Written by Roger Martin-Fagg, Behavioural Economist.
“UK SME confidence remains optimistic but there are economic challenges ahead”
About Roger Martin-Fagg
Behavioural Economist
Roger is an economist turned strategist. He began his career in the New Zealand Treasury, then moved into airline business planning and teaching postgraduates all aspects of economics. He designed and ran the postgraduate diploma in Airline Management for British Airways before joining Henley Management College in 1987, where for 21 years he taught senior managers macroeconomics and strategy.
Roger is an independent teaching consultant. He has been an external examiner to Bath University, worked with the Bank of England and three of the major UK clearing banks, and advised a major London recording studio for 15 years. Roger regularly talks to SME owners in the UK and Europe about economic trends, and is a visiting fellow to Ashridge, Warwick and Henley business schools.
Welcome to the October 2023 Economic Update.
The purpose of the update is to act as a counterweight to the general economic commentary you get from the media. As many of you know I look at the economy through a behavioural lens. I focus on money and how it flows. As I explain in this update, this is missing in the mainstream models which are widely used by mainstream forecasters. Many of you have heard me say that these models and forecasts are precisely wrong. My
approach is broadly right. It’s your choice!
I am naturally optimistic (as most of you are!). As a consequence I tend to accentuate the upside and choose the data which supports my natural inclination.
If you are a pessimist there is a huge amount of analysis and commentary out there to support your mindset.
My optimism is always justified when I spend time with you. Vistage members are thinkers and doers simultaneously. Your adaptation to the reality of lockdown has been remarkable and I know many of you are
producing financial results well above plan. As you are 60% of the economy my optimism is justified by your behaviour. Please continue to train, invest, innovate and lead. My forecasts will then prove correct!
Roger Martin-Fagg
October 2023 Economic Update
I hope most of you have enjoyed a holiday. I see it as a time for reflection and the opportunity to rise above pressing day-to-day challenges.
My three weeks in Pembrokeshire has given me the time and energy to reflect on the current state of the UK and elsewhere.
The most commonly used word in the media is crisis. Crisis is defined as a time of intense difficulty or danger. Parts of the Ukraine, Central Africa, Western Canada, Florida, Libya, Morocco and Hawaii have all experienced weather-related crises over the past six weeks. But is there an economic crisis?
There is no economic crisis. A more appropriate word is malaise. There is a general feeling of unease whose exact cause is difficult to identify. The UK and Germany in particular are experiencing tolerable underperformance. Tolerable underperformance is best described as low or no real growth with full employment.
The latest revisions to UK GDP show that since 2021 economic performance is in line with the rest of Europe, not worse as originally thought. But we should note that the revisions do not mean the man in the street is better off. Wholesalers and food retailers made much more profit than originally estimated. Germany is underperforming because China is. Germany still has a trade surplus of 4% of GDP. This compares favourably to the UK with its 3.3% of GDP deficit.
The politics reflect tolerable underperformance. There are shifts left or right of centre across a range of countries. Ignoring the USA, these shifts are unlikely to result in major changes in economic management. The UK is experiencing petty wrangling and a clash of cultures between young tax payers and the old comfortably wealthy. There are growing numbers of the latter.
Stagflation, a period of rising prices with little or no real growth is tolerable for the majority particularly if pensions and the minimum wage keep pace with inflation. If next year brings a coalition or Labour government, faces will change; there will hopefully be more energy and competence. However, don’t expect any major shifts in economic policy.
The UK’s Growth Rate
Inflation is falling across the globe due to the collapse in money supply growth rate from 14% a year to 1% a year.
Inflation has reduced the purchasing power of existing money by at least 10%. Populations have less real spending power so real demand has fallen back from the end of lock down peaks. Supply and demand in a wide range of goods and services is beginning to balance out.
The current danger is overkill due to a rigid inflation target of 2%. The USA sensibly has a flexible inflation target: they now take an average over a number of years. It means that even if inflation is above 2%, the USA will reduce interest rates if growth stagnates. The UK has a target range of 1-3% but no averaging over time.
Unfortunately, the UK government has politicised the setting of interest rates by the Bank of England. It first blamed gas prices and now it blames the Bank for our inflation rate. The cause is generous furlough and business support during Covid financed by new money from the Bank as requested by the cabinet.
There is NO case at all to raise rates from the current level. There is a case to move to a more flexible target for inflation but the PM has made the inflation target one his five measures of leadership performance. Even though it is completely out of his control!
In fact, of his five targets the only one within his control is to stop the boats. If the Bank of England raises rates further we should expect a mild recession in an election year.
