Services PMI Still Underestimating UK Growth Even after Upward Revision

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- UK services PMI revised higher at IHS Markit for November.

- But economists say it's still understating pace of expansion.

- Nonetheless, risks to UK growth forecasts to the downside.

- Case for BoE rate cut strengthening says Capital Economics.

- But Pantheon says no cuts from BoE over next six months.

The UK services industry fared less poorly than was initially feared, according toWednesday's IHS Markit final PMI, although economists say the influential baromter is still underestimating the likely pace of UK economic growth. 

IHS Markit's services PMI was revised higher to 49.3 for November Wednesday, up from the 48.5 reading of the new 'flash PMI' survey released toward the end of last month. However, the new estimate is still a deterioration from the 50.0 reading reported for the month of October.

November's downbeat PMI still suggests strongly that the economy could have contracted last month nd that it might face another decline for the fourth quarter overall. That would be the second quarterly contraction this year. 

Current activity levels saw "marginal" declines in November but new order inflows decreased at their fastest pace since July 2016, the month after the Brexit referendum, amid uncertainty over future government economic policy and trade arrangements thrown up by the looming December 12 general election. However, weakness wasn't confined only to the domestic facing sectors because exporting companies also saw reduced demand amid a likely continued slowdown in the global economy. 

"Taken together with the construction and manufacturing surveys already released, the all-sector PMI fell to a level consistent with a 0.2% q/q contraction in GDP in Q4. Admittedly, the PMIs have under-estimated quarterly GDP growth by an average of 0.2ppts over the past four quarters. But at the very least, the surveys suggest that underlying growth is very weak and that the risks to our forecast of GDP growth of +0.2% q/q in Q4 lie on the downside. All in all, the survey is likely to give more ammunition to the doves on the MPC who think rates need to be cut," says Ruth Gregory at Capital Economcs. 

PIM surveys measure changes in industry activity by asking respondents to rate conditions for new orders, production, hiring intentions, prices and inventories. A number above 50.0 indicates industry expansion while a number below 50 is suggestive of contraction. The survey results often correlate with official measures of output, although they can often be wide of the mark too.

Services is the largest economic sector in the UK but the industry has struggled since the Brexit referendum of June 2016 due to uncertainty about future goods trade arrangements with the EU and the outlook for the financial sector in London as well as the broader economy. With a few quarters aside, the growth rate for services output has followed the IHS Markit PMI survey index lower in a steady fashion, although output has not fallen to the extent implied by the surveys themselves.  

Meanwhile, the broader economy's fortune has been little better, even if the construction sector's contribution to it is limited. GDP growth contracted by 0.1% in the second quarter after rising 0.6% during the first three months of the year, while the third quarter brought an expansion of only 0.3%. Consensus envisages GDP growth of 1.3% for 2019 overall, although that now looks to be an ambitious target in the wake of the third quarter numbers.

"We remain skeptical, however, that services output really is declining. For a start, the services PMI does not cover the retail and public sectors, which have retained their momentum this year. In addition, the services PMI has been consistent on past form with private non-distribution services—PNDS—output falling at an average quarter-on-quarter rate of 0.2% over the four quarters to Q3 2019. But in reality, PNDS output has increased at an average rate of 0.3% over this period. The PMI, therefore, appears to be excessively downbeat during periods of political uncertainty," says Samuel Tombs, chief UK economist at Pantheon Macroeconomics

IHS Markit released its inaugural 'flash' PMI surveys of the manufacturing, construction and services sectors last month, which pointed to another contraction in the final quarter for the UK economy. However, economists have been reluctant to take the surveys as seriously as they once might have given how they've persistently overstated the impact that political uncertainty has on the economy in recent years.

Nonetheless, the UK economy has doubtlessly slowed again this year and third-quarter growth was below the forecast of the Bank of England (BoE), which has not been known for optimism about outlook at all since the referendum, if ever. And with inflation already back below the BoE's 2% target, and the more important 'core' rate of inflation also in decline, the bank is being undermined on its oft-repeated claim that interest rates will need to rise in the coming years to keep price pressures in check.

Not only that, but with the entire global economy in broad retreat and most major central banks already having cut their interest rates at least once, markets and some economists are increasingly mindful of the risks to the UK interest rate outlook. Some say the BoE could be forced to cut Bank Rate back to 0.5%, from 0.75%, in the quarters ahead in order to provide support to the economy although Pantheon's Tombs has a contrarian view in that regard. 

"We still look for a 0.2% quarter-on-quarter increase in GDP in Q4, and no renewed easing from the MPC over the next six months," Tombs writes, in a note to clients Wednesday. 

Tombs has briefed clients that a possible rebound in businesss investment after any ratification of Prime Minister Boris Johnson's withdrawal agreement, as well as planned increases in government spending, could put upward pressure on the BoE's already-at-target inflation forecasts for 2021 in the year ahead. He says that such developments could prompt the bank to continue briefing markets to expect more interest rate hikes in the years ahead. 


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