UK recession confirmed...and it’s worse than first thought

Data on Wednesday has confirmed that not only did the UK enter a double-dip recession in Q1 of 2012, but it contracted by 0.3%, rather than the -0.2% figure that was initially estimated April. At the time of the initial estimate in April, sterling was spared quite a bit of pain because the market thought it knew better than the Office of National Statistics (which releases the GDP figures). In particular, many questioned the ONS’ assessment of growth in the construction sector. Ironically, a downward revision to construction growth was largely responsible for today's headline.

The MPC was also a little guilty of overestimating UK economic conditions in the first quarter, choosing to focus on some more positive but ultimately misleading PMI surveys from the UK construction, services and manufacturing sectors. Indeed Adam Posen, for his part, has admitted as much.

What seemed like a bright start to the year had definitely fizzled out then and the UK economy is set to struggle for the rest of 2012, possibly contracting by 0.5%, as ongoing UK austerity kicks in and the eurozone crisis weighs on external demand, and internal lending and confidence.

Still though, sterling has weathered Wednesday’s downward GDP revision very well. There is very much a sense that the market is fully aware that UK growth will be stagnant this year, but at least it is getting its public finances in order, and as shown by the UK’s ultra-low borrowing costs, it is clearly removed from the threat of eurozone debt contagion. Sterling’s appeal isn’t based on the imminence of monetary tightening or a positive growth outlook. The pound is basically the poor man’s US dollar, a second tier safe-haven.

In line with a pessimistic outlook for Greece and regardless of the likelihood of further QE from the BoE and the UK’s vulnerability to eurozone developments, we have a positive outlook for sterling against the euro and other risky, commodity currencies like the AUD and ZAR. Clearly, our view is less positive against the US dollar – we see GBP/USD heading down to $1.50 in the second half of this year.

Richard Driver
Analyst – Caxton FX
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What next for Sterling?

The MPC meetings minutes were released this morning much, I’m sure, to the embarrassment of policy member Martin Weale who decided to dance to the tune of raising interest rates. He now joins Andrew Sentance – who has been voting for this policy shift for the past 4 months  – and will probably be rethinking his decision after the release of Britain’s shock GDP figure.

Mervyn King meanwhile, smug in the knowledge that he refused to bow to inflationary pressures, used a speech yesterday to defend the Central Banks ultra lose monetary policy in the face of high inflation. He reiterated that the economic recovery would be ‘choppy’ (understatement if ever I saw one), and that real wages would be heading lower. I’d imagine that King’s Speech will not have been received quite as well by the public as its multi Oscar nominated names sake.

The question now is; what will become of the pound if these figures are to be relied on? How much of a toll did the weather take on these preliminary results? After all, the economic impact of the snow is extremely hard to quantify. My feeling is that the figure of -0.5% shouldn’t be taken at face value. Certainly the recovery has been blown off course, but we should wait for the second and final estimates before completely reassessing the situation. The figure is at odds with the PMI (Purchasing Managers’ Index) surveys and the National Statistics Office has been wrong before, notably coming in 0.4% wide of the mark in the final quarter of 2009. A similar revision this time around could well be on the cards.

Nonetheless, the pound must still deal with the dual hangover of weak economic growth and high inflation: ie stagflation. This is not a concept that will rest too comfortably for the pound. Whereas the expectation of higher interest rates gave sterling a boost in the early part of the year, that eventuality has lost all credibility. Indeed, the prospect of such a move from the Bank of England looks about as likely as Andy Gray presenting Woman’s Hour.

With key US announcements due today and Friday, the market should avert its attention from the UK economy at least in the short term. However, any lasting relief for sterling will depend on a fresh wave of eurozone concerns or these lowly €1.15 levels could endure for now.

Edward Knox

Analyst

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