As a new year arrives, it is only natural to look forward to 2016 and try to discern what may lie ahead for business and the UK economy. Our predictions may not help business people make investment decisions but we hope they will spur thoughts and – with a bit of luck – prove entertaining along the way.
In December 2014, we made several predictions for 2015. These met what is known as the 40 per cent/70 per cent rule. We had at least 40 per cent of the information necessary to make an objective forecast, but not more than 70 per cent of the required knowledge – after which matters move from providing perceptive insight to something of a foregone conclusion.
We kept these factors in mind when making the forecasts:
• Predictions should range across a wide number of areas
• They should look to both the immediate future (one year) and the longer term (five to 10 years)(1)
• Predictions should not be based on wishful thinking
• Reversion to mean is a strong driver of trends
• Consumers and businesses are ultimately self-interested
Moreover, we tried in every case to consider the alternate wording of the question as well, so if we predicted wages were set to rise, what did we think of the idea that salaries would not increase? This is a useful check when making any sort of prediction and one that we have employed for 2016 as well.
So how did we do? Optimistically, we think that we were right in four of our five predictions for 2015, giving us an impressive 80 per cent score.
As to our longer-term predictions, these have yet to come to pass, but we maintain that they remain valid concerns for the future.
Our 2015 economic predictions
• UK wages are set to rise
The rises are unlikely to be spectacular, generally around two to three per cent and broadly in line with corporate performance. This means the increases have the advantage of being in keeping with productivity and are therefore much more sustainable than rises simply tied to inflation, or worse, above inflation. The only caution here is that if legal rulings over issues such as backdated holiday pay come into effect, the meeting of these claims may well preclude pay rises for the present workforce.
This prediction was based on two things: the results of our Policy Voice survey in which IoD members said they were planning pay rises in the coming year and changes to the nature of how employers and employees interact. The co-operation seen in the workforce was both surprising and welcome. The quid pro quo of wage restraint in exchange for job preservation seems to have served all parties well. In part, this development is, we believe, attributable to both better management and the growth of smaller companies where employees are much more aware of the successes and constraints of the business. Long may such maturity continue.
• UK interest rates will remain at historic lows
Monetary policy will remain ultra-accommodative – at 0.5 per cent – for at least the first half of the year. That such a rate remains too low for the long-term health of the economy is going to be increasingly obvious, but for 2015 the perceived dangers and uncertainties (not least the general election) will outweigh the need to dissuade consumers and corporates from again taking on levels of debt which might prove problematic were interest rates to rise even modestly.
We were right – regrettably. We have remained almost a lone voice in calling for a normalisation (or rise) of interest rates for the past year. Exceptionally low interest rates mean that there is a growing misallocation of capital – seen most obviously in asset prices – and that monetary policy is no longer effective, so that come any future downturn we will be unable to stimulate the economy. Looking forward, the UK remains in a difficult position. Any slowing in global growth could well diminish what little appetite there might be for rate rises, yet both the US Federal Reserve and the European Central Bank look set to continue ultra-accommodative monetary policy, leaving the Bank of England with few choices if it wants to maintain sterling at a competitive rate.
• UK infrastructure
A change in government raises the possibility of a cancellation of the HS2 line to Birmingham and Manchester. The temptation of an incoming government to accuse their predecessors of profligacy and to spend the money on projects that will be more associated with themselves could well prove irresistible. A definitive decision on a new airport for the south-east remains highly fraught and a weak minority government may find it difficult to act.
We were simply wrong on this one. The prediction was made on the assumption that Labour would win the general election, or at least the Conservatives would need to be in another coalition. We did not predict the election results but, had we done so, we would have been wrong there as well.
