Evercore Pan Asset

The two official bodies closest to the Treasury and the UK economy have both come to the same conclusion. The Bank of England and the Office of Budget Responsibility have both revised their growth forecasts for the UK down again.

In the June 2010 Budget book, the Chancellor looked forward to growth of 2.4% in 2011-12 and 2.9% in 2012-13. By the time of the March 2011 budget, these forecasts were reduced to 1.8% for 2011-12 and to 2.7% for 2012-13. Now the Bank is saying 2011 will only see 1.4% and 2012 2.0%. The OBR has become similarly more cautious.

Both forecasters still assume growth will accelerate from here. It needs to in order to hit the revised forecast for the current year. Then it needs to speed up again to hit the higher targets for subsequent years. Growth in the first half of 2011 has only been 0.7%, despite the useful bounce in the first quarter after the unexpected fall in the last three months of 2010.

Faster growth is central to the government’s whole strategy for cutting the deficit. The deficit comes under control in the Plan by 2015 thanks to a large increase in tax revenues. This extra tax comes from all the extra incomes and activity growth generates. Tax revenue is very sensitive to growth rates. The whole budget strategy is equally sensitive to government income.

The theory was the public sector would be squeezed and the private sector would take up the slack. The private sector is still much the bigger employer than the public. Recently the two sectors have spent about the same amounts, given the large transfer payments made by the government out of tax revenues. Public spending is almost 50% of National Income, an unusually high figure for the UK.

In the first quarter of 2011 the opposite occurred to the rhetoric around the plan. Increased public spending contributed a positive 1.1% to UK growth, as higher cash spending translated into a real increase. The private sector reduced GDP by 2.0% thanks to depressed consumption and investment. The overall positive balance for GDP was made up by net exports.

Policy makers had intended to deliver tight public spending and borrowing coupled with easy money. So far neither side has delivered. The government has carried on spending and borrowing at high levels. The Bank, despite all its efforts, has presided over tight money. As the Bank reported yesterday, bank lending to businesses and households remained weak in the second quarter of 2011. Money supply as measured by M4 was also sluggish, growing less than the rate of inflation. It is interesting that with the very large level of public borrowing and the increases in public spending, growth was sluggish.

The Bank is saying that years two and three of the government’s strategy are going to disappoint on growth. Their fan chart for growth still assumes it will pick up soon, and will continue to accelerate for the balance of the five years. Its fan chart for inflation assumes it will soon start to fall, and will drop down to the 2% target thereafter. Past fan charts have been equally optimistic, but have not proved so accurate.

If the Bank is right, the government has to consider whether simply to borrow more on the grounds that the tax revenue will come in later, or make further adjustments to curb the deficit. Their rhetoric is more bearish than their forecasts. They stress the international headwinds, and say growth could disappoint more.

We advise caution on UK markets. There has been a strong assumption that the determined deficit reduction strategy will work, and will be the anchor for a better performing UK economy. Unfortunately, international events can depress growth more, which in turn knocks the government away from its stated path for deficit reduction. Homemade problems like the riots in leading cities also do not help. Both the retail and the property sectors will suffer from the damage done. It will be another reason why some businesses will be reluctant to invest. Better growth had been priced in. Now markets are adjusting to possible disappointment, based on new official forecasts and the gathering storm clouds in Europe and the banking sector.