1. Outlook for the UK Economy: Returning to normality... 18 th January 2011 Tom Vosa Head of Market Economics, Europe, Wholesale Banking National Australia Bank, tom.vosa@eu.nabgroup.com

2. 2 Global macro outlook

3. 3 IMF and NAB forecasts still for solid global growth ●From 2004 onwards, global growth picked-up well above its long run average of 3.5% to rates around 5%, its strongest performance since the 1980s. ●Although the IMF have revised down the growth prospects for the United States, Eurozone and Japan in light of the global credit crunch, global growth is still forecast to continue above 4.5% from 2013 onwards. Source: IMF WEO

4. 4 Advanced economies are no longer driving global GDP growth ●Up to 2000, global growth was driven largely by industrialised nations, but the sharp slowdown in activity following the dotcom bust was followed by the rise in emerging markets. ●Going forward, industrialised countries will become much less important drivers of global growth. Source: IMF WEO

5. 5 Emerging markets are leading the way forward Source: IMF WEO ●But both Africa and the Middle East are expected to post around 5% annual growth, not far from the 6% peaks seen in the early part of last decade. ●Developing Asia is forecast to grow by over 8% per annum.

6. 6 Average projected real GDP growth 2010-11 Source: IMF WEO

7. After sharp G10 slowdown in 2009, growth now picking up across the world ●China and India grew strongly during the global downturn. Without their contribution, the world economy would have shrunk more than 2% in 2009 ●Massive fiscal and monetary policy stimulus will see global growth rebound sharply in 2010 ●In both 2010 and 2011, global economic growth should be back above the average of the last 25 years. Source: National Australia Bank Research Latin America World India China New Zealand Australia Canada eurozone UK Japan US Annual average Latin America World India China New Zealand Australia Canada eurozone UK Japan US Annual average 45.4 3.0-1.14.64.24.05.0 7.56.88.47.87.39.2 9.58.710.59.18.011.8 0.0-1.62.83.53.03.2 3.10.53.53.74.34.0 0.4-2.73.22.83.02.5 0.5-4.01.71.71.62.7 0.8-4.31.52.12.32.6 2.3 0.4-2.43.12.83.22.1 2010(f)200920082007 4.1-2.06.55.04.05.4 9.2 11.8 3.2 4.0 -1.2 -5.1 3.1 2.52.5 2010(f)2007 2011(f)2012(f) 7

8. 8 UK macro outlook

9. 9 After six tentative months of recovery, the second quarter saw impressive growth... ●...Which has continued. ●The recession saw peak to trough output loss of 6.4%. ●Over 2009 Q4 and 2010 Q1 output increased by 0.7%. But in Q2 it leapt by 1.2%, the fastest quarterly growth since Q1 2001, before rising by 0.7% in Q3, more than double expectations. Source: ONS

10. 10 Recent growth rates have been flattered by a huge rebound in construction ●Most sectors saw growth in the third quarter, with manufacturing rising by 1.1% and service sector growth of 0.5%. Within services government output rose 0.6%. ●But the figures were pushed higher by the largest rise in construction since 1963 as the sector grew by 4.0%, after growing by 7.0% in Q2. The annual growth rate is now 9.5% -a record. Source: ONS

11. 11 Growth is slowly easing ●Government spending probably reflected a dash ahead of the General Election. ●But growth remains broadly-balanced, which suggests that private sector activity will continue, even if quarterly growth rates ease further.

12. 12 Worries over strength of underlying private demand persists Source: ONS ●Growth in Q4 2009 and Q1 2010 was partially due to an increase in inventories. And they contributed 0.4pp to growth in Q3. ●Net trade has been extremely disappointing, deducting 0.1pp from Q3 GDP growth. Although surveys show manufacturing exports rising in the fourth quarter, the economy is still some way from rebalancing.

