The Puzzle in UK GDP

UK GDP came out Friday morning, and here are the facts: Output fell -0.1% q/q in Q2, according to the Office for National Statistics’ (ONS) first estimate, with the bulk of the decline seemingly coming from June’s -0.6% m/m drop.^[i] Ordinarily, the logical interpretation would be that the flattish quarterly reading obscures a late-quarter slide, implying the economy has weakened significantly since spring and signaling bad times ahead. However, due to some calendar quirks that the ONS warned skewed monthly data pretty heavily, in this case we think the quarterly figure is probably more telling. It isn’t predictive, and stocks are likely looking ahead to the next 3 – 30 months rather than what happened in April through June, but we think putting these data in context can help investors better weigh the UK’s economic fundamentals overall.

The calendar quirk in question is the Queen’s Platinum Jubilee, which pulled one bank holiday from May into June and added another to the calendar. This resulted in two fewer working days in June and an extra one in May, which the ONS warns threw off their seasonal adjustments. The official monthly GDP release states plainly that there will be a visible effect on both May and June data and concludes: “Caution should be taken when interpreting the seasonally adjusted movements involving May and June 2022.”^[ii]

In our view, this should provide some relief about the fact that all major categories—services, heavy industry and construction—declined month-over-month. Most of that drop stems from having fewer working days in June than May. Similarly, the jump in entertainment services and restaurant spending probably stems from people having two additional days of leisure—days with big celebrations up and down the country to celebrate the Queen’s 70 years on the throne. We don’t view this boom as any more representative of the country’s underlying economic health than the drops in other categories of services and the manufacturing industry. We aren’t saying there is no core weakness. Businesses reported higher energy and input prices as headwinds in June, which probably contributed to falling output in the categories that rely on petrochemical feedstock. But with so much one-time skew, it is impossible to disentangle the two. With July data likely to benefit from an easy comparison with June, we probably won’t get a clearer read until August figures hit the wires—which won’t happen until mid-October.

But the quarterly print smooths all of this out, making it easier to see the longer-term trend and, crucially, how inflation is affecting behavior and eroding nominal growth. The biggest detractor, aside from net trade (which is skewed by post-Brexit measurement challenges), was government spending. That reflects the end of the COVID test-and-trace program as well as the end of the spring booster campaign—making it more of an accounting entry than actual lost output. As the ONS also takes great pains to remind people, the UK’s National Health Service doesn’t charge users at the point of service, and most government spending in this realm doesn’t happen at market prices. But GDP is calculated at market prices, so the ONS imputes what the price for these services would be if they happened in the open market, then adds or subtracts that from GDP. It is basically an estimated counterfactual, not actual spending.

Looking deeper, consumer spending fell -0.2% q/q once adjusted for inflation—wiping out nominal spending growth of 2.6% q/q.^[iii] We don’t normally highlight nominal GDP, but with inflation riding high right now, the degree to which any decline reflects an inflation adjustment rather than actual spending cuts is a key point of curiosity with many. In Q2, UK consumers were just about able to keep up with rising prices, which shows some underappreciated resiliency even if the headline tally isn’t great. But the other critical question—how much higher home energy prices detracted from discretionary spending—won’t be answerable until the second estimate reveals the detailed spending breakdown. In our view, these data will be crucial to setting expectations from here, given the household energy price cap is set to soar again in October.

On the positive side, business investment returned to growth, rising 3.8% q/q—its biggest increase in a year.^[iv] This figure also suffers from some measurement issues, as it is based on ONS surveys, and the response rate fell during the pandemic. Q2’s response rate of 63.2% was higher than 2021’s 57.7% and 2020’s 56.5%, but it trails 2019’s 67.3%, making it still subject to rather large revisions as more responses come in, potentially.^[v] But even with that caveat, there are several encouraging developments. Investment rose in all major categories, and far fewer businesses reported delaying investment due to Brexit and the pandemic. Businesses in several industries reported easing supply chain pressures, with even the semiconductor shortage starting to ease—which contributed to rising investment in transportation equipment and machinery as well as IT equipment. This has long been the strongest category of UK business investment, which passed its pre-pandemic high a year ago. Interestingly, it is also the category that should benefit most from a special temporary tax deduction, yet the ONS observed that few respondents mentioned it as a factor—a timely lesson in how little temporary tax tweaks tend to encourage or discourage long-term investments.

So overall, no, this wasn’t a great GDP report. Inflation remains a headwind, particularly on the consumer side. There is also the prospect of energy rationing this winter if natural gas is in short supply and the government’s contingency plans are forced to kick in. These factors are all worth watching. But for now, we find it encouraging that businesses are investing more in long-term projects despite higher costs. This is not typical recessionary behavior—usually, in a recessionary environment, the private sector would be getting lean and mean, not launching long-term projects. Q2’s results don’t guarantee rising investment over the period ahead, of course, but they argue against the notion that a deep recessionary climate has already set in. Mostly, we see a nation with forward-looking businesses and resilient consumers. Judging from UK stocks’ big bounce off their early July low, it seems to us markets also see these silver linings. When in doubt, trust forward-looking stocks.