Are we going into a recession, or aren’t we? That is the economic question of the moment, and it came alive last week when the so-called Purchasing Manager Index (PMI) for July was published, showing a plunge to 47.7, from 52.4 in June. This is the lowest level since the spring of 2009. What does this signify, and how should we interpret it? More to the point, are we even asking the most important question?
PMIs and other indicators
The first thing we should note is that the PMI is survey evidence. It does not measure actual changes in anything, but reflects changes in sentiment about output, orders, employment, inventories and so on. Economists pay a lot of attention to PMIs, normally because they constitute the first indicators in the calendar month, and because some of the information, for example on orders, form part of the universe of “leading indicators.” And one month’s survey evidence doesn’t amount to proof of anything. It will clearly require corroboration in subsequent months and of course in hard post-referendum economic data, which in the UK’s case won’t really be available until October.That said, the PMI was especially weak in the services sector, which is what the UK economy is about, for the most part. It also showed weakness in orders both in services and manufacturing. And so it merits close scrutiny as we go through the summer and into the back end of 2016.
It should also be noted that this bad PMI news comes at a time when economic “evidence” is mixed and also pretty sparse, since the referendum was only a month ago. Data on restaurant bookings, store sales, and travel bookings have shown few dents in spending patterns. Housing, on the other hand, has been more mixed. Mortgage applications and housing completions are down. Sellers, especially in London, have been knocking down prices amid a drop in inquiries. From these trends and other anecdotal evidence, UK consumers do not appear to have retreated into a shell. Indeed, with employment at an all-time high, and unemployment still very low, why would they have?
But the key to what happens to the economy isn’t in current consumer readings but in future investment and recruitment. This is why the PMI data are important. If companies really start to retrench, concerned about the lack of business opportunities or unwilling to commit internal funds to capital projects, software upgrades, training and employment, then we will have more immediate and serious cause to worry about a recession.
Misreading the markets
Some high-profile commentators have ridiculed the notion that there might be a recession by drawing attention to the buoyant performance of the stock market. The FTSE 100 closed last week at 6730, having risen from its pre-referendum low of 5923, and as we all know by now, this is strongly related to the fall in the pound. Foreign earnings, in other words, are now worth more. But even the FTSE 250, a broader middle-market index with less exposure to exports, rallied to close at 16983, compared with 14967 on 27th June, and is within spitting distance of its 2015 high of 17700. Does this mean that there won’t be a recession?This too would be a simplistic assessment. The cheerleaders are taking a far too UK-centric view and ignoring a global improvement in equity market sentiment. The UK has participated in this—but not to the same extent as markets elsewhere. It is piggybacking off steady, if unspectacular growth in the US, economic stabilisation in China, and a more positive sentiment in emerging markets. Brazil, for example, has provided one of the world’s stellar equity and currency performances this year in spite of the economy being mired in its deepest recession for 100 years, and a deep and long-running political and constitutional crisis.
Investors are also less miserable about deflation as the slump in commodity prices starts to drop out of inflation readings and as labour markets tighten (or remain tight). By next year, it is conceivable that reported inflation rates will be rising, though they will still be low. The expected announcement of a Y10 or Y20 trillion stimulus package in Japan next month and our new government’s statement that it will no longer target a fiscal surplus by 2020 have been taken as signs that the end of austerity is nigh, even though concrete evidence of an about-turn in Europe and the US is still elusive.
In any event, the bounce in UK equities has as much, if not more, to do with global sentiment as with whether or not the UK may experience an economic contraction soon. If it looked like it were going to, Philip Hammond has already stated last weekend at the G20 in Chengdu that the government would wait to see what happened, and if necessary, “reset” tax and public spending policies in November. In the same vein, the Bank of England recently passed on the opportunity to lower interest rates, deferring until some time later, if need be, when its own policies and those of the government might be better calibrated. So the short answer to the question “Are we or aren’t we going into a recession” is “It depends on investment and recruitment, which may yet deteriorate and cause an economic contraction, to which the authorities would now surely respond.”
More important is the economy’s supply-side
Even so, the recession question is not the most important macro-economically (though for those affected by it, it matters a lot). If we didn’t go into recession, and instead went through a patch of slower growth, it probably wouldn’t have significant consequences. If we did go into recession, it would, but it would end—and probably more quickly than the last one did because the financial system isn’t as compromised as it was in 2008-10.What matters more in post-Brexit Britain is what happens to our economy over the next several years when our trade, investment (domestic and foreign), and labour supply relationships and patterns become disrupted or compromised. This is what we call, in the trade, a supply (rather than a demand) shock. It is less noticeable, and less shocking than a conventional recession but it is more enduring and corrosive of productivity growth and therefore of living standards.
For example, the recently announced SoftBank takeover of ARM Holdings does nothing to comfort us that this is a trend because ARM is not a typical UK company. It is a special, technologically advanced company in a special sector that earns revenues in US dollars. Nor should we delude ourselves that eventually putting together some free trade agreement with the US, China, Australia or others—which could take three to seven years or longer—would substitute for the direct and indirect benefits we receive from being in the Single Market. The deals may or may not happen, and we can’t know in advance whether they would be advantageous to the UK or not, or to what degree. And if the restriction on free movement of labour with Europe is non-negotiable in a post-Brexit deal, then this too is liable to act as a constraint on the UK’s trend growth rate, especially if the new climate makes it harder to recruit skilled people from overseas in general.
So, while we should of course be concerned if the economy goes into a recession over the next three to 12 months, this isn’t really the thing that should worry us most. We should pay closer attention to our national income accounting, as what happens to it could lead to very different outcomes over the medium-term. It can only derive from labour and capital inputs, and productivity. As things stand, these things all look likely to deteriorate, leading to some degree of impoverishment. The lesson we have yet to learn is that it won’t mend on its own or as a consequence of a few trade deals.
