RICS Economic Brief reveals that the economy has continued to show moderate growth over the summer.
Milan Khatri, chief economist at RICS, says that consumer spending has stayed flat and is likely to remain restrained as household incomes are squeezed by rising oil prices.
Growth in government spending is also showing signs of tapering off after a significant rise in 2004. However, tentative signs of a revival in housing activity and business investment, along with a stable labour market, suggest that the economic slowdown is not developing into a recession.
For the three months to July, employment rose 83,000, with annual growth picking up to 1.1%. The rise in employment is in line with growth for the past decade, but above its historical average. However, it contrasts with figures based upon surveys of businesses showing a small drop in the number of jobs in Q2.
The contraction in manufacturing employment worsened, but some areas of the service sector also showed a slowdown, reflecting weakness in consumer spending. Still, business surveys point to a moderate pace of hiring in the service sector, which is offsetting job losses in manufacturing.
Despite good growth in employment, underlying average earnings in the quarter to July dipped below 4% annual growth for the first time in 1o years. Signs that labour market conditions are softening are supported further by a steady drop in the level of vacancies from a four year peak in January, although vacancy levels remain firm. Overall, the data gives a softer tone to the labour market.
Concerns over employment prospects amongst households have surfaced in recent months as unemployment has crept higher. Nonetheless, by August, unemployment had stopped rising after a brief spurt higher in the first half of 2005.
Headline consumer price inflation picked up to 2.4% in
August, the highest level since late 1996. Factory gate prices have trended higher this year, reflecting the climb in oil prices.
However, core inflationary pressures for manufacturers (industrial goods excluding food & energy) remained subdued, and indeed slipped back again in August. This suggests that so far the oil price rise has not had second round effects on production costs.
Inflation is also muted in the more economically buoyant service economy. Core consumer price inflation slipped back to
1.7% in August, but is still up from less than 1% last autumn due to a hike in utility bills and higher rents.
Still, the 13% rise in raw material prices over the last 12 months will trouble the Bank of England, because of the risk that the economy cannot absorb further rises in costs without spilling over into higher general prices. The oil price hike reflects the effect of cyclical growth in the global economy – the adverse impact of Hurricane Katrina is not expected to last.
Still, the BoE is wary that oil price rises could push up wage demands and lead to higher inflation. Structural changes in the labour market have mollified such effects. Reduced trade union powers and flexible working patterns due to a shift to a service based economy, make a spill over from higher oil prices less likely than was the case in the 1970s.
Ultimately, the balance of inflationary and deflationary risks from higher energy costs depends on the economys level of spare capacity and the overall trajectory of growth.
The British Chamber of Commerce survey suggests available capacity amongst all firms is slightly lower than the long-run average. With the BoE expecting consumer spending to pick up over the coming months, the lack of capacity presents a case for keeping interest rates on hold.
However, consumer spending has been flat for a year with no signs of a turnaround. The marked drop-off in sales growth has largely followed the fall in housing sales but also rising interest rates, with sales of household goods down by the strongest margin since 1991.
Nevertheless, housing activity has shown a recovery according to chartered surveyors during the summer months. Although this will provide some lift to household spending, the probability of the housing market making a full recovery is limited.
Two other factors point to consumer spending growth remaining muted. Firstly, flat house prices mean that consumers are less willing to draw on home equity to finance spending. Secondly, growth in real incomes is likely to be squeezed by an upturn in inflation, even though rises in incomes have stayed constant at a respectable 5% per annum.
Since the dotcom bust in 2000, the economy has had a high level of dependence upon consumer spending, which has been significantly above the average recorded since the 1970s. A slowdown in consumer spending therefore has been a key factor in slowing the economy.
Also, there been a large difference to the historical trend in government spending, which has accounted for a third of economic growth since 2000, compared to an historical average of less than a fifth. The contribution of public spending to economic activity in the medium term is set to diminish, with only public investment likely to stay firm.
Government spending is set to slow in the next year and consumer spending will be held in check by rising inflation.
Therefore, we need to look to other sectors to keep the economy growing. Export activity has risen strongly in recent months but the upturn is likely to reflect erroneous data as industrial activity is stagnant and business survey evidence point to a modest rise in foreign sales at best.
An upturn in business investment last year seems to have petered out in 2005, and the outlook will not be helped by higher energy costs. However, output of capital goods rose a robust 1% in the quarter to July, which indicate s that some near term strength may materialise.
