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Economics Weekly - Interplay between economy and financial crisis intensifies; Weekly economic data preview - UK data this week to show weakening trend

Economics Weekly - 19 January 2009


Interplay between economy and financial crisis intensifies

As everyone is already well aware, economic data in the UK and elsewhere in the world have taken a turn for the worse in recent weeks. UK industrial production, business surveys, and the volume of UK exports and imports all disappointed. Despite the sharp fall in sterling over the last year, the UK’s volume of goods exports in the three months to November fell by 3.2%, while the volume of imports was down by 6.8%. It is clear from these figures that the recession is not yet easing up, and indeed appears to be worsening. And financial markets remain clogged up as the economic downturn deepens, worsening credit risk for lenders.


Financial markets still in the doldrums...

Chart a shows that although there has been a fall in the VIX volatility index, a measure of equity market risk, it remains higher than at any time since just after the failure of Lehman Brothers on 15 September 2008. Moreover, one measure of credit market risk, the European Itraxx crossover index, although no longer rising and off its peak, is still close to its all time high. Recent figures from the latest Bank of England Credit Conditions Survey (CCS) highlight the unsurprising expectation amongst lenders of further increases in defaults as the economy enters recession, see chart b. This is leading to a toughening of credit conditions for borrowers, see chart c, as lenders reduce credit. The Q4 Bank of England CCS revealed that lenders expect a sharp rise in the default rates on their loans from mortgage borrowers, on unsecured products and on corporate advances.


...leading to a worrying interplay as economic conditions worsen

This outlook in turn might be leading some companies to cut costs even more to try and ensure that they survive the economic downturn. Of course, as companies reduce activity this will slow economic growth further increasing defaults at the macro level, leading to tighter credit conditions hence impacting companies and creating a negative feedback loop. Such a cycle is likely to worsen the economic downturn unless there is sufficient liquidity in the monetary system to help prevent it from happening. This is especially important since the sharp rise in commodity prices and in price inflation last year drove down real earnings for households and real profits for companies. The implication is a squeeze on cash flows and a worsening of economic growth, as consumer and corporate spending is cut back, something that is happening already. This can be thought of as separate from the effects that directly emanate from the problems in financial markets caused by the bursting of the bubble in securities markets. In reality, of course, the two are hard to disentangle and their impact on the real economy is almost indistinguishable.


What do the latest trends suggest for UK credit conditions and the performance of the economy in the next three months?

As noted in charts b and c, a rising expectation of defaults from customers is leading to a tightening of credit conditions, including credit availability and spreads. There is beginning to be a closer correlation between the results of the Bank of England’s Credit Conditions Survey and the worsening trend of some key sectors of the UK. We have looked at some of these linkages in the following charts. A reduction in the availability of credit for household unsecured lending (credit cards etc) did not prevent continued annual growth in loans accelerating from under 6% in June 2007 to a peak of just under 7% in June 2008. However, loan growth to this sector started to slow by the June 2008 CCS report and this slowdown has become more pronounced in the last few months as credit conditions have tightened further, and unsecured lending is heading below 5% growth at end 2008. Bearing in mind that charts b and c showed that credit conditions are expected to tighten further in the next three months, this trend is likely not only to persist but possibly accelerate. The same pattern is evident in growth for mortgage-related loans and credit intentions by lenders to the sector. Chart e shows clearly the implied relationship between a reduction in credit for mortgages and the rapid slowdown in mortgage growth. This has slowed from nearly 12% in June 2007 to under 4% growth in November last year as the mortgage market seized up.


Economic conditions are set to get worse before they get better

The decline in the availability of loans to the corporate sector is as sharp as it has been for the household sector. Corporate borrowing growth is weakening fast, see chart f, and this is perhaps one of the factors behind the sharp fall in industrial production. Chart g shows that the fall in the output of UK non-financial firms is nearly 7%, the fastest pace of decline since 1981. All of this is suggesting a bleak outcome for overall economic growth in the months ahead and implies that the worst of the economic downturn may yet be to come. Indeed, one feature of the slowdown so far is that it has been led by a sharp correction in firms’ investment spending. The worry has to be that with the rise in unemployment yet to fully come through, that the downturn in company activity this implies when it does will lead to a sharper cutting back in consumer spending in the months ahead. This suggests that the recession will persist well into 2009 or even into 2010.

