UK economic growth remains around trend at 2.6% per annum
Detailed UK statistics for the second quarter of 2006 show that economic growth remained around trend at 2.6 per cent. There was a significant increase in business investment with capital formation growing by over 4 per cent year-on-year. This bodes well for future growth prospects. Given the recent increase in Base Rate, we expect UK growth to remain around long-term (between 2.5 per cent and 2.75 per cent) until end of 2007. The recent strength of consumer spending in the second quarter largely reflects exceptional sporting and weather related factors.
Going forward, consumer spending power will become more stretched by a combination of higher taxation and higher inflation at a time when average earnings growth is relatively stable. Underlying average earnings rose at an annual rate of 3.9 per cent in the 12 months to the end of June. The comparable figure for retail price index (RPI) was 3.3 per cent. RPI is a better indicator of inflation than the consumer price index (CPI) from the viewpoint of many people in the personal sector. Allowing for tax increases, the recent increase in RPI allows little room for an increase in average real personal incomes. The momentum of the housing market is likely to be maintained by cash input (including parental and other support for first-time buyers) and by consumer preference for owner-occupied housing against a background of sustained economic growth.
Uncertainty over inflation
The Bank of England (BoE) Monetary Policy Committee (MPC) surprised financial markets with a 0.25 per cent increase in Base Rate on 3 August. The subsequent MPC minutes showed a 6-1 vote in favour of the increase. The previous month, the vote had been 7-0 in favour of no change. The increase reflected concern that inflation, as measured by the CPI, might breach the government’s 3 per cent upper limit during the next few months.
A key factor that has emerged is the impact of higher university tuition fees, which could add a further 0.25 per cent to October’s inflation rate. In addition, feedback from the Bank of England’s industrial contacts indicated an increased propensity to pass on higher energy costs. There is now a high probability that the MPC will increase Base Rate by 0.25 per cent in October or November. We believe that Base Rate will not rise above 5 per cent in 2006/07 given the lack of inflationary pressures in the labour market.
Underlying average earnings rose by 3.9 per cent in the 12 months to June, well below the level the MPC perceives to be an inflationary threat. While period rates rose significantly on the MPC decision, they have since eased back on a market perception that US short term rates have peaked (American interest rates are a key driver of UK longer-term rates). Over the next month, we expect the five-year swap rate to stay within a range of circa 5.10 per cent to 5.30 per cent. A key proviso is that the degree of uncertainty apparent in the MPC minutes could lead to a degree of volatility in UK period rates.
Housing market activity
The impact of the 0.25 per cent Base Rate increase on the housing market in the remainder of 2006 is likely to be marginal. The UK market is still being driven by the strong consumer preference for homeownership and by shortfalls in housing supply.
The latest government housing statistics (published 17 August) relate to England. They show that total starts in the 12 months to end June 2006 amounted to 182,400, a 4 per cent increase on the comparable figure to end June 2005. The increase is marginally above the growth in household formation. It will be several years before the excess of demand over supply in the housing market is eliminated. We therefore forecast that average house prices will continue to exceed inflation for the rest of the decade, and that the average house price for the UK as a whole will rise by 6 per cent this year and by 4 per cent in 2007. Net mortgage lending this year is likely to be marginally in excess of £100 billion, representing a 10 per cent increase on the 2005 figure. The impact of the BoE’s more aggressive monetary stance is likely to be felt on next year’s mortgage activity. We anticipate that net lending will increase by 5 per cent in 2007 i.e. half the forecast 2006 growth figure rate, but still representative of a resilient market.
House price inflation
The latest data shows a gradual convergence between Halifax and Nationwide data. The annual rate of the Halifax Index still shows an inflation rate close to 9 per cent but as the high monthly rates in September to December 2005 gradually drop out of the Index, we anticipate that the annual Halifax rate of inflation will ease back towards 6 per cent per annum. The Nationwide Index is currently in this region.
The increase in Base Rate to 4.75 per cent is not expected to have a major impact on house prices, but the cumulative impact of a further increase would have a more significant effect in terms of both affordability and psychology. However, the driving force of the housing market remains the excess of demand over supply. We expect the rate of house price movement to remain in positive territory, both in actual and real terms. The monetary stance of the BoE will make an impact on house prices and we therefore forecast that average house prices next year will ease back to a rate of 4 per cent per annum.
