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Market commentary

20 September 2011

UK economic prospects appear closely tied to how effectively eurozone policy-makers resolve Greece’s sovereign debt problems over the coming months.

Over the coming months, we may see renewed quantitative easing in a number of major developed economies, including the UK, in an effort to cushion slower economic growth.

Once seasonal factors are stripped away, the underlying position for the housing and mortgage markets is broadly stable, but with subdued levels of activity and downside vulnerability to bad economic news.

World economy

UK economic prospects continue to be vulnerable to global developments. As Christine Lagarde, the IMF’s new managing director, remarked recently, this is a new and dangerous phase of the financial crisis, that requires action, political leadership and cooperation if the world is to see sustained recovery.

While the US is by no means out of the woods, the immediate source of market jitters has been the slow-motion traffic accident that eurozone policy-making has started to resemble. Recessionary pressures have added greatly to Greece’s problems in bringing down its government debt as quickly as its backers demand, intensifying market fears about the implications of a Greek default or exit from the euro.

The stakes are undoubtedly high.

Uncertainty about the exposure of banks to eurozone sovereign risk has been building over several months and - a painful reminder of liquidity conditions post-Lehmans collapse - started to adversely affect the willingness of banks to lend to each other. This prompted a coordinated move in mid-September by five central banks to provide commercial banks with additional tranches of dollar loans to help ease short-term funding pressures.

The balancing act for policy-makers is a challenging one, because there is also much concern that the developed world risks acting too aggressively to tackle sovereign debt burdens. The worry is that not all countries can rapidly and simultaneously shrink their public deficits, without depressing economic growth, so making rebalancing harder and increasing the risk of protracted deflation as happened in Japan.

The recent decline in US, German and UK bond yields to Japanese-like levels are seen by some commentators (for example the FT’s Martin Wolf) as presaging a fresh and protracted period of economic weakness globally.

In recent weeks, the European Commission has revised down European growth prospects to negligible levels for the second half of this year. And the European Central Bank, which had been tightening monetary policy until recently, now looks ready to cut interest rates again over the coming months.

UK economy

The global backdrop then suggests that the period ahead for the UK economy will continue to be testing. Recent indicators point to weakness in UK manufacturing and a sharp slowdown in the services sector.

Adding to the gloom, the headline unemployment total saw its sharpest increase for two years, with an 80,000 increase to just over 2½ million in the three months to July. While private sector jobs growth has continued, a very sharp fall in public sector jobs sat behind the latest rise.

For the time being at least, the febrile state of financial markets and anxieties about the sovereign debt position of certain eurozone members appear to have strengthened Chancellor Osborne’s resolve to maintain the pace of fiscal cuts in the UK. Senior Coalition colleagues, meanwhile, including deputy PM Nick Clegg when he spoke at the LSE, have adhered to the mantra of sticking to the current fiscal framework, but been pushing a more growth-friendly line. This may herald Chancellor Osborne announcing fresh tax incentives to invest, as The Economist newspaper has recently suggested, or other pro-growth measures, when he presents his autumn statement on 29 November.

But the immediate attention has shifted to monetary policy. The Chancellor's recent speech at Lloyd’s of London and Business Secretary Vince Cable’s pamphlet for CentreForum, a Liberal think tank, have raised expectations of further monetary actions. A paper in the latest Quarterly Bulletin from the Bank of England concludes that the Bank’s earlier £200 billion asset purchase programme had a significant benefit in boosting GDP, but also lifted CPI inflation.

The MPC left base rate and the Bank of England’s asset purchase programme unchanged at its early September meeting, but the case for further quantitative easing (QE2) has clearly strengthened. While the near-term inflation outlook does not help – CPI climbed to 4.5% in August and is set to move higher over the next few months as energy price rises show through in higher utility bills – we should not discount the possibility of the MPC sanctioning QE2 later this year. There is a strong expectation of the US Fed announcing its own fresh quantitative easing when it meets on 20-21 September.

Housing and mortgage markets

Despite difficult market conditions, banks have continued to repay liquidity provided under the Bank’s Special Liquidity Scheme, such that there is now less than £20 billion of the original £185 billion outstanding. 

The summer months are traditionally a quiet period for public debt issuance, but there have nevertheless been signs of funding markets being disrupted by escalating eurozone sovereign debt problems.  There is therefore a risk of conditions becoming stressed if eurozone uncertainties persist over several months.

For the time being, however, mortgage offers remain relatively attractive, and the key influence on market conditions is likely to have been the extent to which economic factors are weighing down on demand.

Much of the recent variation in monthly lending figures appears to have reflected seasonal factors, with the underlying picture being one of activity levels that continue to be subdued but broadly stable.

We estimate that gross lending totalled £13.4 billion in August. This would have been 6% higher than the £12.6 billion reported by the Bank of England for July and 10% stronger than a year ago. But it is important not to look at monthly figures in isolation. August's performance more or less offset a weaker than expected July figure. Taking July and August together, lending has shown little change on the same months of 2009 and 2010.  

Despite the weakness of consumer sentiment associated with ongoing pressure on household incomes and the uncertain economic outlook, there are no signs of significant house price falls. Values continue to be strongly underpinned by the limited volumes of new build and forced sales. While current survey data suggests that house prices nationally may be drifting modestly lower in nominal terms, the prevailing view among economists – as reported in HM Treasury’s Forecasts for the UK economy - is for house prices to stabilise through 2012 and then revert to positive growth of 4-5% per annum (broadly in line with likely earnings growth) from 2014 onwards.

The latest RICS survey reports broadly flat activity levels in August – with new buyer enquiries down, new instructions flat and anecdotal evidence of vendors taking properties off market.

Chart 1: Housing transactions and approvals for house purchase 

Housing transactions chart

Source: HMRC and Bank of England

According to the Bank of England, seasonally adjusted house purchase approvals in July, at 49,239, were modestly higher than in June and the strongest for more than a year. This is a welcome development, but still indicates subdued levels of activity rather than a housing market recovery, and would be vulnerable to any bad news on the economic front.

Meanwhile, seasonally adjusted remortgage approvals, were unchanged in July at just under 31,000.  This suggests a degree of resilience despite expectations of interest rate rises moving further out into late 2012. However, year-earlier comparisons will inevitably begin to look less favourable over coming months, given the stronger showing of remortgage activity in Q4 last year.

CML Research

  1. Name: Bob Pannell