1. UK Economic Prospects October 2014 Peter Spencer

2. Turning cautious… We’ve seen the benefits of a rebound in confidence following the Euro crisis but now the worry list is lengthening The Scottish Referendum was not decisive and the panic reaction in Westminster leaves a big constitutional mess This adds to the uncertainty over the outcome of the general election, which is very hard to predict following the Clacton buy-election The gap between the two main parties is greater than at any time since 1992, particularly on the key economic issues of fiscal retrenchment and the EU referendum. Political stability is crucial for international investors, underpinning FDI and financing the current account deficit, which has opened up again this year, moving back to 5% of GDP

3. …’cause breaking up is hard to do ► As we saw in 2011 and 2015 with the €, these break-up risks are almost unfathomable and can paralyse investment ► We don’t expect paralysis this time, but investment will slow if firms begin to worry about existential risk again ► Mortgage lenders and borrowers have both become more cautious following the Mortgage Market Review and the prospective increase in interest rates ► While export growth is held back by the weakness of European markets and the weaker Euro

4. Remember how uncertainty about the banks and the € trashed business confidence… 40 45 50 55 60 65 70 1996199820002002200420062008201020122014 Source: Haver Analytics % balance UK: CBI uncertainty about demand

5. …and the consumer -50 -40 -30 -20 -10 0 10 20 1996199820002002200420062008201020122014 Source: Haver Analytics GfK NOP Index UK: Consumer confidence

6. Mortgage lenders and borrowers have become more cautious…

7. Still not worried? Take a look at the incoming threats on the global risk radar… Should we still be worried by the global search for yield? And about the tightening of US monetary policy? Will the ongoing crisis in the ‘fragile 5’ EM’s undermine global growth? How serious is the continued risk of a Chinese financial crisis? Last but not least, is Europe headed for deflation?

8. Here we go again - compression in EM risk premia…

9. Monetary policy remains a major uncertainty… The low level of US and EZ interest rates compressed yields and led to an under-pricing of risk similar to the one that led to the crunch The Fed is nearly done tapering, prior to raising interest rates at some stage next year But Janet Yellen has said this will be dictated by the US economy and labour market rather than global risk factors This has given the EMs another headache, following last year’s ‘taper tantrum’ With another test to come in the form of the effect of higher US interest rates on the carry trades

10. Here we go again - compression in EM risk premia…

11. The Fed has done tapering, with the first rate hike expected in 2015H2…

12. The Fed’s tightening adds to the currency problem in the EMs…

13. …weakening the short-term growth outlook…

14. … but the EMs are in a much better place than in 1997…

15. World: share of disposable household income Source: Oxford Economics. …and long-term, the emerging market growth story is inescapable

16. Global risk radar… US Monetary policy? Will the crisis in the ‘fragile 5’ undermine global growth? How serious is the risk of a Chinese financial crisis?

17. Will China suffer a banking crisis? A crisis is not my central expectation China has over $3.6trn in reserves and government debt is low. The government is focused on financial sector reform. The authorities still have much greater control over the economy than we have in the West. However: High levels of corporate debt Excess supply of real estate. Serious questions over the ability of the Peoples’ Bank to control the growth in shadow banking. These risks may be related in ways we can’t see yet.

18. Forecast is for smooth rebalancing…but…

19. …construction is still adding to the excess supply of real estate…

20. …and could trigger a crisis

21. Trade with PRC is not a serious problem for the UK…

22. …and lower commodity prices have a silver lining for the UK…

23. ... helping to subdue input costs… 65 70 75 80 85 90 95 100 105 110 115 70 75 80 85 90 95 100 105 110 115 120 125 199820002002200420062008201020122014 Source: Haver Analytics 2010=100 Core producer input prices (RHS) Import prices (LHS) UK: Import and producer input prices 2010=100

24. …and output prices -15 -10 -5 0 5 10 15 20 25 30 35 1996199820002002200420062008201020122014 Source: Haver Analytics % year UK: Headline producer prices Output Input

25. Global risk radar… US Monetary policy? Will the crisis in the ‘fragile 5’ undermine global growth? How serious is the risk of a Chinese financial crisis? Europe – headed for deflation?

