U.K. GDP Surprises to the Downside: Is the U.S. Next?

By Bryan Banish

The last time I wrote about global GDP, European countries Germany and France were surprising to the upside. Last week was the opposite for Britain. The United Kingdom was the first of the major economies to report on its third quarter growth in gross domestic product or GDP. Most economists were expecting a positive statistic but the UK National Statistics reported a further contraction of 0.4% from the prior quarter on its index of national output.

Given the many similarities between the United States and the United Kingdom, the U.K. economic numbers are worth a look. It is also worth questioning whether the U.S. will also surprise to the downside when it reports later this week.

click to enlarge

The United Kingdom has had six consecutive quarters of decline in its GDP Index. In many ways, the U.K. economy is an amplified version of the American economy. While the United Kingdom is home to many of the largest energy, health care and consumer products companies of the world, relatively little of the production related to those companies actually happens inside the country. Therefore, much of this does not count towards the country’s GDP. Some manufacturing industries such as automobiles, now weak in the U.S., have virtually disappeared from the British economy.

The United Kingdom also has similarities with the United States in high levels of debt (both government and household sectors) that depended heavily on the process of securitization to fund it. If there is an industrialized nation that can make American government finances look sound, it is Britain. Both countries are expected to see deficits exceed 10% of GDP in the coming year.

In 2007 and other years leading up to the global financial meltdown, the city of London had begun to rival New York as the world’s financial capital. Even more than the U.S., the U.K. economy had become one based on services, financial services in particular. Until recently that allowed the U.K. economy to edge out other industrialized nations in growth.

The IMF is calling for positive growth in 2010 for the United Kingdom and other countries. The International Monetary Fund just this month released their latest projects for economic growth with the U.K. expanding faster than the countries using the Euro. It called for 0.9% growth next year versus 0.3% for the Euro area as a whole and, of the major European nations, only France is to grow as fast.

If the British economy is to recover as fast as or faster than most other European nations, we aren’t seeing it yet. The forecast might simply be wrong or it would be that the benefits of a weak currency have yet to flow through to the economy. If there is to be a rebound, it will likely be on the back of a weak pound.

Sterling is strengthening against the US dollar but still weak against the Euro. Since the beginning of 2007 Sterling weakened more than 25% against the US dollar to a rate of £1 = $1.37 but now stands only 17% lower today. The recent rate of £1 = €1.08 represents a nearly 27% correction against the Euro. The overly strong Euro is one reason the IMF forecasts a weaker recovery for continental Europe.

One problem with this weak currency approach is the risk to inflation. U.K. consumer prices remain more than 1% above where they were a year ago. This is compared to meaningfully negative readings for inflation in Japan, the United States, and much of Europe. None of these countries want the deflation that they have but as investors around the globe worry about how and when the deflation fight will reverse into inflation fears, the U.K. economy seems second only to China as a place for the inflation spark to strike.

Weak British Pound may have helped stabilize trade. In stressful times many countries seek a weak currency for the benefit it is supposed to have on export prices. A drop in the price of exports should, in theory boost demand. While the swift currency depreciation of the pound sterling may have led to stabilization in trade, the rebound has not been spectacular. As I point out in my article two weeks ago, many nations are bouncing along in a flat trajectory after bottoming out earlier in the year.

The U.K. economy has yet to rebound in industrial production. The one major difference between the United Kingdom and other major economies such as America, Japan, and Germany is the trend in industrial production. And this is where the answer resides in the difference in GDP figures.

Preliminary estimates of GDP out of the U.K. focus heavily on manufacturing output and do not capture broader measures of GDP such as business investment. These measures will be captured in future revisions. It is quite possible that future revisions could show that British GDP grew in the third quarter. Whether the growth is slightly positive or slightly negative, the manufacturing sector in the U.K. is lagging other advanced economies.

First in Japan, then in Germany and recently in the U.S., industrial production found a bottom by mid year and is now moving in the right direction. We have yet to see a set of industrial production figures out of the U.K. that show a sustained upward trend. Even though both the U.S. and the U.K. are service-dominated economies, it is this difference in manufacturing trends that explains why the economy in the United States will likely grow in Q3 even though it did not in the United Kingdom.

Physical activity as captured in manufacturing sectors still holds powerful sway over business confidence, business investment, and government statistics like GDP.