13. 13 Business surveys point to volatility ahead ●Economy grew by 0.7% in the three months to September, but survey data show a small acceleration in Q4. ●But bad weather overstates the strength of activity, especially in construction so we look for growth to slow to 0.4%-0.5%. But if bad weather has reduced growth, then fears of a double-dip might be lessened.

14. 14 The labour market is showing signs of improvement… ●The numbers claiming unemployment benefit fell by 1,200 in November, after a 5,200 dip in October. ●But the labour market is still soft. 85% of employment creation has been in part-time work and record amounts of part-time workers want full-time jobs. The ILO measure rose to 7.9% in October. Source: Reuters Ecowin

15. 15...After a year of stagnation, wages are drifting higher Source: Office for National Statistics

16. 16 And rebalancing will keep unemployment elevated Source: Office for National Statistics ●At the broadest definition, the number employed in education, health and public administration has risen by 1.7 million since 1999 to 8.4 million. ●Just over 1.5 million private sector jobs have been lost since June 2008.

17. 17 OBR forecasts look sensible Source: Office for National Statistics, Office for Budget Responsibility ●Despite the noise, the OBR forecasts look for general public sector employment to fall by just over 400,000 between 2010/11 and 2015/16. ●From 1992 to 1998, some 693,000 public sector jobs were lost, so the fall look to be much less aggressive than unions are complaining about.

18. 18 But further falls in unemployment look unlikely Source: Office for National Statistics ●The outflow rate is beginning to stabilise (although it remains above the lows seen in early 2009). ●The inflow rate looks to be stabilising and indeed could be in the very early process of turning.

19. 19 But who will be getting the available jobs? ●A fall in UK employment since 2007 has been offset by employers seeking to hire foreign nationals. ●The outflow seen in 2009 more than reversed in the year to September 2010, so even if there is net job creation in the UK, the benefits might not feed through to regional economies. Source: Reuters Ecowin

20. 20 Inflation is well above target, but should come down ●The Bank of England’s job is not being made easy by VAT changes and energy price moves. ●This is obscuring the underlying trend in inflationary pressure, which should still remain contained given the large degree of slack in the economy.

21. 21 But the MPC will have to watch expectations carefully ●Inflation expectations have been rising sharply as oil and food price increases have fed through. ●VAT and fuel duty rises are seeing inflation expectations rise higher and it could feed through to wage demands this year.

22. 22 Talking Points Access to finance

23. 23 Lending to corporates is still falling ●At -1.1%yoy, bank lending to the economy is back at its lowest annual growth rate since records began in 1990. ●Lending to private non-financial corporates (PNFCs) is actually contracting, an increase in lending to households has not been enough to offset this. Source: Bank of England

24. 24 Banks are weaning themselves off of relying on wholesale markets ●Bank of England data on household and non-financial corporation deposit holdings and lending, including lending to individuals shows the widening gap that has until recently been reliant upon wholesale funding. This has grown from £150bn in 1996 to a peak of £7696billion in October 2008. ●Even now the gap is around £632 billion, its smallest level since December 2006. ●But with wholesale funding expensive, banks are reluctant to lend. Source: Bank of England, National Australia Bank

25. 25 Funding conditions will remain extremely tight until 2013 ●BoE calculations suggest that UK major banks have around £480 billion of unsecured senior debt, subordinated debt, covered bonds and securitisations maturable or callable over the period to end 2012. ●At the same time £165 billion of high quality collateral supplied under the SLS will be repaid. ●All of the £120 billion in remaining guarantees issued under the CGS will also expire, but banks can roll over up to one third of their initial limit of CGS drawings until April 2014. ●So banks need to raise £800 billion or £25 billion per month over the next two and a half years. Source: Bank of England

26. 26 Bank lending appetite is still depressed... ●The BoE credit conditions survey shows that banks are still reluctant to lend against property and housing. ●Loans are still being extended to the corporate sector reflecting bank pledges.