26. There’s no silver lining for he UK in the clouds hanging over the Eurozone… The € recovery has stalled in Q2, with the Ukraine having a surprisingly large effect on confidence… But Mario Draghi has successfully devalued the € This has fallen back from $1.43 to $ 1.26 This helps fight deflation by raising import costs And boosting € zone exports But at the expense of US and UK exporters!

27. Recovery stalls in Q2…

28. Ukraine has damaged sentiment…

29. Low inflation and the large output gap means deflation risk…

30. But Draghi has successfully deflated the €, which helps stave off deflation and bodes well for European exporters…

31. This points to steady but unspectacular growth

32. ..but with no support from fiscal policy

33. Global forecast summary

34. Global risk roundup The US monetary policy tightening has been problematic for EMs But Asia is less risky than in 1997 and the long run growth story is inescapable The stronger US economy and dollar now helps the Eurozone And of course UK exporters.

35. The latest UK data show a much stronger recovery… This month’s ONS data revisions give a very different perspective on the shape of the recession – and recovery GDP has been revised up, meaning that we passed the previous peak a year ago and output is well above the 2008 peak This is more consistent with the strong growth in employment, although productivity has still fallen The upward revision in investment has been particularly pronounced, meaning the need to catch up for the low levels of the recession is less than previously thought

36. …and put the UK in an expansion phase

37. They give a very different picture for investment…

38. ..but show much smaller revisions for consumption

39. But where is next year’s growth coming from? The labour market remains strong and flexible and we expect consumer incomes to be buoyed up by rising employment Employment growth should slow but wages should pick up a bit as unemployment falls and the labour market tightens Financial conditions favour investment and firms are still catching up with the effect of the recession on the capital stock We expect GDP to growth to ease back to 2.4% next year after 3.1% this year, with interest rates on hold until next spring

40. Consumption is constrained by weak wages and the need to save… The recovery in real incomes and consumption has been founded on employment rather than wage growth This has been reinforced an improvement in job security and consumer confidence, encouraging people to reduce rates of precautionary saving and to go out and spend However, savings ratio has now fallen back to around 6%, just about consistent with a stable debt to income ratio of around 1.4 Pension pressures and the prospect of higher interest rates likely next year should stop the saving ratio from falling further And the FPC will also be keen to prevent rising debt ratios Meaning that the growth in consumption must move back towards the growth in household disposable incomes

41. The FPC will be watching these ratios…

42. …and especially this one this one…

43. …very closely 20 40 60 80 100 120 140 160 180 200 1990199319961999200220052008201120142017 Source: Oxford Economics Forecast 1995=100 Mortgage interest payments/income House prices/incomes UK: Housing ratios

44. This is where the growth is coming from…

45. ITEM Club UK Autumn forecast 2014 The EY ITEM Club forecast for the UK economy, Autumn 2014 % changes on previous year except borrowing, current account and interest & exchange rates GDP Domestic Demand Consumer spending Fixed investmentExportsImports 20120.71.41.10.7 3.1 20131.71.91.63.20.5 20143.1 2.19.3-0.3-0.4 20152.42.82.37.55.15.4 20162.32.52.27.85.25.5 20172.52.32.07.35.14.2 20182.52.11.86.25.13.7 Net Govt Borrowing( *) Current account (% of GDP) Average earningsCPIBank Rate Effective exchange rate 20127.2-3.72.42.80.583.0 20135.6-4.21.42.60.581.5 20145-4.61.11.60.587.2 20153.9-32.11.31.187.4 20162.4-22.81.52.186.4 20171.0-1.63.32.03.185.5 20180.1-1.23.82.23.584.7

46. Summary Uncertainty is now likely to slow UK investment The weakness of wages constrains the consumer, but employment growth remains strong The export outlook remains poor, particularly in Europe, given the fall in the €. But falling commodity prices should give the advanced economies a significant boost, especially large oil importers like the Eurozone and Japan. In the UK, they have sharply reversed the inflationary pressures of recent years, taking CPI inflation down to 1.2% I expect GDP to grow by 3.1% this year and 2.4% in 2015, with interest rates on hold until next spring at the earliest, depending on how these risks play out