Inflation will only fall to 2% in countries which enjoy productivity growth. In this the USA leads. And most other countries lag. As I have said in previous updates, unless productivity can be increased through automation, inflation control requires higher unemployment for all skill sets i.e. a recession.
This chart explains. The growth in private sector pay is running at 7% excluding bonuses. The UK services inflation rate is slightly lower. If productivity was growing at say 2% then services inflation rate would be 5%.
An important component of the surge in inflation was the rise in import prices as global energy and food costs soared with the outbreak of war in Ukraine. At one point last autumn that price surge damaged our terms of trade and subtracted about 1.5 per cent from our national income. The terms of trade is the difference between import prices and export prices. If export prices are rising by more than import prices; the terms of trade are improving. If Import prices are rising by more than export prices, the terms are deteriorating.
However, the surge which drove consumer price inflation to annual rates above 10 per cent, has now fully reversed. Indeed, the terms of trade are now slightly better than they were at the beginning of 2022.
Consequently, the rate of price increases is falling fast: consumer prices in the month of June rose at an annual rate below 2 per cent, and in July the CPI index fell by 0.4 per cent, due to a decline in energy prices.
The UK suffered an unavoidable loss of real income as import prices rose. If workers attempted to maintain their previous levels of real income, the result would be a wage spiral. This happened in the 1970s, when the terms of trade deteriorated significantly due to a quadrupling in the price of oil.
Given the terms of trade recovery and no growth in money supply there will not be a wage price spiral. Real wages are down 4.5 per cent since the beginning of 2022, having failed to keep pace with inflation. But companies have done well. The latest revisions to GDP are the largest we have seen. £44bn added due to actual profits being higher than the estimated profits in the food retail and wholesale sector plus more accurate data on health sector output. As the NHS provides 88% of UK health care output it’s clearly performing well. 85% of NHS output is now measured on an output basis, when formally it was on an input basis. (i.e. how much was spent rather than what was produced).
Overall if the UK had matched EU14 levels of spending per person on health, day-to-day running costs would have been £39bn higher each year, on average, over the past decade (£30.5bn of which would have been additional government spending). For capital spending, matching the cumulative EU14 average over the past decade would have resulted in the UK investing £33bn more in health related buildings and equipment. These are significant gaps in spending. Had the UK spending kept up with European neighbours it is fair to assume the NHS would have been more resilient and had greater capacity to provide care during the pandemic and reduce the large backlog of care that is its legacy.
The UK has no spare workers. Any business which increases its headcount using local labour will have poached from another business by offering more money and better conditions.
The policy judgment now has to be whether employers will respond to the inevitable above-inflation wage demands by attempting to preserve past improvements in profit margins. That obviously depends on the strength of demand and activity in the economy. The picture is clouded by the long and variable lags in monetary policy. The time lag is up to two years. Putting it bluntly, currently there is not enough money being created to enable any significant increase in prices or wages in 15 months’ time. This will be a headache for the new government.
The effect of interest rate increases on the cost of consumer credit has been rapid, but that on mortgages has been delayed while fixed-rate contracts work through. There are tentative signs of a slowdown in activity and a slackening in the labour market as tight money bites.
A look at wage growth by sector three months to June 23. Over the same period CPIH (consumer prices including housing costs) Index rose 7.3%
Retail 7.7%
Hospitality 6.5%
Manufacturing 8.2%
Construction 5.8%
Financial Services 9.4%
Health 6.8%
Simply put: if you work in finance and manufacturing your real income before tax is growing.
Households’ net increase in their bank accounts is normally £6-8bn a month, in July it was zero.
This means any increase in income was entirely spent. This spending is preventing a recession.
Explanation of the chart below. PNFCs are any business which isn’t finance. Non-intermediate OFCs is any financial business which isn’t a bank or building society.
The light blue box shows the impact of furlough plus lock down on household money balances.
The latest data point is for July 23. It shows there was no net increase in household bank deposits, even though incomes are rising. We can assume that households spent all their earned income in July. Consumer spending is the main driver of nominal GDP growth.
Public Sector Spending
The next government will need to raise taxation or cut spending. The most likely approach is to keep personal allowances at current levels. This is taxation by stealth.
Given the age profile of the electorate the untouchable spending is pensions and health. Given the tax base the only tax change which raises serious money is the basic rate.1% on the basic rate raises £7bn.
VAT on private schools would raise £1.3bn and taxing nondom would raise £3.2bn.
