Evercore Pan Asset

The UK GDP figures came as a shock to the markets. Most forecasters had been expecting a small increase in activity after the long recession. Business surveys reported better news. The feeling abroad was the long de-stock was over. There were signs of life in the car and housing markets.

Instead the figures showed the first signs of reality dawning in the previously ever buoyant public sector, continued gloom for manufacturing, weak performances in construction, hotels and leisure, and little progress in consumer spending despite low mortgage rates.

The public senses that all the efforts to ease the situation are temporary. They know the money printing and bond buying cannot go on for ever. Companies are having to reduce their workforces even after the worst of the downturn has occurred. The winter looks set for major Union struggles against more aggressive management in a number of important cases. BA are having another go to cut the wage costs and manning levels in their airline. The Post Office is locked in a damaging row over work practises, dressed up as a dispute about “modernisation”. A number of Council services are being challenged to become more efficient, leading to rubbish on the streets of Leeds and threats of strikes elsewhere. 

The iron law of the three huge UK deficits is a simple and remorseless one. Each sector in deficit, the banks, the public sector and the private sector, needs to cut its borrowing. Each will recognise that a substantial part of the adjustment has to be made by cutting costs. The banks are boosting income by putting up fees and charges, and are benefitting from the cheap money the government is supplying in abundance, but they have to rein in lending to get into balance. The public sector is putting up taxes, with proposed increases in petrol tax, Income Tax and National Insurance, but it is all highly marginal compared to the scale of the running deficit. They will have to cut spending. The government now accepts this but is delaying the timing of the first major cuts. The private sector has limited scope to boost incomes at a time of wage cuts, bonus contraction (outside the banks) and rising unemployment. Individuals are paying back credit card debt and even making some inroads into the amount of mortgages outstanding. That leaves less for discretionary purchases. Men are deciding they like the old car enough to give it another year. Women are seeing virtues in shoes and bags that have rested at the bottom of the wardrobe. 

All this implies slow growth at best. It also implies a long period of activity depressed by the overhang of too much borrowing. The government rightly says that if they can stimulate more rapid growth that would speed the adjustment. If the economy recovered swiftly that would bring in more tax revenue to cut the government deficit, generate more income to cut the private sector deficit, and allow the banks to generate more profit to improve their balance sheets. The problem is the most likely source of such growth, more borrowing to pay for the extra cars, houses, business ventures, is largely ruled out by the weak state of the banks and by the overhang of debt throughout the economy. Some in the government would like to think they could play the old game of getting UK people to borrow more one more time to lift us, but the banks are still weak and the economy as a whole so soaked in  debt to make this difficult at best and dangerous at worst. 

So what is likely to happen? There will be a recovery of sorts at some point. You cannot de-stock for ever. Mortgage rates are very low so there is some spare money around. There are now profits to book from asset markets. Last quarter’s figures may even be revised up a little in due course. Many analysts would like that, to make their error less remarkable. The Chancellor has always said he expects a recovery of sorts to begin around the turn of the year. This would suit the political timetable, allowing the government to carry on with many of its special measures until close to the election.

The future of the UK economy rests more than ever on what progress is made with restoring the banks to health and more normal activity levels. All the time their Regulator insists on more cash and capital for current levels of lending there will be restrictions on new lending and a low cap on UK growth. The public sector will remain better protected through the mechanism which will require banks to lend more to the state in the years ahead to hit the higher liquidity requirements, but it too will have to cut spending. The cuts when they come, whoever is in government, will be larger than anything we have seen before. Concentration on boosting public sector efficiency will produce more bruising strikes and discord with employees, in the name of protecting front line services. Individuals against this background are likely to remain more cautious than in the heady days of 2005-7, and will understand that at some stage interest rates have to go up.

The long term rate of growth of the UK economy over the next decade will be below the trend rate of the past 60 years. There remains the danger of disappointment at any time, as the economy is vulnerable to shocks. Once you are over-borrowed, there is no quick and easy way back. Governments need to keep the confidence of international money lenders, and need to avoid a further sterling devaluation.