Friday's GDP figures make a W-shaped recession more likely.
The news on Friday that the economy had continued to contract in the third quarter of the year stunned analysts and economists.
As I wrote then, Howard Archer, chief UK & European economist at analysts IHS Global Insight described the figures as "a real shocker and desperately disappointing." He, like most other observers, had expected a very modest return to growth.
Instead, GDP contracted over the quarter by 0.4% -- almost as bad as the revised contraction of 0.6% seen in the second quarter, and the sixth successive quarter of contraction.
The result: we're living through what is now the longest recession since records began in 1955 -- as well as the steepest. While comparable figures don't go back any further, it's at least highly probable that this recession is the worst since the 1930s, eclipsing the immediate post-War contraction.
The outcome no one foresaw
Investors take more than a passing interest in GDP. While company fundamentals matter most, it's the state of the economy that sets the backdrop for market demand, trading conditions, and the cost of funding.
And there's no mistaking the extent to which economists were wrong-footed by Friday's news.
As IHS Insight's Dr. Archer points out, in a poll of 33 economists by conducted Bloomberg, not one person forecast that the economy would have contracted. The consensus was for the economy to have grown by 0.2%, with the range of forecasts being 0.0% to +0.7%. Exactly the same results, he adds, came from a similar poll conducted by ThomsonReuters, this time of 29 leading economists.
His conclusion: when 33 out of 33 economists get something so very wrong, there's something strange going on that needs consideration and explanation.
Is it a W-shaped recession?
One obvious concern -- to me, at least -- is that the surprise contraction heralds a W-shaped recession, rather than a V-shaped one. Given the strength of the recovery in the summer, most observers had plumped for a V-shaped recession.
And, it has to be said, the critical determinant of a W-shaped recession is when things turn down again, instead of turning up. So is that what we're experiencing?
Data error?
Most economists seem to think that this is still unlikely. Their view: the problem mainly lies with data flaws in the figures that make up the GDP estimate -- which, it must be said, is an estimate, and is subject to revision over the coming months. (Subsequent revisions to the GDP figures for the last quarter of 2008 and the first quarter of 2009, for example, made them worse than first estimated; revisions to the second quarter of 2009, on the other hand, made the early estimates seem too gloomy.)
And, as economist Stephen King of HSBC (LSE: HSBA) notes, initial measures of quarterly GDP made by the Office for National Statistics are somewhat unreliable. Based on only 44% of the data which will eventually become available, they're more of an impression than a serious estimate.
Indeed, as a number of informed posts on our discussion boards revealed over the weekend, it was the assumption that the GDP figures were plain wrong that kept the FTSE buoyant in the aftermath of the announcement. When the real GDP figure is known, ran the logic, the picture will be much rosier.
But will it? While upwards revisions are very possible, revisions on the scale of 0.5% are fairly rare. And it is indeed a revision of this magnitude, it must be stressed, that will be required if the latest quarterly figure was to eventually turn out to have seen growth.
So here's the crucial point to emerge from Friday's figures. Although the size of the continued contraction may be wrong, the Office of National Statistics' estimate of the direction that the economy was heading is almost certainly correct. In short, it wasn't growth; it was contraction.
Where next?
What does all this tell us about the final quarter of 2009 -- and critically, the first quarter of 2010? Well, a boost in consumer spending ahead of the end of the temporary 15% rate of VAT is likely. And consumer spending, of course, accounts for a significant proportion of GDP.
What's more, consumer confidence -- unlike in America -- is growing, with figures released today already point to buoyant High Street sales, with tills during October ringing at their fastest annual rate for almost two years.
So economists are predicting that the modest growth they expected in Friday's figures will now be seen in the last three months of this year -- an assumption that seems entirely reasonable. And if we don't see it, we'll know the answer to the V-or-W question for sure.
But if we do see it, it certainly doesn't mean everything is rosy. Having re‑run their economic models, IHS now expect the UK economy to contract by 4.7% in 2009 and to grow by 0.8% in 2010 -- a rate of growth that can only be described as anaemic, and which could easily falter and turn negative.
How so? Well, there's that higher rate of VAT, the big increase noted in the household savings ratio in recent weeks, the end of the car scrappage scheme, the rising price of oil, and so on. And that's before factoring in a winter outbreak of swine flu, which analysts Oxford Economics estimate could knock 3% off GDP.
Nowhere to go
In short, Friday's news was both unexpected and troubling. For if the economy does turn down, the government has little wiggle room and few tools at its disposal. A further large-scale expansion of quantitative easing is surely unaffordable.
While investors can take some comfort from the fact that interest rates look set to remain low, the real reason for this is simply that the economy won't be strong enough to sustain higher rates. In short, we're not out of the woods yet.
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