• Eurozone quantitative easing is coming
The European Union is likely to undertake a form of quantitative easing for the eurozone, but it is unlikely to have the desired results. There are two reasons for this: the scale of QE in the US is $4,488bn (or 25.57 per cent of GDP), and in the UK it is £374,911bn (or 21.09 per cent of GDP). The EU is likely to contemplate a fund of potentially €3trn (22.46 per cent of GDP) – so similar in size to the US and UK efforts. However, eurozone funds will almost certainly be an amalgam of existing funds being double-counted in order to give the impression of size without the actual spending of money. Second, there is a better than even chance that any QE flows will be directed at politically expedient long-term infrastructure projects, where the economic multiplier effects of spending are likely to be muted and the longer-term ability of such projects to generate their build costs has to be questioned. Still, in the short term, QE is likely to be a mild stimulus.
This one came right within weeks of the forecast being made, but the prediction went beyond simply stating that QE would be undertaken, but that it would ultimately not make much difference. It may be too early to tell if QE will be a success, but having created approximately €1trn (£662bn) to date, the best that can be said is that renewed recession across the eurozone as a whole has been avoided. Equally, as the European Central Bank has said, monetary policy cannot be used as a substitute for structural change, however much many politicians might wish. QE looks set to continue and our concerns over how it will be unwound, and the consequences of the scale of the easing, remain extant.
• Europe will avoid deflation, but only technically
Deflation can be triggered by a number of things – some of which are positive, such as technological change, which dramatically raises productivity. However, the deflation Europe is grappling with is the consequence of deteriorating consumer confidence, not a failure of monetary policy. This means that people are not deferring purchases to take advantage of price falls; they are avoiding purchase as they remain cautious about their prospects. It is very difficult to turn around a moribund consumer, particularly with more of the same politics. The long-term danger is that deflation leads to fringe political parties seemingly offering the only way forward, but that is not a problem for 2015 – Greece excepted.
We give ourselves a tick here. In 2014, there was much talk of deflation and the steep fall in oil prices did pull overall prices down, but this is a positive. What Europe has to fear is a widespread failure of consumer confidence about the future, and a consequential unwillingness to spend that this would trigger. Outside selected parts of southern Europe, this dire scenario has not materialised.
Economic predictions beyond 2015
In addition to the short-term forecasts above, we also made several longer-term predictions.
• Social media will drive public-sector reform
The gap is becoming ever starker between those areas where the public sector is reforming and, as a result, delivering enhanced services within a constrained budgetary environment, and those public servants who still believe that the solution is more money delivered through traditional channels. Social media means that individuals are able to easily draw direct comparisons between neighbouring services being offered, and they are rightly questioning why such disparities exist. Some local authorities may refuse reform for ideological reasons, but public opinion is more interested in results and increasingly aware of the different possible outcomes.
Travelling around the country and visiting a wide range of successful local councils, it is evident that services from the NHS, to schools, to council services, are feeling pressure to emulate success. That pressure is amplified, as it is easier than ever for people to use social media to compare and contrast what they and their neighbours receive. These hard questions focus policymakers’ minds on what works rather than ideological purity.
• Fiscal consolidation will raise questions over spending priorities
If the (2014) autumn statement deficit reduction forecast is adhered to, at some point people – and eventually politicians – will start to question just how much public spending should be, for example, devoted to the hithertofore sacrosanct NHS, which in 2012-2013 cost £108.9bn. Long before questions over the NHS come to the fore, the international development budget (£10.3bn in 2014-2015) will be slashed, while pensioner benefits are likely to trump the demands of those in receipt of in-work benefits.
The advent of a majority government – and one that is now planning for the long term – does raise the possibility that spending priorities can and will, over time, be reordered. For health, holding budgets steady, or in line with economic growth, is sensible, but will still feel constraining in light of the demands of an ageing populace and advancing medical technology. The affordability and ubiquity of the state pension is complex and depends upon retirement ages, indexation and the state of private savings. However powerful pensioners remain as a voting bloc, a degree of intergenerational fairness will need to be brought to bear.