Trevor Williams, Chief Economist, Corporate Markets


Weekly economic data preview - 19 January 2009


UK data this week to show weakening trend

Focus is on a wide range of UK economic data releases. Also, the minutes of the Bank of England’s  7/8th January MPC meeting should throw more light on its decision, probably unanimous, to cut Bank rate by 0.5% to 1.5%. Importantly, the minutes may clarify the amount of concern that the committee attaches to the likelihood of inflation undershooting the 2% CPI target and, therefore, the possibility of another 0.5% interest rate cut to 1% at its February meeting when projections will be released. This is particularly pertinent since CPI inflation data for December, due on Tuesday, may show the annual growth rate slowing sharply to 2.5% compared with 4.1% in November - in our view, CPI inflation could fall below the 2% inflation target as soon as April, justifying more cuts. UK Q4 2008 GDP and labour market data are among other key releases this week. Also important, BoE Governor Mervyn King delivers his first keynote speech of 2009 on Tuesday. In Europe, the German ZEW institutional investor and the EU-16 PMI surveys, both for January, may add to the gloomy regional outlook, providing further justification for the ECB’s decision to cut interest rates by 0.5% to 2%. On the events agenda, the Euro area finance ministers meet in Brussels today and President Trichet makes several speeches over the course of the week. While the US economic calendar is quiet by comparison and US financial markets are closed for holiday on Monday, Barack Obama’s Presidential inauguration on Tuesday will provide political focus. The BoJ will leave its interest rate at 0.1% on Thursday, while the he Bank of Canada may lower official interest rates by 0.5% to 1.0% on Tuesday.


􀂄 UK economic data take centre stage with a wide range of releases, including CPI inflation, labour market and public finance data, money supply growth and retail sales. The preliminary estimate of Q4 2008 GDP is released on Friday morning. It will show a -1% to -1.5% fall in GDP. So, with two straight quarters of decline (-0.6% in Q3), this will confirm that the UK is in technical recession. This is leading to job cuts - we expect the ILO unemployment rate to hit 6.1% of the workforce in November, having risen successively from 5.2% last August. As labour markets are softening, the average 3-month trend headline earnings growth rate may have eased to 3.2% in November. But with RPI inflation likely to fallen to an annual rate of 1.8% in December (3% in November), this is starting to indicate a return to positive real incomes growth for those in employment. We also expect to see publication of a -0.8% fall in retail sales in December (+1.5% annually) as BRC stores’ own figures show a significant deterioration in their own sales. Money supply growth may have stayed around 16% pa in December, reflecting the activities of other financial institutions, which mask a significant weakening in monetary holdings growth by households and a contraction in private non-financial companies’ holdings. Finally, the PSNB borrowing requirement may have reached a cumulative £66.6bn in December.


􀂄 The EU-16 publishes its flash PMI surveys that will highlight the level of economic activity in the region during January - both the manufacturing and the service PMI indices are likely to have weakened. In addition, the ZEW survey for January will give a useful indication of economic confidence among institutional investors and analysts and may be negatively affected by DAX weakness and a sharp deterioration in both new industry orders and unemployment in Germany. We expect these outcomes to have been factored into the ECB’s decision to cut interest rates by 0.5% to 2% last week. But, although it seems possible that the ECB may pause and keep rates on hold at 2% at next month’s meeting, it is likely that incoming data will determine the need for more cuts in coming months. ECB President Trichet’s speeches this week, including to the Euro Parliament’s Economic and Monetary Affairs Committee on Wednesday, will be carefully interpreted for information on monetary policy direction.


􀂄 Political events, including Barack Obama’s presidential inauguration, as well as more financial results from US banks may dominate the US headlines. However, economic data include publication of another outcome of around 500,000 in initial jobless claims for last week and possibly another fall in monthly housing starts and building permits in December. During the course of this week, financial markets will increasingly turn their attention to the 27/28th January FOMC meeting and subsequent statement, which may expand on any Fed plans to buy a range of debt securities.

Nichola James, Senior Economist


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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