Economics for BusinessThe consumer is back but not like before

Special report on consumer spending

Ernst & Young ITEM ClubErnst & Young solely sponsors the ITEM Club as part of its offering as a global leader in professional services. ITEM Club is the only non-governmental economic forecasting group to use the HM Treasury model of the UK economy, independent of any political, economic or business bias. This report summarises the latest special report and gives Ernst & Young’s assessment. Combining our skills in assurance, tax, transaction and advisory services, we are well-placed to help businesses work through the detailed implications of changes in the economic environment.

Consumer spending forecast in summary In his March Budget, the Chancellor effectively admitted defeat in his attempts to rebalance the UK economy. At best, the plan to move from an economy dependent on consumption to one led by exports and business investment is on hold — and the UK has essentially returned to relying on its old friend, the consumer, to drive economic growth.

The latest Ernst & Young ITEM Club special report on consumer spending reflects this shift. With consumers having struggled against falling real incomes since the onset of the financial crisis, in 2012 consumer spending was still 4% below its 2008 peak. However, the beleaguered UK consumer finally began showing signs of life in 2012, following a recovery in real household incomes driven by employment growth, the uprating of social benefits, and weaker inflationary pressures, as highlighted in our recent special report on inflation.

Last year’s remarkable labour market performance is unlikely to be repeated in 2013, and inflation is not expected to slow significantly from its current levels. But the impact of these factors will be partially offset by the boost to take-home pay from the increases in income tax personal allowances.

Taking all these factors into account, ITEM expects that the upturn in consumer spending will gradually gather momentum, with growth of 1.2% in 2013, 1.9% in 2014 and 2.2% in 2015. These growth rates may mark a step-change from the past five years, but they are nowhere near the levels seen in the decade leading up to the financial crisis.

Peter Spencer

Business implications in summary After such a significant slowdown, businesses will be understandably wary about embracing the projected revival in consumer spending too enthusiastically. However, holding back may bring its own risks, since the growth momentum may build quickly, meaning the overly cautious get left behind. To strike the right balance, businesses will need to understand in detail what is happening and, likely to happen, to consumer demand and spending in their segment, and use this knowledge to guide their planning and investment decisions.

With several drivers — including rising employment income, favourable tax changes and slowing household deleveraging — converging to propel a recovery in consumer spending, it is imperative that businesses stay close to the fundamentals and avoid incorrect, snap decisions. They also need to be aware that, while consumer confidence is rising, the past five years have left consumers wary of further shocks. So any adverse news is likely to provoke an overreaction and an immediate blip in spending growth.

That said, while a fully-fledged consumer boom is unlikely, rising confidence and incomes will see consumers start to stretch their expectations and buy more discretionary goods. Car sales have held up well, and we expect people to start to indulge in more of life’s little luxuries, with spending on recreation and culture and communications — including in-home technology — set to be amongst the fastest-growing sectors. As the housing market picks up, we can also expect to see rising spending on household goods.

Mark Gregory

Peter SpencerSenior Economic Adviser ITEM Club

Peter is a professor of economics and finance at the University of York.

Mark GregoryChief Economist Ernst & Young

Mark is a partner with over 20 years experience as an adviser to governments and industry on economics, strategy, policy and regulation.

@EY_ITEMClub economics@uk.ey.com

@MarkGregoryEY ey.com/uk/economics

2 Economics for business Special report on consumer spending

Our viewpointThe Ernst & Young ITEM Club special report identifies five drivers that are coming together to fuel a sustained revival in consumer spending. These are:

► Continuing high levels of employment and hence overall employment income, albeit with growth decelerating slightly in the short term.

► A switch from shrinkage to growth in real incomes per head, as inflation eases and employees gradually gain a stronger bargaining position.

► Favourable changes to the tax system, further increasing spending power.

► A slowing of household deleveraging, now that debt levels are closer to more sustainable levels.

► A boost from the housing market, as transactions and prices rise in response to greater availability of funding and Government support for buyers.

As businesses map out and execute their strategies for capitalising on generally rising consumer spending, they need to keep close tabs on how each of these factors plays out, and flex their plans as appropriate. While reviving consumer spending may well drive UK economic growth over the next few years, it is vital that companies bear in mind that we are not contemplating an old-style consumer boom.

Instead, bruised by the experience of several tough years, and as their specific economic circumstances continue to evolve, consumers will exhibit much more caution in their decision-making and wider variations by segment than before the crisis. For example, the tax changes will disproportionately affect the lower income segments; and the higher income groups will gain greater bargaining power in the labour market as the economy picks up.

As ever in the ‘new normal’ economy, understanding and monitoring the detail is key. So each business must analyse how demand for its own products and services will play out in its target segment(s) — and operate accordingly.

Mark Gregory

Consumer spending forecast in detailConsumer spending has consistently disappointed since the onset of the financial crisis, hampered by a severe squeeze on real wages and the need to pay down domestic debt. As a result, consumer spending is currently almost 4% lower than its 2008 high-point, a marked contrast with previous recoveries when spending had risen well above previous peaks by this stage. However, the consumer finally showed signs of life in 2012 following a strong recovery in real household incomes, and we project that the momentum behind rising consumer spending will build gradually over the next few years. This should enable real consumer spending to grow by 1.2% this year before accelerating to growth rates of 1.9% in 2014. In cash terms this would represent spending growth accelerating from 3.9% last year to 4.2% in 2013 and 4.9% in 2014.

