More bad news for the UK economy

The UK economy unexpectedly shrunk in May, and activity fell by 0.1%, analysts were looking for a 0.1% expansion. The 3-month-on-month rate of GDP expanded by 0.5%, however,  after a dismal performance in April and May, the focus will now shift to June, to see if activity picked up enough to protect the Q2 GDP rate.

Tariff overhang weighs on growth

The weakness in growth for May was driven by production . Activity was not nearly as strong as predicted, and production weighed on GDP in May to the tune of 0.9%. The decline in production suggests that there remains some ‘tariff overhang’ even though the UK/US trade deal was announced in May. Perhaps it was too optimistic to think that the UK’s factories could re-start production so quickly, and maybe we need to wait until June to see the ‘benefits’ of the trade agreement with the US.

The drivers of weakness in the production sector were oil and gas, car manufacturing and pharma. While oil and gas extraction was less likely to be impacted by tariffs, car manufacturing and pharma were. Car exports were subject to a 25% tariff at that stage, it has since fallen to 10%, with an annual quota where no tariffs apply. Thus, the decline in the May GDP report has President Trump’s fingerprints all over it. Pharma is still waiting to hear what tariff rate will be imposed on the sector, however, the US and UK trade agreement stated that the US would negotiate preferential outcomes for UK based pharmaceutical companies and pharmaceutical ingredients.

Thus, all may not be lost for the UK’s production sector, and there is a good chance that activity could bounce back in June. However, the UK’s GDP woes in April and May is a warning shot to other key trading partners with the US, who do not report monthly GDP. Q2 growth could be ugly.

Construction sector on pause

Construction was another weak spot in the report; it was down 0.6% in May. It will be interesting to see if the extreme temperatures that we have seen in June, and now in July, have hurt the construction sector. Countries that experience regular extremes of temperature can be less productive, especially in sectors that are exposed to the elements. Thus, construction activity could be erratic for the coming months.

GBP continues decline after GDP

The pound has continued its decline after this report. GBP/USD is below $1.3550. The dollar is strengthening broadly on Friday and is the strongest currency in the G10 FX space, so the pound is not standing out as an underperformer on the back of this data. However, since last week’s bond market wobble, the pound has lost some of its shine, and GBP is the second worst performer in the G10 FX space this week.

Trump’s tariff threats weigh on risk sentiment

The rally in the greenback comes after Trump informed the Canadian government that some of their exports to the US could be hit with 35% tariffs from August 1^st, and he touted the possibility of raising the tariff rate for all other countries who do not have a trade agreement in place, to 15% or 20%. We have still not heard what tariff rate the EU has agreed, so the chances are it could be set between these levels.

The FTSE 100 is expected to open down a touch on Friday, after reaching a record high on Thursday. We don’t think that the GDP news will have too much impact on the UK’s stock markets, as they are forward looking and are focusing on life after this tariff uncertainty. However, we think that markets could trade with a risk off tone on Friday, as tariff risks rise in the short term on the back of Trump scaling up his rhetoric.

Weak GDP heaps more pressure on the Chancellor

Another weak month of GDP growth heaps pressure on the UK government, and the bond market.UK yields are rising modestly at the open and UK bonds are underperforming vs. their European counterparts. The second month of negative growth could weigh on the bond market, and bond yields could rise especially at the long end. Although 2-year Gilt yields are rising on Friday, short end UK yields may fall over time, as investors boost the odds of BOE rate cuts. There are currently just over 2 rate cuts priced in for the UK by the end of this year, with a cut expected in August and a 65% chance of a subsequent cut in November. On the back of this data, the market could boost expectations for a November cut, and price in the possibility of a cut in September, which may weigh further on the pound in the short term.  

While bond investors will not pay too much heed to monthly GDP figures, each negative print increases the chance that the OBR will revise growth expectations lower in the Autumn Budget, which will put Chancellor Rachel Reeves in a tricky position as she seeks to avoid breaking her fiscal rules and raising any of the three main tax rates. The UK needs to balance the books somehow, as growing our way out of debt has not been going to plan under the Labour government.