UK: Growth rebounded in Q2 – focus now on next MPC meeting

The Office of National Statistics has just released the first estimate of UK Q2 GDP growth (based on less than 50% of the total information required for the final estimate). The figures show that growth rebounded in Q2 to 0.7% q/q from 0.4% q/q in Q1, in line with both our expectations and consensus. This implies GDP in Q2 15 was 2.6% higher than in Q2 14 and 5.2% higher than the pre-crisis peak in Q1 08.

The service sector (78.4% of GDP) was still the main contributor to growth. Services increased by 0.7% q/q and thus contributed by 0.5pp to quarterly GDP growth in Q2 (up from 0.3pp in Q1). Construction growth was flat. Total production increased by 1.0% and thus contributed 0.1pp to quarterly GDP growth in Q2. Total production increased mainly due to mining & quarrying (mostly oil production), which increased 7.8% q/q – the largest since 1989. Manufacturing production on the other hand declined slightly by 0.3% q/q.

We expect the UK economy to expand further, mainly driven by domestic demand, especially private consumption. Private consumption is stimulated by a combination of low interest rates, very high consumer confidence, increasing house prices, high employment and positive real wage growth for the first time since 2009. We also expect investments to pick up as the slack in the labour market has diminished significantly although it is uncertain to what degree investments will be affected by the in/out EU referendum. Exports have been weak due to a combination of the strong GBP and weak growth in Europe. If growth picks up in Europe, this would increase foreign demand for UK goods and services and according to Bank of England calculations more than offset the negative impact of the strong GBP. The fiscal consolidation will also pull growth down but less than previously thought.

We still expect Bank of England to hike rates in November this year as the medium-term inflation outlook still calls for tighter monetary policy, in our view. Despite the very low inflation there are signs that the underlying inflation pressure is increasing, especially as wage growth has picked up more than expected. Recent comments from MPC members and minutes from the July MPC meeting revealed that more members tilt towards an interest rate hike, see also UK:More MPC members tilt towards a hike, 22 July. The deal between Greece and the creditors implies that we have got rid of a large amount of uncertainty. The low core inflation, strong GBP and the timing of the first Fed hike present downside risks to our call, as they imply that MPC may be more patient with the bank’s first rate hike.

GBP trades higher on the solid Q2 GDP figure. Following past days’ pricing action, EUR/GBP remains overbought according to our short-term financial models trading 1.6 standard deviation above model’s estimate of 0.6944 (spot ref.: 0.711). Hence, there should be room for further decline in EUR/GBP in the short term if risk sentiment improves. Fundamentally, we expect EUR/GBP to fall towards 0.70 in 3 to 6 months driven by a re-pricing of BoE. We stress that risks are skewed towards the cross undershooting our targets during the autumn.