Warning! This piece contains optimism about the UK economy in 2017! All public commentary to the contrary, return on capital is improving even as the expansion of capital stock quickens, the decline in labour productivity is moderating, and the terms of trade are near record highs. On top of all that, the private sector has been busy deleveraging throughout 2016 (yes really), replenishing its potential firepower. All of it points to stronger growth in 2017.
The preliminary estimate of 4Q16 GDP growth showed a rise of 0.6% qoq and 2.2% yoy, both identical to the 3Q results. For 4Q, the largest rises were in electricity.gas +3.9% qoq, distribution, hotels and restaurants +1.7% and business services & finance +0.9%. But in addition, manufacturing rose 0.7% qoq and 1% yoy. Overall, the result could only be considered exciting or surprising if one expected an immediate collapse in confidence (hence spending and investment) in the immediate wake of June’s referendum vote. In fact, as the chart suggests, GDP growth in 2016 was at the lower end of the ‘new normal’ band.
However, for reasons not connected with the Referendum, I had expected a sharper slowdown this year for what I considered good reasons. So what went right?
The ONS’s first sighting shot at 4Q GDP is delivered in a form which resists analysis: we have only a set of ‘real’ chain-linked volume indexes by industry. This is the least-useful possible form of accounting. By the time you’ve indexed, deflated and seasonally adjusted the raw data, one cannot know whether the fraction of a percentage point movements reported are being generated by the economy or by the statisticians. We have to wait months for what we need: the raw nominal breakdown by expenditure. In the meantime, what follows can only be my best efforts at estimating results and extrapolating trends. I start with returns to the two main factors of production: capital and labour.
Returns to Capital: Asset Turns Inflected Upwards, and Most Likely Capex Responded
I estimate trends in return on capital by expressing nominal GDP as an flow of income from a stock of fixed capital; I estimate changes in the stock of fixed capital by depreciating all gross fixed capital formation over a 10yr period. On that basis, by 3Q, nominal GDP grew 3.1% in the previous 12 months, whilst average capital stock was growing 3.4%, so overall asset turns were still in decline in yoy terms.
However, as the chart shows, that decline has bottomed out, and if nominal GDP growth accelerated from 4% yoy in 3Q to 4.6% in 4Q whilst capital stock growth was maintained at about 3.4%, then we see that 4Q did represent an inflection point. Quite possibly, 2H16 saw a combination of recovering asset turns and, in response, saw a modestly positive response in investment spending. If so, the prospects for 2017 are improving.
Labour Productivity Trends Improved as Employment Growth Slackened
Throughout much of 2015 and 2016, the rapid growth in employment seen over the previous two years was threatened by a mild deterioration productivity, defined here as real GDP per worker deflated by changes in capital per worker. Although the decline was modest, it does seem to have modestly depressed labour demand: by 4Q, I think employment growth had slowed to around 1% yoy, or 1.5% on a 12ma.
But by 4Q we appear to be reaching a new equilibrium, as this measure of labour productivity stabilized in the first half of the year and began a very fractional recovery during 2H. In the 12m to 4Q, I think employment rose by 1.5%, and output per worker by 0.5%, but with capital per worker rising 1.9%, output per worker minus capital stock per worker fell 1.4%. But, as the chart shows, the situation was steadily improving, albeit modestly. Labour market prospects too. .
i) employment growth likely to rise slightly from the 1% seen in 4Q, based on an slightly improved productivity performance; and
ii) capital stock growth to accelerate modestly from the 3.4% averaged in 2016, in response to the upward inflection of ROC;
the chances of sustained, and probably modestly accelerated growth in 2017 are good.
Terms of Trade Have Improved
The third factor which is encouraging is the rise in Britain’s terms of trade (including or excluding the trade in oil), which will help secure operating margins. As the chart shows, 2H16 saw a positive breakout for UK’s terms of trade, regardless of oil-price movements, to levels not seen for at least a decade. By November, the total terms of trade had improved 3.1% yoy, or by 3.5% yoy if one excludes the trade in oil. Doubtless some of these gains reflect a fall in Sterling which was the result of political risk aversion rather than trading pressure: as this abates, we should expect the terms of trade gains to be gradually lost. But that issue probably turns live only in second half of 2017, with a negative impact surfacing possibly in 2018. For now, however, it is factor supporting further expansion.
Private Sector Deleveraging: Believe it or Not
If return on capital, labour productivity and terms of trade all suggest continued and possibly mildly accelerated expansion, the fourth factor moderates that. Although this contradicts all conventional thinking and a never-ending deluge of headlines, banking data tells us that the UK private sector returned to deleveraging during 2016. During the 12m to November, private sector sterling deposits grew by 6.5% yoy whilst sterling lending to the private sector grew only 5.14% yoy. As a result, the private sector grew its net sterling deposits by £37bn, or by 24% yoy, to £192.4bn. Meanwhile, banks’ private sector loan to deposit ratio fell to 91.5% in November 2016 from 92.7% in November 2015.
The deleveraging seen in 2016 was the first significant re-build of the financial position since 2013, and has helped explain the mild slowdown in growth seen in the last two years.
We do not know what drove this deleveraging, and consequently cannot be certain of its likely trajectory in 2017. If it continues, it will continue to act as a drag on growth. But if the determination to deleverage reverses, perhaps on a recovery in economic or political confidence, the financial retrenchment seen in 2016 could provide some firepower for better-than-expected demand growth in 2017.
What is noticeable about this analysis is that it directly contradicts virtually popularly-held reason for gloom. The analysis which insists that productivity has stalled, investment spending has stopped, wages growth has fled, and that Britain has no comparative advantage in international trade, but nevertheless is growing only because of a reckless willingness to take on new debt turns out to be demonstrably wrong in every particular. In every point, the current crop of data tells us the opposite is true.