UK: The power of credit impulse at work

The UK growth is like a bouncing ball: in the first quarter, it grew by 0.5%, higher than the average of the G7 countries, and in the second quarter, it went into negative territory at minus 0.2%, rising fears that recession has started. This downturn resulted from factory shutdowns and the fallout from pre-Brexit stockpiling. However, more fundamentally, the disappointing Q2 growth print reflects the lack of new credit growth and the power of credit impulse.

As you can see in the chart at the bottom of the page, over the past ten years, the UK economy has mostly been driven by high inflow of new credit, especially from the period 2015 to 2017, when credit impulse reached a record high of 11% of GDP in the immediate post-referendum era. Since then, credit impulse has sharply fallen and has already experienced seven consecutive quarters of contraction. This is, in our view, the primary factor driving the UK economy down. The length of the contraction is similar to that of the GFC, but with a smaller amplitude (credit impulse is running at minus 4.4% of GDP according to our latest update). The lack of new credit growth coupled with four consecutive quarters of contraction of business investment are strong arguments in favor of upcoming recession.

The UK economy is flirting with recession…but it should avoid it in Q3

We have called for UK recession for a while, as a consequence of contraction in credit impulse. However, contrary to an increasing number of market participants that consider the UK economy is already in recession that began in April, we think that Q3 GDP growth bounce is on the cards. We expect stagnation – and not contraction – in the third quarter. The first GDP estimate is expected on November 11th – after initial Brexit deadline.

This “unexpected” rebound that we call for is likely to be driven by stockpiling boost in lead up to Brexit deadline of October 31st (like the 0.5% rise in Q1), and slightly better service sector linked to improved consumer sentiment. In line with this, we notice some signs of economic revival: the July services PMI rebounded to 51.4 and the construction PMI, though remaining at very low level, increased to 45.3. In addition, consumer economic sentiment continues to improve. GfK personal financial situation over the next 12 months is back to 7, its highest level since September 2018. This trend is explained by higher wages and higher gross disposable income per head, which positively affect household’s final consumption expenditure (+1.8% YoY in Q2). On the top of that, we may have a less negative figure for UK car production in Q3 as summer shutdowns have been advanced to Q2, thus affecting less production data this quarter.

Considering the combination of stockpiling and positive consumer sentiment, we think that the likelihood of another quarter of contraction (leading to technical recession) is remote. Stockpiling will bring some short-term relief to the economy, but higher stockpiling is not the sign of a very dynamic economy. The UK economy is not in good shape to face Brexit. The UK Q3 growth that we expect to be slightly above zero will be a sign of false stabilisation. Recession is still looming at the corner.

Snap elections are unlikely to bring clarity

The two major factors that usually cause a recession, namely the lack of investment and the lack of new credit in the economy, are already in place. What is missing nowadays is the trigger for the recession to occur: it could be a further deterioration of global growth, in relation to trade war, or a no-deal Brexit by accident.

So far, this is not our central scenario, as we expect snap elections in coming months to postpone Brexit deadline once again. This seems to be confirmed by July Cabinet appointment. The most important appointment was that of Dom Cummings, acting as de facto Chief of Staff of Boris Johnson. Cummings is foremost a campaigner which tends to indicate that the Prime minister is getting ready for election.

His strategy will likely be to reunite the Leave vote behind the Conservative Party, to get rid of the Brexit Party by the way, and to win the election against a Remain vote that is widely divided between many parties. If this scenario happens, it means that tensions will probably rise between London and Brussels during the campaign period, notably about the backstop, and no matter who will win the election, it is improbable that it will bring clarity when it comes to Brexit.

Recession is only a matter of time, but it is unlikely to be officially announced this year.