27. 27 Talking Points Public sector outlook

28. 28 June ‘Emergency’ Budget saw borrowing plans reduced ●Deficit now expected to by 1.1% of GDP by 2015, which brings the UK back into balance one year earlier than laid out in the March Budget. ●The lower growth assumptions mean that there is more plausibility in the borrowing plans.

29. 29 The burden is squarely on spending cuts

30. 30 Assuming of course that cuts measures are enacted. ●In the short-run fiscal tightening coming from tax increases. ●Spending measures really only start kicking-in from 2013.

31. 31 UK regions have different growth speeds Source: ONS ●Southern regions tend to grow faster due to larger population growth.

32. 32 Different employment patterns

33. 33 Would a smaller public sector boost growth? Source: Office for National Statistics ●Small public sector is correlated with higher economic growth, so shrinking the state should boost growth.

34. 34 Can we rebalance using taxes then?

35. 35 So what will the new normal look like?

36. 36 Taking the long view... Source: Bank of England

37. 37 With lending appetite depressed, mortgages will remain weak ●Approvals are running roughly half the pace averaged between 1993 and 2006. ●With lending capacity still depressed, it is hard to see how this will turn around without securitisation markets opening.

38. 38 The housing market may be poised for renewed weakness ●Housing bulls cite the fall in new instructions as supporting the housing market this year. ●But new buyer enquiries are also much lower. ●We expect prices to continue to fall this year and next.

39. 39 House prices unlikely to regain earlier highs ●The Halifax house price index fell by over 22%, before recovering in recent months. ●However, the downward trend now seems to be back. ●In the early 90s recession it took house prices 9 years to regain their previous level. This time looks to be a lot longer.

40. 40 Indeed, given house prices, sales have been strong ●Despite fears of the impact of VAT increases, it seems that the housing market has done much to explain the strength of retail sales. ●Yet looking at the fall in the Nationwide index, the surprise is that sales have not been weaker Source: Bloomberg

41. 41 Car industry will remain depressed ●The dip in new car registrations seen this year needs to be put in perspective. ●From 1990 to 2002, registrations averaged 167,000 per month, so the 200,000+ seen from 2002-2007 are more of an abberation. We doubt that we will see any return to those levels as house prices and rising mortgage costs prevent mortgage equity withdrawal. Source: Bloomberg

42. 42 UK policy rates have fallen to historic lows ●At 0.5%, Bank Rate is at its lowest level since the Bank of England was formed in 1694.

43. 43 Taking the long view... ●The nominal average interest rate between 1694 and December 2010 is 5.0%. ●So we cannot expect interest rates to remain at current levels, nor should be expect to. ●The question is how far and how fast... Source: Bank of England

44. 44 Financial markets are now beginning to price in BoE tightening ●Although over the year as a whole, we have seen the timing of the first rate increase progressively pushed back.

45. 45 Economy will remain reliant on consumption ●Without a big surge in net trade or investment, and with government spending being cut, the economy will remain reliant on consumption. ●But this is unlikely to remain large-ticket items. Instead, spending on food and energy will dominate. Source: ONS / National Australia Bank

46. 46 The Yorkshire Economy

47. 47 Purchasing Managers’ surveys show output decelerated in Q4

48. 48 Yorkshire domestic demand looks better ●The BCC surveys show that after sharp falls in activity through 2008, sales are now beginning to increase. ●Note that manufacturing activity is running well ahead of services and that Yorkshire is also outperforming the UK average. Source: British Chambers of Commerce

49. 49 But service sector struggling in exports ●Export growth remains a little weaker, especially in services, which seems to be lagging manufacturing anyway. Source: British Chambers of Commerce

50. 50 Goods outperformance clearly seen in HMRC data Source: HM Revenue and Customs ●HMRC data only cover goods trade, but they show a very sharp fall in exports in the first half of the year. ●The slowdown in Q3 is consistent with BCC data, but we hope that Q4 will be better.

51. 51 Which looks to reflect export direction Source: HM Revenue and Customs ●The region has a slightly weaker exposure to the eurozone, but greater exposure to the faster growing regions.