Against this mixed economic background, and the global economy being hit by an oil price shock, a further interest rate cut cannot be ruled out. The tentative improvement in housing activity and business investment though suggests that the economy is not heading for a recession, particularly as the rising trend in unemployment has stalled.
Growth likely to remain at a sub-par at an annual rate of around 2% in the next year, though is not a disaster. As such, the Bank of Englands preference is to wait-and-see what impact the oil price shock has on the economy and inflation before considering another interest rate move.
Occupier demand for commercial property continued to hold up in August with annual rent rises the highest in four years. Rents in the retail and industrial sector showed rises of 4.2% and 1.2% respectively, despite the recent downturn in consumer demand.
Office rents rose for the third consecutive month on an annual basis following over three years of decline which ended in June 2005. A strengthening stock market and expansion in financial & business services supported a rent rise of 0.5% in the year to August.
Retail rents have been resilient in the face of subdued consumer spending, confounding any suggestion that the sector will see a significant slowdown. Moreover, a stabilising housing market in recent months as opposed to a much feared collapse could help consumer demand and business confidence looking ahead.
However the sustained rise in oil prices in recent months could yet prove a constraint on rental growth.
Bond yields have declined further in August reflecting market expectations that reduced economic growth as opposed to in-creased inflation, will be the main outcome of any sustained oil price rises. Low bond yields will continue to encourage investors to seek higher income returns through alternative asset classes.
Indeed, property yields continued to fall in August and are now at 6.4%, down almost half a percentage point in 2005. Reduced economic growth due to an oil price shock implies depressed rental growth going forward, though investors could also point to evidence for economic stability as a reason for optimism.
Construction employment in Q2 showed the largest quarterly decline in nine years according to National Statistics. The rise in employment for the year was 1.9%, the lowest pace in four years, but is above the long-run average for the industry and ahead of growth in the overall economy.
Some slowdown in the labour market is not surprising as construction vacancies have slumped by 15% in the past year, and indicates that expansion in the industry is now adjusting to the slower demand conditions evident in the housing and commercial property sectors.
However, just as the labour market has shown signs of easing, activity seems to have stabilised and may have actually picked-up modestly. Construction output rose 2.8% in the year to Q2, up from a low point of 1.9% in Q3 of 2004.
Moreover, the August survey from the Chartered Institute of Purchasing and Supply indicates that growth has once again accelerated. The ongoing steady growth of the service economy, particularly business and financial services may be providing some support to commercial building work despite overall business investment activity showing only slight rises in the past year.
The other main source of workloads is ongoing growth in government investment, which has risen sharply in 2005. For the year to date, investment is up almost 40%, and compares with no growth at all for the same period in 2004. The third area of potential support is the housing market. There are indications that buyer interest has improved over the summer, which will help to lessen fears of a housing crash, and may support house building, which reached an 11 year high in Q2.
Latest figures from RICS indicate that the residential property market has felt the impact of the August interest rate cut by the Bank of England. While house prices continued to fall in August, declines were the smallest for a year and support an overall picture of a stabilising market. Completed property sales rose for the second month running, which suggests that a degree of confidence is returning to the market.
In addition, enquiries from would-be buyers rose for a third consecutive month, up at the fastest pace since January 2004, as the August interest rate cut provided a lift to confidence. Selling pressure has reduced with increasing signs of market stability.
Some of the more gloomy housing commentators view the market upturn as at best a temporary event in a downward trend. The reason why these commentators have been consistently wrong on the housing market is their under-estimation of the impact of changes in interest rates on the housing market. The monetary policy cycle since the housing market slowdown began has been very different than in the previous housing market downturn.
While interest rates have risen by more than a third from their lows in the autumn of 2003, the rise is still significantly less than the doubling of interest rates in the late 1980s. Moreover, interest rates have been cut less than two years after the housing market activity peaked, whereas in the early 1990s, policy was eased almost a year later in the cycle.
As a result, the economy has maintained a comfortable pace of growth in 2005 despite the slowdown of the past year, and is still generating a high number of new jobs (more than 250,000 in the last 12 months). The most interesting statistic is that households are MORE confident over prospects for incomes than when the housing market peaked, and contrasts starkly with a collapse in confidence in the early 1990s.
As such, surveyors are expecting a further pick-up in sales activity in the months ahead. It seems that the housing market is experiencing a soft-landing, with only a severe shock, such as ongoing sharp rises in the price of oil, likely to derail the market.