AXA IM's David Page – UK reaction: January GDP provides a further upside surprise

• UK monthly GDP for January surprised to the upside, falling by 2.9% as the UK entered its 3rd lockdown, less than an expected 4.9% drop.
• Services output again provided the bulk of the upward surprise, falling by less than expected, as in November. Construction output unexpectedly rose in January.
• Yet manufacturing fell back more sharply than expected – we wonder if this reflects a preliminary impact of the move to new trade regulations with the EU.
• January’s upside surprise leads us to revise our Q1 GDP outlook to -2.9% (from -3.5%) and the 2021 outlook overall to 5% (from 4.6%).
• The BoE will likely leave policy unchanged next week, although we expect a dovish tone to target tightening financial conditions across the UK. It remains to be seen whether words alone will suffice and we still, on balance expect a final tweak to the QE envelope in May to avoid a premature taper of UK asset purchases.

UK monthly GDP fell by less than forecast, again in January. On the month GDP dropped by 2.9% in January as the UK economy fully entered its 3rd national lockdown. However, this fall was once again less than markets expected, with consensus forecasts estimating a 4.9% drop on the month (our own forecast -4.0%), but against a broad range of forecasts between -0.8% and -7.0%. Sectoral output data provided some additional detail to today’s release. Most of the upward surprise was once again delivered by a smaller than expected contraction in the service sector. This fell by 3.5% on the month in January as lockdown measures hit. However, consensus had expected this to contract by 5.5% and as the UK’s largest sector this contributed markedly to mitigating the contraction in overall GDP. Additionally, construction output surprised. It rose by 0.9% on the month in January, defying expectations for a 1% contraction, rebounding for the unexpected 2.9% fall in December. Meanwhile manufacturing (and the broader industrial sector) fell by more than expected, manufacturing down 2.3% on the month versus expectations of -1.0% (broader industry down 1.5% versus -1.0%).  

While monthly data has proven volatile in this climate - as evidenced by the huge range in economist forecasts – the better-than-expected January output leaves the outlook for Q1 better than we expected. Admittedly, construction, which has recovered well since the pandemic, should be supported by renewed buoyancy in the housing market, but remains vulnerable to weather shocks and could stumble over the coming months. However, we would expect modest improvement in services and manufacturing over the coming months. One uncertainty remains the impact of Brexit. We expect to see some impact of the increase in trade barriers that the new EU-EK trade agreement imposes, but at this stage identification remains a matter of intuition and guesswork as we await a full data picture. In January, this effect was not obvious as the trade deficit for January narrowed to -£1.630bn from -£6.2bn in December (and for goods to -£9.8bn from -£14.3bn), but this likely reflected falling import demand as consumer spending fell back in January and precautionary inventory inflows ceased. It is plausible that some of the surprise drop in manufacturing, against a generally firmer global tone (France and Italy posted strong gains in January,  with German figures adversely impacted by the inclusion of construction), reflected UK manufacturers deliberately paring back output ahead of more difficult export conditions around the turn of the year. A fuller analysis of broader data will be necessary to determine this precise effect, but this could continue to weigh on UK output for the coming quarters. However, our forecasts had already allowed for such an impact and in the light of January’s figure, we raise our GDP forecast for Q1 to -2.9% (from -3.5%) and our full year outlook to 5.0% (from 4.6%).

Today’s release will also have an impact on the Bank of England’s decision next Thursday. BoE members including Governor Bailey had warned of downside risks to the Q1 outlook in the light of the sharp 8.2% drop in January’s retail sales report. Now they will be faced with upside risks to their -4.2% forecast for Q1. While likely tempered by caution in the immediate pace of snap-back in the economy, this could also add to the broader upside concerns of other Committee members, including Chief Economist Andrew ‘coiled spring’ Haldane. While this will likely add to the view that the UK economy should rebound quickly across the course of this year, it may add to the headache of a broader improvement in sentiment further tightening financial conditions. Since the February Monetary Policy Report, the outlook for underlying policy rates is broadly 20-25bps higher over the coming three years than the BoE had conditioned its forecasts on, while sterling is currently 3% in trade-weighted terms than the BoE assumes. Together and with no other changes, this could see the BoE’s inflation projections nearly 40bps below target two-years out. We expect the Bank to leave policy unchanged at next week’s meeting, but provide a dovish tone to address the disinflationary impact that this tightening in financial conditions would otherwise deliver. Any market reaction – and so far there is little reaction in sterling currency markets to today’s upside surprise – over the coming weeks in anticipation of stronger growth could exacerbate this headwinds from financial conditions. The Bank will monitor these developments, but it could add to the need for an additional tweak to the BoE’s QE envelope in May to remove the outlook for a tapering in BoE asset purchases materially ahead of that of international peers, as we still, on balance, expect.