UK Q2 GDP: not as bad as feared, but worse to come

The UK Q2 GDP report showed that the economy did indeed contract between April and June this year, albeit not by as much as the market was expecting. The actual contraction of 0.1%, was half the 0.2% expected by market analysts. However, the detail of the report is what is most interesting to us at Minerva Analysis. The market had expected the index of services for the three months to June to surge by 0.9%, instead there was a decline of 0.4%. Added to this, expected declines in industrial and manufacturing production were not as large as expected. Overall, this is not a good report, but it suggests the UK is not in as bad a position as expected. The question now is, could this shift the dial on the Bank of England’s dire economic projections for later this year?

The UK consumer clings on, just about

Looking at the decline in the index of services, the first reaction is to worry that the recession that the BOE predicted last week is already upon us, after all the UK economy is a majority service sector economy. However, this 0.4% decline was driven by a negative contribution from human health and social care, reflecting a reduction in coronavirus activities, which is a good thing for society at large. The Office for National Statistics notes that there were still positive contributions from consumer-facing service sector activities, including travel agencies and tour operators, accommodation, food service activities, arts and entertainment and recreation activities. Thus, even though there was a 0.2% decline in household consumption for Q2, consumption is holding up well in the face of soaring inflation and rapidly rising energy bills.

The deflator lets the air out of the UK economy

On a monthly basis, June GDP declined by 0.6%, the market had expected a 1.3% decline. However, this is where the “good” news stops. The May GDP figure was revised down to 0.4%, while the implied GDP deflator, which measures inflation, rose by 6% in the past year, driven by a 7.3% increase in the price of household consumption expenditure, which is the largest annual increase since 1991. The GDP deflator measures the change in prices for all goods and services produced by an economy. It is considered a better measure of inflation than CPI, because it measures inflation in a boarder range of goods and services. The GDP deflator is a good way to indicate how much the economy grows because of a rise in prices, or, to put it another way, a rise in prices can impact GDP from one year to the next. Thus, the fact that the UK’s GDP deflator is 6% for Q2, at the same time as GDP contracted, is a sign that growth is slowing at the same time as people are having to cough up more for the goods and services the economy produces. Thus, while the headline figures are not as bad as analysts expected, the truth is that the UK economy remains in a perilous position. When the deflator is this high, there is a large risk that householders, business and even parts of the government will have to reduce their spending as budgets get constrained by rising prices for essential items. Therefore the BOE’s forecasts were so gloomy last week, and this report does nothing to shift the dial on this.

US inflation review: are we past the peak?

It is worth noting that US inflation was weaker than expected last month. Both headline and core CPI fell, with headline inflation falling to 8.5% in July, down from a 4-decade high of 9.1% in June. On a monthly basis, CPI was flat in July, however, as we have pointed out before, even if US monthly inflation remains flat for the rest of the year, the annual rate would still be 6.3%, way above the Fed’s 2% inflation target. The biggest surprise in the US’s inflation report for July, was the 0.3% increase in monthly core inflation, which is down sharply from the 0.7% monthly increase recorded in June. The largest decline in US prices was recorded across energy categories, along with used car prices and airline fares. Grocery costs were up 1.3% on the month, which is a 13.1% increase in a year, the largest annual rise since 1979. Dining out costs also rose. However, with wheat shipments leaving Ukraine in recent weeks, there is some hope that grain prices may have peaked and we could see food prices moderate from here, especially now that it seems gas and petrol prices are past their peaks. However, there is still work to do to bring down inflation and this is why the Fed is unlikely to reduce the pace of rate increases, at least not in September, until they see a stronger pattern of declining prices. It is worth noting that core prices are still 5.9% higher than a year ago, and prices increases remain somewhat embedded in the US, and global economy. However, since the US’s CPI report that was released on Wednesday, the 5-year 5-year forward inflation expectations rate, measured by the St Louis Fed, has moderated slightly to 2.27%, which is probably a level of future inflation expectations that the Fed will tolerate.

The market reaction

Looking at this week’s key data releases from the financial markets’ point of view, the rally in stock markets sparked by the drop in US CPI on Wednesday had fizzled out by Thursday, however, European stocks had a decent start to Friday’s trading. We expect stocks to trade in a range, as is often the case when we see potential turning points in the economic cycle, and as the market waits to see if we have reached peak inflation. Post the UK GDP data, the pound is lower by 0.4%, and GBP/USD is trading below $1.2150. Overall, we think that stocks may continue to grind higher, as there is no real driver to push them lower right now, although we will be watching the University of Michigan Consumer Sentiment Survey to see if the decline in long-run inflation expectations has moderated. If we do see a moderation in inflation expectations, then this could set the scene for a rally in risky assets next week. In the FX space, the dollar index is trading in a narrow range around 105.00, which is limiting GBP reaction to the GDP data. In the long term, if we see stocks continue to recover, then this is bad news for the dollar in the medium term.