City & Business: Soft landing? Maybe but not definitely

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The Independent Online
IF THE end of last year was characterised by doom and gloom, the theme for early 1999 seems to be: "Don't worry, things won't be as bad as you expect." In my view, neither theme is right. The Bank of England has cut interest rates early in the economic cycle and the financial position of many businesses is far more robust than at the end of the 1980s. That, and the Government's spending plans, should underpin a cautious recovery from the second half of the year. A deep, prolonged recession is unlikely. But things will get worse before they get better.

Growth in household spending has fallen back over the last year or so, even though income growth has been firm and inflation on the high street non-existent. It's unlikely that trend will be broken over the next six months as rising unemployment forces households to draw in their horns. Spending growth should fall to 1 per cent by the middle of the year.

Moreover, the risks to growth are on the downside. Inventories have risen sharply. They're not yet at levels seen before past recessions, but stock levels are better managed than they used to be. I expect the run-down of inventories by businesses to take 0.1 per cent off growth this year. If stocks are cut back more aggressively, gross domestic product might not grow at all in 1999. In the last two downturns, destocking took around 2 per cent off GDP growth at the low point of the cycle.

I'm also fairly concerned about the impact of the Brazilian crisis. If this leads to a collapse of intra-Latin American trade, the second round impact on the UK's GDP (via trade with the US) could be significant. GDP could grow around 0.25 per cent less over the next year or so.

Putting this together makes us think GDP will grow only 0.5 per cent this year with a technical recession in the first half - activity will fall 0.1 per cent in the first two quarters. In 2000, growth should rebound but only to 1.9 per cent. With weak world and domestic activity keeping a lid on prices, underlying inflation should fall below 2.5 per cent next month and stay there until mid-2000. Prices won't rise because consumers won't pay them.

Against that background, interest rates should fall sharply through the first half of 1999. By summer the repo rate should be at 5 per cent. Cautious members of the Bank of England's Monetary Policy Committee may want to slow the pace of cuts a touch, but the data won't let them. Sharp cuts after the summer are unlikely unless risks to growth materialise. The repo rate should have fallen to 4.5 per cent by the end of 2000.

As the economy slows and the Government's spending plans kick in, the public finances will deteriorate. This makes me bullish on gilts - particularly the long-dated stock, which should post a double-digit return over the next six months. Inflation-linked gilts look expensive against equities, given our low inflation forecast of 1.2 per cent.

So, to summarise:

Interest rates have been cut early in the cycle, but not soon enough to prevent a further slowdown in consumer spending growth. The underlying position of the consumer is fragile. That's shown most clearly by the trends in consumer prices. Prices of items like appliances have have fallen 2.2 per cent.

Price weakness is not the result of a strong pound. Income growth has been firm in the recovery so retailers would not have passed on lower costs unless consumers had forced them to do so. Below average income growth in 1999 will act as a downward influence on saving, but the sense of insecurity generated by higher unemployment will offset this by pushing saving higher. That means the saving ratio should be flat over the next few years. Lower saving will not boost spending.

Exports will fall this year as the impact of weaker Latin American activity works through - second round effects on trade with the US will be significant. With overseas and domestic orders falling back, manufacturing should fall around 1 per cent in 1999. Investment won't rise more than 2.2 per cent.

GDP should fall around 0.1 per cent in the first half of this year - a technical recession. As activity slows, the MPC will push the repo rate down to, then through, a "neutral" level. Nominal rates will be as low as 5 per cent by the summer. That, and an increase in government spending, should underpin a cautious recovery from the second half of the year. A sharp shock is more likely than a prolonged downturn.

That said, the risks to 1999 growth are on the downside. Inventories have built up. If manufacturers and retailers cut these aggressively, GDP might not grow at all this year. In the last two downturns, destocking around the low point of the cycle reduced GDP growth by 2 per cent.

Weak global activity and a firm pound (in 1999) should keep the cost of imported inputs low. Slower domestic activity will reduce wage costs. Underlying inflation will be below the 2.5 per cent target until the second half of 2000. If imported costs are higher than we expect this year because the pound is weaker than our forecast, profit margins will fall. Prices won't rise because consumers won't pay them.

David Hillier is UK economist for Barclays Capital.

forecast summary

Annual percentage

1995 1996 1997 1998(F) 1999(F) 2000(F)

Increase in domestic expenditure 1.8 3.0 3.8 3.5 1.5 2.0

Exports 9.5 7.5 8.7 2.5 -0.4 3.3

Imports 5.5 9.1 9.5 6.9 2.7 3.5

Net trade: % of GDP 1.0 -0.5 -0.3 -1.5 -1.0 -0.2

GDP at market prices 2.8 2.6 3.5 2.5 0.5 1.9

Inflation (Q4) 3.23 2.6 3.7 2.9 1.2 2.3

Unemployment (Q4) 2.24 1.94 1.44 1.32 1.55 1.46

Current account (pounds bn) -3.7 -0.6 6.1 -0.7 -6.9 -6.6

Sterling index (Q4) 84.0 90.8 103.1 100.5 104.0 101.0

(F)= forecast Source: Barclays Capital