52. 52 RICS house price survey: a regional breakdown South East South West London Scotland Wales North North West East of England Yorkshire & The Humber West Midlands East Midlands

53. 53 Source: RICS The housing correction has further to go ●Expectations already below those seen in England and Wales. ●And the fall in prices has still not attracted new buyers to the market.

54. 54 Affordability remains a constraint

55. 55 Yorkshire labour market looks to be stabilising

56. 56 Female workers have seen largest improvement

57. 57 Labour market fundamentals remain weak ●The economic activity rate remains well below the UK average, as does the employment rate. ●So the labour market is smaller and less are employed, which will weigh on consumer spending.

58. 58 Which is why the unemployment rate have been higher through 2010

59. 59 Construction employment fell as projects were completed

60. 60 The housing market seems to explain most of the slowdown ●But note the strength of retail sector hiring.

61. 61 Health and social work still remains the largest single government employer

62. 62 Conclusions

63. 63 UK Outlook  The UK started recovering in the latter half of 2009 – after experiencing one of the worst recessions of the postwar period. Although growth was surprisingly strong in June quarter 2010, we do not expect to see a very strong recovery in activity.  There is a good chance that the UK upturn will be sustained but modestly paced – modest because the serious fiscal position has required deep cuts in spending and tax rises to maintain the sovereign credit rating. The necessary fiscal retrenchment should slow economic growth in the next few years.  The UK economy requires a structural re-balancing in its growth through the next few years – with more reliance on exports and private investment spending and less on consumption, government spending and housing prices. The approx 25% drop in Sterling should contribute significantly toward that rebalancing in activity toward traded goods output and investment  System credit growth should start to grow again next year as the phase of business sector de-leveraging draws to an expected close and modest growth in housing lending resumes. However we expect credit growth to be subdued compared to the pre-recession period  Although system asset quality has worsened with recession and rising unemployment, it has not fared as badly as might have been expected and unemployment has not risen to the extent initially feared. Economic Indicators (%) CY08CY09CY10(f)CY11(f)CY12(f) GDP growth-0.1-4.91.52.12.3 Unemployment6.67.88.0 7.3 Inflation3.62.23.02.71.9 Cash rate2.00.5 1.52.5 System Growth (%) FY08FY09FY10(f)FY11(f)FY12(f) Housing8.52.21.02.64.7 Consumer6.62.9-0.11.62.5 Business12.70.7-3.2-2.12.2 Total lending9.81.7-0.60.83.6 Household deposits6.34.25.96.47.0

64. 64 Conclusions ●The worst is behind us, but it’s hard to see the impressive performance in Q2 being repeated this year. ●Having fallen by 4.9% in 2009, we only expect 1.8% growth in 2010 and 2.1% in 2011, a very weak recovery given the depth of the downturn. ●Recoveries from recessions are rarely straight line affairs. We can expect slower growth in the second half of this year. ●Emergency Budget has tightened policy, but real tightening starts from 2013. In the short-term, the government is using tax increases. ●But the recovery faces several headwinds to growth, with households, the banks and the public sector all needing to deleverage. ●The new trend of rate growth for the UK economy is likely to be 2.0 - 2.25%; almost half a percentage point lower than the average over the past decade. ●Rebalancing the economy requires higher interest rates, weaker spending on large-ticket items sourced from lower mortgages. Asset prices will not be supportive ●We believe that interest rate increases will be delayed until May 2011 at the earliest, with Bank Rate reaching 1.50% by year-end. That leaves us currently in line with consensus estimates. ●The MPC are aware that aggressive rate increases could push the economy back into recession so they will not tighten pre-emptively. In the future macro-prudential tools such as capital constraints or lending targets could be used to constrain asset price inflation, limiting the need for aggressive rate increases. ●But it the market believes that the bank is ‘behind the curve’ then the current fall in bond yields will quickly reverse, providing some upside risk for our forecast that 10-year rates reach 4.50% by Dec- 2011.

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