The pace of the recovery Momentum will continue to build, with real spending forecast to grow by 2.2% in 2015, at which time we expect that the level of spending will have finally returned to its pre-financial crisis peak. We then expect it to rise by 2.6% a year from 2016-2020. Though much faster than recent growth rates, this would still represent a significant slowdown on previous trends; the ten years prior to the financial crisis saw consumer spending grow by 3.7% a year.

Income and labour market factorsOne of the main drivers of the revival in consumer spending will be a return to growth in real incomes per head, as inflation eases and labour gains greater bargaining power. The strong rebound of 2.1% in real incomes seen in 2012 will not be sustained, with last year’s remarkably robust employment performance unlikely to be repeated in 2013, and inflation not expected to slow down from current rates. However, these effects will be mitigated by the generous increases in the income tax personal allowance, which will boost the take-home pay of all workers over the next two years, particularly those in the lower reaches of the income distribution. Overall, these factors should mean that real incomes grow by around 1.2% in 2013 and 1% in 2014, slower than last year but still sufficient to sustain the recovery in consumer spending.

The wider economic backgroundThe momentum behind the steady recovery in consumer spending over the coming years will be helped by the wider economic backdrop becoming more supportive. The strengthening of the labour market and the recovering housing market will bolster consumer confidence, although the experience of the past few years means the consumer mood will remain fragile and vulnerable to shocks. At the same time, consumers have already made the ‘hard yards’ in deleveraging to more sustainable debt levels, so are likely to pay down their debts at a slower pace in future.

Variations by consumer segmentWhile consumers as a whole will remain more cautious than in the pre-crisis days, the strength and speed of the recovery in consumer spending will vary between different segments, as a result of the differing economic circumstances and pressures they face. Lower income consumers will benefit particularly from the tax changes, while those in higher incomes groups will have more bargaining power in the labour market thanks to the stronger economic conditions, helping to sustain growth in wages.

Impact on sectorsBusinesses in all sectors will need to work out how the factors above will shape demand for their products and services among their target consumers. In the past five years, high inflation rates in categories where demand is relatively insensitive to price — such as food, non-alcoholic drinks, housing and transport — have seen consumers cut back on more discretionary spending such as education and hotels and restaurants. But in 2012 rising incomes and confidence saw this situation start to turn around, with robust rises in sales of cars and audio-visual equipment. We expect this trend to continue, with recreation and culture and communications products and services performing well, as rapid advances in technology, new products launches and falling prices help to sustain strong demand.

Peter Spencer

3Economics for business Special report on consumer spending

Consumer spending forecasts, current prices, annual % change

1997-2007 2007-2012 2013(f) 2014(f) 2015(f) 2016-2020(f)

Housing 6.5 6.4 5.6 6.1 6.5 6.1

Communications 6.1 4.9 4.8 6.9 6.4 5.8

Recreation and culture 5.9 0.5 3.8 4.0 4.9 5.5

Transport 5.0 2.2 3.0 4.4 5.5 5.5

Hotels and restaurants 4.4 2.8 4.4 4.3 5.0 5.2

Food and non-alcoholic drinks 3.0 3.8 5.6 4.9 5.0 5.0

Household goods 4.7 0.5 2.7 4.1 4.3 4.6

Alcohol and tobacco 3.5 3.8 2.1 4.2 4.5 4.0

Education 4.4 2.6 16.5 14.7 12.1 3.9

Clothing and footwear 5.0 3.7 3.1 2.8 3.3 3.6

Miscellaneous 5.2 -2.8 2.7 4.2 3.0 2.7

Health 2.3 0.9 0.7 2.1 2.0 1.9

Total 5.3 2.5 4.2 4.9 5.3 5.1

Source: ONS, ITEM Club

(f) denotes forecast. Categories ordered according to their projected growth rate over 2016-20 period

Guest viewpointThe outlook for the high streetWhile a return to sustained growth in consumer spending must be seen as generally good news for the high street, the pattern of growth over the next few years raises two clear issues for the evolving retail sector. The first is that the increase in spending is expected to be strongest in areas like entertainment, leisure, broadband services and technology, indicating that the transformation of the high street towards leisure experiences will continue and that the battle intensifies for our £ spend. The second is that consumers’ spending will be affected by continuing caution following the downturn and greater divergence between different segments. This means all retailers will have to keep close tabs on their own consumers, by using analytics to generate deep insights from their customer data — and then acting quickly in response to emerging shifts.

Julie CarlyleHead of UK Retail, Ernst & Young

The outlook for consumer productsConsumer spending now appears to be on a sustained upward path, but this does not mean that all retailers selling consumer products can breathe easy. The rise will not only be gradual — with real spending only set to return to its 2008 level in 2015 — but will also be focused more on services such as housing, leisure and communications than on physical goods. Furthermore, the drivers of increased spending will also affect different types of consumer in different ways. All of this means that businesses will need to maintain a detailed, real-time understanding both of the level of demand for their products and services, and of their own cost base in meeting that demand. This need applies especially if they are facing high input inflation on supplies sourced from overseas.

Ed HudsonUK&I Consumer Products Sector Leader, Ernst & Young

2011 2012 2013(f) 2014(f) 2015(f) 2016(f)

Social benefitsWage inflationEmployment growthOther incomeIncome tax and NICsPrice inflation

UK: Decomposing real income growth

%pts

Source: Haver analytics

-6

-4

-2

0

2

4

6

Food, drink and tobacco13%

Clothing andfootwear6%

Housing andhousehold goods30%

Health andeducation4%

Transport and comms17%

Recreationand culture10%

Hotels andrestaurants10%

Miscellenous10%

Shares of nominal consumer spending, 2015

Source: Haver analytics, ITEM club

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4Economics for business Special report on consumer spending

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