UK economic rebound fails to excite the markets

This morning we had confirmation of another solid quarter of growth for the UK. Q2 GDP rose by 0.8%, the same pace at Q1. This is encouraging as there were plenty of headwinds to knock the economy off course, including geopolitical fears, rising expectations of a UK interest rate increase and a surge in the pound.

Our annual rate of growth is now 3.1%, up from 3% in Q1. To put this in some context, the UK’s growth rate is just under half the pace of China’s 7.5% growth for Q2, and we don’t even have much of an export machine, so what is driving our economy and can it last into the second half of the year?

The cloud that could get in the way of the silver lining

When you dig into the data there was one worrying trend in the Q2 figures, the Office for National Statistics (ONS) reported that output only increased in two of the four main industrial groupings within the UK economy. Growth was driven by the service sector, which increased by an impressive 1%, while growth in production was less than half of that rate at 0.4%. Construction was a big disappointment, falling 0.5% in the quarter, with agriculture down 0.2%.

On the bright side, the UK’s economy is finally bigger (by 0.2%) than the pre-financial crisis peak. It took the UK a while to catch up, the US and parts of Europe bounced back quicker than the UK did, but it had a mountain to climb, from 2008 – 2009 the economy shrank by a massive 7.2%.

Is construction really slowing down?

Although this is only a first reading of GDP, and the data content is less than half of the total required for the final output estimate, the ONS has been fairly good at predicting the UK’s economic growth, especially compared to the US, which had huge downward revisions in the first quarter. However, the anomaly in the UK data for last quarter was the decline in construction. The weather was good for the bulk of the quarter, and the construction PMI, a measure of sentiment in the sector, was above 60.0 for the three months to June, which is a historically high level. Although construction output fell 1.1% in May, there is still a risk that this could be revised higher and bump up the overall GDP figure for Q2.

Light wallets could disrupt the recovery

Looking ahead, the Bank of England mentioned in the minutes of the July meeting that were released earlier this week, that the outlook for household spending was weaker for the rest of the year due to real income growth having been slower than expected in the first half of this year. Due to the fact that the UK’s economy is reliant on the service sector, the market may ask how sustainable the expansion is if wages do not pick up. The BOE also expects a “modest slowing in output” in the second half of the year.

Back to Q2, the second reading of GDP, which is released on 15th August, is worth watching as we get more detail including business investment. This surged to 10.6% in the first quarter of the year. If we get another solid reading then it could assuage fears of a slowdown for the rest of 2014. We will also watch for any upward revisions, particularly to the service sector.

The tide shifts for sterling

The positive market reaction to the UK data was short-lived, after popping higher on the back of the release; the pound has continued its drop and is now below 1.70. This is fuelled more by a dollar rebound in our view, as the dollar index attempts to break above the June 5th high at 81.02, which is the highest level since February. A sustained move higher in the buck could weigh heavily on GBPUSD, which has enjoyed an uptrend for most of the past 12 months, but is now testing a critical level of support at 1.6967 – the 50-day sma.

The daily close below 1.70 on Thursday was a bearish development and suggests a protracted period of consolidation, although the broader bullish picture remains in play. The next key support level to watch is 1.6882 – the 61.8% retracement of the May – July advance, see the chart below. If we get a daily close below this level then we would expect to see a deeper downtrend in GBPUSD start to develop.

Takeaway:

• UK GDP hit the bull’s eye and the UK economy is now bigger than its pre-crisis peak, by 0.2%.

• However, the market has given the news a lukewarm reception.

• There was a couple of worrying details in the nitty gritty of the data, including a drop in construction and agricultural production.

• The latest economic expansion for the UK is driven by the service sector, so if wages remain weak then the economic recovery may not be sustainable.

• The pound is under pressure at the end of the week as doubts about the sustainability of UK growth combined with a resurgence in the dollar weighs on GBPUSD.

• GBPUSD looks like it is experiencing a short term correction right now; however, a daily close below 1.68854 – a key support level noted above – could trigger a deeper sell off.