• Troubles in the eurozone are far from over
The ECB’s willingness to “do whatever it takes” is not a substitute for structural reform, a point well understood by central bankers and less acknowledged by politicians. Even more concerning is that many European populaces are less willing to see the need for reform of the European social model and they are being encouraged by a range of political parties to believe that structural reform is not necessary.
We were concerned about the pace and depth of reform across a wide range of areas and we are still worried. The constraint of living within one’s means is proving difficult for many governments and a host of political parties are claiming it is not necessary. To compound the problem, too many areas of Europe have failed to develop an entrepreneurial outlook and the new companies that might allow growth to ease the pain of reforms.
• There will emerge a modern day failed developed nation – an Argentina for the 21st century
A country that was once thought of as developed is likely to slip down the global prosperity league and a series of populist governments will squander its wealth and discredit its institutions. Whether the rest of the world sees this as an example to be avoided, or a specific case with no greater relevance, depends largely on how similar the situation in the failed state is to the situation of the observer. Such modern day failed developed nation states will see saving and capital flight, large-scale outward migration (particularly of the young and educated), an inability to attract investment (investors will be more concerned about rule of law than taking advantage of low-cost labour) and, as a result, long-term stagnant GDP.
In 1910, only seven countries were more prosperous than Argentina – per capita income was 50 per cent higher than in Italy, 180 per cent higher than Japan, and almost five times higher than Brazil. By 2000, Argentina’s income per capita was less than half that of Italy or Japan. Yes, we feared Greece could be at the start of a similar path; that other politicians seem intent on joining the Greeks is cause for further concern.
• Government debt ceases to be risk free
It will begin to dawn upon governments that there is something more important than meeting the terms of international bond contracts and that something is the need to incentivise their populaces to get up in the morning. If debt interest payments become so onerous that large portions of taxation are devoted to debt servicing, it is not unreasonable for a populace to rationally ask the following questions: Who incurred the debt? What degree of responsibility should today’s taxpayers have for that debt run up by yesterday’s politicians? What degree of responsibility should investors who lent an already highly indebted government have for irresponsible lending? This line of rationalisation might well lead to selective defaults directed at certain creditors, or on certain debt issues.
This issue remains a concern. The idea of a risk-free rate based on sovereign borrowing rates is central to the daily operation of financial markets, so the realisation that the underlying instrument which provides such a rate is not as safe as assumed is potentially profound. That said, financiers have in the past used a mix of highly rated corporates to provide a benchmark rate and there is nothing to prevent a similar basket of credits emerging in future. Indeed it may be that eventually a type of Bitcoin, or Bitcoin derivative, emerges as investors conclude that the present taxpayers’ desire to stand behind debts run up by previous generations is less certain than anticipated.
Our economic predictions for 2016
We believe the outlook for the UK remains positive, with few indicators so stretched that a painful snap back – reversion to mean – looks imminent, but there are several broader macro-economic concerns which could have a significant impact.
• UK interest rates will finally rise
While it is true that the economic situation has changed since we first advocated monetary tightening, if we do want to have interest rates rise on a long and gradual path, we should set out in that direction sooner rather than later. We believe there is now a danger that rates will not rise steadily to a new normal over the coming three years. Ultra-low rates have contributed to capital misallocation, and while this has not resulted in consumer inflation as initially feared, there has been a degree of asset price inflation. The unwinding of these asset valuations is unlikely to be smooth, but, with luck, they are not so stretched that they will correct in 2016.
• UK corporate profits are near their peak
Profits of UK corporates have reached all-time highs of £77.5bn(2). There are two questions: Can the trend of almost seven per cent per annum growth be sustained? Are we likely to see a mean reversion? We believe very low inflation has removed pricing power from companies while ultra-low interest rates have promoted misallocation of credit, as larger businesses which can borrow have levered themselves while smaller businesses have not been able to gain a similar advantage. But this trend has almost certainly run its course and any interest rate rise will make borrowing less attractive and, as a consequence, corporate returns are likely to disappoint as the year progresses.
