition, the Empire Manufacturing survey and industrial output data, including capacity utilisation will inform on the health of US manufacturing

EU-15 CPI inflation for May should be confirmed at 4% for June (well above the ECB's 2% target), giving justification to the decision to hike 0.25% to 4.25%. In addition, the German ZEW survey may fall to -55 in July from the low of -52.4 in June, underpinning the ECB's decision to send out a neutral interest rate bias in its accompanying statement. EU- 15 industrial production may have contracted in May, which may raise concern that regional exports are eventually feeling the adverse effects of the strong euro, thereby dampening overall GDP growth in the eurozone.
Nichola James, Senior Economist

Economic Research,
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