So the mantra during the election campaign will be raising real growth to finance public services. And this is the challenge.
A look at history
Between1950-2008 UK real growth averaged 2.3%
Between 2008-2016 UK real growth averaged 1.3%
Between 2016-2023 UK real growth averaged 1.1%
NB the colour of government makes no difference!
My simplistic view is this. When people age, their desire to take risks and innovate diminishes. They become more cautious and satisfied with their lot. This places the growth burden on the young. Modern technologies allow people to interact with global markets regardless of domicile. Thus dynamic, creative youngsters who are the engine of growth can live anywhere and there is increasing evidence that it’s not in the UK. The recent choices made by the older members of the UK population are growth inhibitors. Brexit being the most obvious one.
I am sure every reader knows of people in their twenties and thirties who are choosing to live elsewhere albeit not permanently.
Our demographics predict virtually no increase in labour supply over the next ten years. Our average productivity is 1.1%. Unless this is increased, our growth rate will also be 1.1%.
Productivity enhancing automation is now imperative.
The UK is internationally recognised for its leadership in research and its scientific institutions. While the UK’s expenditure on innovation has been lower than some of its competitors (France, USA Japan, and so on), the government has committed to boosting investment in R&D to 2.4% of GDP by 2027 and to increasing public funding for R&D to £22bn per year by 2024–25.
Also, between 2007 and 2019 the UK received venture capital investments of a total of $20.4bn, above other European nations. By the end of 2020, as stated in the UK Innovation Report done by Cambridge, the UK had 25 unicorns (a start-up valued at over $1bn), and its start-up scene ecosystem is as vibrant as ever.
At last the government has agreed to re-join the EU Horizon programme. This is a £100bn EU-wide technology incubator .
Share of Business Adopting by Sector, 2020 (per cent)
How much Automation (AI) is taking place in the UK?
The UK has an AI workforce of over 50,000. AI contributed £3.7bn to the economy in 2022.
Britain has twice the number of AI-based companies than any European nation. The largest estimated net job gains from AI over the next 20 years are predicted to be in the UK’s health and social care sector.
Of the UK’s main regions, Greater London leads the market for AI skills with 2.2% of all job postings in the capital mentioning them, followed by Northern Ireland (1.0%), and the South East (0.9%).
London serves as the primary hub for AI startups in the UK, hosting approximately 80% of the top 50 AI companies in the country, including: DeepMind, Adbrain, and BenevolentAI, alongside prominent machine learning research groups at UCL, Kings, and Imperial College.
In my opinion this will be the source of significant gains in productivity over the next ten years.
As the chart shows, with an average adoption rate only around 20% of UK business, the potential is huge. And hopefully the UK will be a major exporter in due course.
As a nation, we have a competitive advantage in services. 6% of GDP is derived from services exports. Unfortunately, it is not enough to offset the 8.5% of GDP which flows abroad when we buy food, raw materials and manufactures.
The Housing Market
The general public are being misled by the media. The only accurate data on house prices is from the Land Registry.
As of June 2023, property prices rose 0.7% compared to May and were 1.7% higher than a year earlier. The average price is £287,546. This is 7.5 times median disposable household income, (ie income after tax).
The number of transactions is down 16,000 compared to the average per month at 100,000.
As I have said, there is no case for further increases in interest rates. Assuming we are at the peak, then given real wage growth, affordability should improve slightly over the next six months.
We know that the big five are cutting back supply of new homes. Therefore, prices will not fall. Transactions will pick up slightly from now.
We should factor in that the government may yet again stimulate the market with a package of incentives as we enter the election cycle. This would be a mistake.
It’s nearly a year since the Truss/Kwarteng mini budget spooked the market and things have settled down. The Bank of England in a recent stress test showed that UK banks are well capitalised , increasing their profitability and could easily survive a 30% fall in house prices with a 9% unemployment rate.
The chart below shows the proportion of income that UK households spend on mortgage payments.
It’s called the debt service ratio (DSR). The projection does not take into account the fact that incomes will still be rising over the next two years. This means the projection is overly pessimistic.
The UK Outlook
Research from the Bank of England shows the majority of UK businesses have increased both margin and profitability since the end of lockdowns. And as non labour input costs fall from the peaks of a year ago they have no intention of passing this on in lower prices. This applies particularly to larger businesses with significant market shares.
The constraint on growth is labour supply. Data on work visas granted to overseas workers shows that 80% are health and care workers.
The only solution is re-engineering business to use the same or less labour. AI in all its forms is now an imperative.