• UK productivity is set to improve
Long-term UK productivity grew by around two per cent per annum from 1960 to 2007, at which point it stalled. Our report out earlier this year (3) highlighted a number of the trends behind this decade of lacklustre growth, as well as why, in the longer term, business agility matters more. However, more immediately, productivity is likely to resume its long-term trend rate of growth. This is partly a result of the economic cycle moving onwards to the next phase of the recovery and to some extent due to a slowing, or even reversal, of employment growth.
• Talent wars are going to intensify
In terms of employment in the UK, 2015 may well be as good as it gets: high employment, low unemployment and, for employers, subdued wage demands that are largely tied to corporate performance. Too often we only see how good things were in retrospect, so remember the employment situation now. The more there is a clampdown on immigration, the more that businesses are going to have difficulty finding the people they need to expand and thrive.
• The southern eurozone remains mired in recession
If there is one thing that a business needs to grow and prosper, it is credit. In 2008, southern European banks saw their deposit bases flee to the perceived safety of northern banks. Few depositors have seen any reason to reverse these capital flows. Efforts to reassure investors and savers through a banking union have yet to come to pass, and our view is that even if it were in existence, such a union would be seen as a (mistrusted) political promise. Without credit, there is little prospect of any near-term growth.
The advent of a Capital Markets Union, while highly desirable, is only a long-term solution.
Economic predictions beyond 2016
Last year we made several predictions where we did not set out a time scale, but we still thought were interesting and relevant, if not quite as immediate. We stand by those forecasts and add to them the following:
• Wealth taxes prove irresistible
Governments across Europe are struggling with the concept of living within their means. The UK has for the last three decades only ever been able to collect approximately 35 per cent of GDP in taxes; whenever government spending has risen above this sustainable rate of taxation it has been funded through borrowing. Realistically, governments need to have the ability to spend money on a number of immediate political priorities. Where finances are particularly tight, the obvious answer should be to reallocate existing spending, but too often this proves very difficult. This leaves finding new ways to tax, or new areas to subject to taxation. Here, our prediction is that for some, advocating taxation of wealth becomes irresistible. Justified on the basis that the distribution of wealth is skewed, the proponents of such taxation will, in effect, seek to convert long-term investment to immediate spending. At a time of rapid economic, social and business transformation, the desirability of maintaining long-term investment should be beyond question, but that does not mean that short-term politics could not trump long-term economic considerations.
• Pretty cities prosper
There was a time when modern communications meant “the death of distance”; that there would no longer be a need for any employee to be in close proximity to their business. The reality is much more complex and it is now realised that many businesses and industries thrive in clusters where like-minded and interested people work in reasonably close proximity.
We believe there are a host of elements that come together to form such clusters. One of the most important is the existence of an amenable built environment, or “pretty cities”. New industries with a plethora of high-value-adding companies and executives have the luxury of establishing themselves in any number of locations. Physical environments matter and high-value-adding workers who can choose where they work will gravitate to aesthetically pleasant towns. That such towns will find they can support a greater range of cultural activities and amenities will only add to the positive spiral such a situation creates.
The Nobel Prize-winning physicist Niels Bohr is reputed to have said: “Prediction is very difficult, especially if it’s about the future.” An apt warning, but one which we have ignored.
James Sproule is the IoD’s chief economist and director of policy. He will be outlining his economic predictions for 2016 at a Directors’ Networking Lunch held by IoD Berkshire on 29 January 2016. Visit iod.com/events
For more information about Big Picture, visit iod.com/bigpicture
If you would like to part in Policy Voice surveys, visit iod.com/policyvoice
1. The Ministry of Defence handily describes forecasts of one to two years as “Insight”; those of three to five years as “Trends”, five to 10 years as “Foresight” and 10-30 years as “Farsight”.
2. ONS data for: Gross trading profits of private non-financial corporations
3. Balancing UK Productivity and Agility; IoD, September 2015.