That does not make the U.S. recovery substantial or better than that of its peers Japan and Germany, it simply means that enough business cycle factors and stimulus efforts combined to provide growth on one side of the Atlantic that didn’t on the other.

Disclosure: No positions

Comments

[Robert Mart...:]

Individual Global Investor:

I agree with the similarities between the U.S. and U.K. economies. Both have weak currencies, bulging trade and budget deficits, and global leadership in financial services. You could have mentioned the real estate bubble, which is also common to both.

The headline of your article implies that disappointing GDP in the U.K. bodes ill for the U.S. But you don't make the connection in the article. In fact, you point out that industrial production in the U.K. has NOT rebounded as it has in the U.S. Thus, if the U.K. is showing disappointing progress in industrial production, we should NOT expect this to be reflected in the U.S. economy.

In fact, you come out and say this towards the end of your article:
"...it is this difference in manufacturing trends that explains why the economy in the United States will likely grow in Q3 even though it did not in the United Kingdom."

Did an editor at Seeking Alpha change your headline? As it now stands, the implication in your headline is contradicted in the text.

Thank you for the article. I look forward to your comments.
Rob

Oct 27 12:26 PM

[Individual ...:]

<IMG class=authors_reply src="static.seekingalpha.co..."> Rob,

Your point is well taken. I realize that most of the times when questions are in the title, they are rhetorical ones. This time the question in the title was a sincere one. When I saw the headline numbers for the U.K. I asked myself this very question and the point of the article was to answer the question. In my mind the answer could have been yes or no.

It is my read of the data that the difference in trend of industrial production figures between the U.S. and the U.K. is sufficient to explain a negative initial GDP growth figure for the U.K. while supporting the forecasted positive growth number for the U.S. when it comes out on Thursday. Therefore the answer to the question posed in the title is, "No."

While it has happened before that SA editors rephrase the title, that wasn't the issue this time. It is simply that the title is the question I posed at the beginning of my investigation and the conclusion when I had finished was no. Sorry for any confusion.

- Bryan

Oct 27 01:45 PM

[Buckoux:]

It is impossible for those who work in the service sectors such as academics, legal, financial, medical, and especially political, to understand the necessity for the industrial sector. In fact, the service sectors consider the industrial sector to be inherently "dirty", polluting (un-green) and good riddance to it. Nevertheless, it is the welder, and other skilled craftsman, who build the infrastructural foundations that the service sectors have survived and thrived upon. Now a Chinaman does the welding, but not for the USA. He's building the foundation for the emerging service sector in China. We won't need health care reform in the future, just an airplane ticket on an airplane owned and flown by Chinamen, so we can be treated by a Chinese doctor in China. Brother can you spare a Yuan?

Oct 28 01:13 PM

[Robert Mart...:]

Bryan,
Thanks for your response, and especially for your candor.
I respect your approach, since you started with a valid question and looked at data from the U.S. and U.K. economies. Many investors start with the conclusion first, and then filter the facts accordingly.
All the best,
Rob


On Oct 27 01:45 PM Individual Global Investor wrote:

> <IMG class=authors_reply src="static.seekingalpha.co...">
> Rob,
>
> Your point is well taken. I realize that most of the times when questions
> are in the title, they are rhetorical ones. This time the question
> in the title was a sincere one. When I saw the headline numbers for
> the U.K. I asked myself this very question and the point of the article
> was to answer the question. In my mind the answer could have been
> yes or no.
>
> It is my read of the data that the difference in trend of industrial
> production figures between the U.S. and the U.K. is sufficient to
> explain a negative initial GDP growth figure for the U.K. while supporting
> the forecasted positive growth number for the U.S. when it comes
> out on Thursday. Therefore the answer to the question posed in the
> title is, "No."
>
> While it has happened before that SA editors rephrase the title,
> that wasn't the issue this time. It is simply that the title is the
> question I posed at the beginning of my investigation and the conclusion
> when I had finished was no. Sorry for any confusion.
>
> - Bryan

Oct 28 06:56 PM

[Inpropsicated:]

I think the wild card to this comparison is the US stimulus and the growth (unsustainable IMHO) did to US numbers. I think everyone expects a very positive number. All most everyone. Keep in mind, I do not think we have hit a bottom so IMHO tomorrow's numbers will disappoint being the Contrarian that I am.

Oct 28 07:41 PM