As a simple example, in the past year I have purchased food and fuel with almost no human interaction.
The money supply data suggests inflation will continue to fall over the next 18 months. If it doesn’t then output will fall.
The options are inflation at 4% with real GDP at 1% or inflation at 6% with a mild recession. I expect the former.
The problem with using interest rates to bear down on inflation
To reduce the rate of inflation the demand for goods and services has to be softened. The logic is that businesses will not increase prices when demand is flat or falling. So consumers need to have less real disposable income in order for this to work.
In the seventies and eighties raising interest rates was an effective tool. It worked because the majority of mortgages were floating rate. An increase in base rate had an impact on households and businesses with a mortgage. It reduced their disposable income immediately and demand for goods and services.
Within a short time frame businesses stopped recruiting new staff and after around six to nine months began laying off existing staff. This increased the supply of available labour and the wage bargaining power shifted in favour of the employer. The rate of wage inflation dropped quickly during the downturn in demand and the ensuing recession.
Today only 20% of mortgages are floating rate and the majority of these are held by people with plenty of spare cash. A base rate of 5.25% has virtually no impact on their willingness and ability to spend. It is ineffective in reducing demand.
Additionally, 12 million retired people see their income going up as interest on their savings improves although not in real terms. Their spend on holidays and pub lunches softens a bit but not much.
Who cuts their spend due to higher interest rates? About 1.2 million borrowers who are facing an interest rate 5% larger than before, and some renters.
Out of a working population of 32 million only 3.2% of home owners are put under pressure by higher rates in 2023, and an additional 3% in 2024.
There are 210,000 buy-to-let mortgages. Many of these are fixed rate for two to five years. Landlords do adjust the rent to reflect higher interest rates. We can add 210,000 individuals to the list of those squeezed by high rates.
Thus those with less disposable income amounts to around 1.4 million in 2023 and another 1.4 million in 2024. Those with more disposable income are 12 million (even though it is down in real terms).
Raising the rate of interest to bear down on inflation is much less effective than it used to be because there are relatively more gainers than losers. The gainers are mostly retired; the losers are primarily young with growing families.
The most effective and much fairer way would be to raise income tax. But ideology prevents this. Frankly the current short-termism of the British government as they scratch around government budgets to squeeze enough out to bribe the electorate with small tax cuts is staggering.
At last the Bank of England has recognised that to raise interest rates further would be a mistake.
The inflation rate in Western economies from now on will be driven by wage awards adjusted for productivity.
I anticipate wage growth at 5%, adjusted for productivity of 1%, will produce an inflation rate of 4%.
This implies base rates of 4-5% until labour productivity improves or a deep recession increases unemployment. The latter is highly unlikely.
France is the only country which has matched USA productivity
Conclusion
Money supply is either contracting or flat except in China where it still growing by 10%. Current inflation rates are falling everywhere. Real GDP is growing in the USA by 2.5% but elsewhere in the West it is at or close to zero. The Middle East oil exporters are growing well as the barrel price hits the nineties due to their decision to restrict supply. China has over investment in real estate problems, but recent data shows growth returning, with 6.3% the latest reported figure.
Inflation has delivered the required reduction in real spending power.
Global GDP pre-Covid was $100tn. Covid support resulted in the creation of $20tn of unearned new purchasing power. Commodity prices reflected this massive increase in spending power, increasing by 65%. Consumer prices followed, growing above 10%. The purchasing power of the $20tn is being reduced month by month and the global system is slowly beginning to balance.
Wealth for the majority has reduced by around 15%, although the money illusion disguises this fact. For example the real value of the average UK house is now the same as it was in 2004. The chart on the next page gives some country examples.
Inflation rates will remain above government targets for at least another three years. However, I think interest rates are at their peak. They will remain at current levels unless fourth quarter data is much softer than forecast at which point they will be reduced but not by more than 0.75%.
Western economies are still running at close to full capacity. Demography indicates this is the new normal. Until investment raises productivity sluggish growth below previous trends is also the new normal.
Individual businesses will only enjoy rapid growth by being superior to their competitors or by offering unique technologies which are attractive to consumers.
Prepared 24th September 2023
UK Forecast Inflation: 5% end of year, 4% in 2024
Interest rates: 5.25% end of year 5% in 2024
Real GDP: +0.5% end of year 1% in 2024
Exchange rates: same as today
Unemployment: 4.3% but still under 5% next year
A coalition government in 2024: Labour/LibDem or biggest Labour victory since 1997.
Sources: Mr Roger Martin Fagg, Vistage International