Eurozone Crisis Threatens to Crush UK Economic Recovery

George Osborne warns today that Britain faces “enormous risks” from chaos in the Eurozone, admitting that the government is preparing for the crisis to deepen. In a bleak assessment the chancellor voices fears that the turmoil in the European Union may “only get worse”, hampering Britain’s recovery from the double dip recession. As hopes of a swift solution to Greece’s financial woes faded, with G8 leaders this weekend failing to achieve any breakthrough, Osborne issued an urgent plea to the leaders of France and Germany to find an answer. “We need the Eurozone to solve its problems …The alternative scenario carries enormous risks for everybody,” he said. Europe’s debt crisis dominated the meeting of leaders of the main world economies at Camp David, near Washington, with François Hollande, the new French president, floating a radical approach. In a sign of increasing desperation for a solution, Hollande outlined suggestions including direct lending to Greece by the European Central Bank (ECB), The Sunday Times says.

The growing Eurozone crisis threatens to shatter Britain’s stock market and crush hopes for an economic recovery. With fears mounting that Greece was set to leave the euro and that the crisis was spreading to Spain, shares had already slumped in value. But risk analysts warned yesterday that a Greek exit from the single currency would wipe another 10% off the value of British banks. At the same time, recovery among manufacturers could be strangled by the crisis. With funds pouring into London, sterling is being pushed up to levels that could make exports more expensive, hitting trade and threatening jobs. Sir Mervyn King, Governor of the Bank of England, last week refused to rule out intervention in foreign exchange markets to try to cap the value of the pound, which has risen by four per cent since February, says The Financial Mail on Sunday.

While the UK outlook hinges on euro area developments, last week’s Inflation Report showed that domestic matters still influence markets. The Inflation Report painted a confused outlook for the UK and we look to the coming week’s MPC minutes to provide some clarity. Lloyds TSB believe part of the confusion reflects a split Committee and look to a 7-2 vote for no further QE. It is even possible that Governor King dissented from the decision to suspend QE, something that would add to the dovish interpretation of this week’s Report. Other releases should add to such a trend. Lloyds TSB expect retail sales to retrace most of March’s buoyant retail sales, affected in part by the wettest April on record. Q1 GDP looks likely to be downgraded after the substantial downward revision to construction. And CPI inflation also looks set to fall back to 3.2%, reinforcing hopes of renewed disinflation, although we see this more as volatility associated with the timing of Easter. Alongside continued uncertainty in Europe, market appetite for further QE looks set to grow. Further afield there is little scheduled to provide much steer. Preliminary estimates of HSBC’s China manufacturing PMI will be watched for any signs
that the recent softer official figures are reflected. Lloyds TSB do not expect the PMI to slip from here. The US also sees a new ‘flash’ PMI released, but this is unlikely yet to garner sufficient market attention. Which leaves the focus squarely on Europe.

CPI inflation ticked higher in March to 3.5%, its first rise since September’s peak. Some of this likely reflected the fact that Easter fell early in April and we think this is the main reason why inflation should fall back this time. Lloyds TSB forecast inflation dropping to 3.2%. In the main this will be driven by last year’s Easter rises (namely in airfares and clothing) not being repeated. This effect should prove temporary. Moreover, with water charges, gas tariffs and even petrol edging higher on the year, we see little discernible downward trend in inflation over this summer, an outlook recently reflected in the BoE’s latest Inflation Report projections. Lloyds TSB thinks that this change in outlook had some impact on the Bank’s desire and ability to provide further stimulus to the economy. RPI inflation looks set to drop further to 3.4% in April from 3.7% in March.

May’s Inflation Report did little to clear up the outlook for monetary policy. The Bank lowered its GDP and medium term inflation outlook further and despite the economy reportedly in renewed recession, chose not to provide fresh stimulus. Where, the medium-term Inflation Report failed to shed light, we look to the minutes to provide more insight. Not least, Lloyds TSB expect a split decision in May with two members likely to have voted for more stimulus. Lloyds TSB think that this will include David Miles, but could also include Governor King. Notwithstanding the Bank’s lower GDP outlook, its central forecast stills seems rosy and Lloyds TSB expect weaker activity. On balance, Lloyds TSB think this could tip the Committee back towards more QE, particularly if downside risks materilaise across the Euro area.

The preliminary estimate of Q1 GDP suggested that the economy contracted by 0.2%, putting the UK back into recession. Since then, the subsequent release of weaker construction output for March has raised the likelihood of a downward revision to Q1 output. While we believe that services output continues to be understated by official data, in the absence of any correction, the quarterly reading is likely to be revised lower to -0.3%. The release will also provide the first insight into the performance of the demand components. The solid 0.8% rise in Q1 retail sales raises the prospect of household spending posting a second consecutive quarter of growth (+0.3%q/q). However, with the consumer still facing significant headwinds, this is unlikely to mark the beginning of a turnaround in prospects for the sector.

Headline retail sales rose strongly in March, up by 1.8% – the fastest monthly increase since April 2011. The sharp rise in March was driven by a combination of pre-Easter spending, unseasonably good weather and panic buying of fuel ahead of a potential strike. With these representing one-off factors and with fading impetus from housing sales, Lloyds TSB expect April ’s retail sales to reverse last month’s gain. Lloyds TSB pencil in a 0.9% drop in ex-auto fuel sales, with the wettest April on record dampening shopping enthusiasm. A reversal of March’s 4.9% spike in fuel sales should see the headline rate drop further, by 1.5%. Longer term, conditions for the consumer remain challenging, as real incomes continue to contract and labour market conditions remain soft. Lloyds TSB expect this to be reflected in sales over coming months.

The contents of this report are for information purposes only. It is not intended as a recommendation to trade or a solicitation for funds. The author(s) cannot be held responsible for any loss or damages arising from any action taken following consideration of this information.

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