This article was written by Austin Hughes of KBC Bank for the CIS Construction Opportunities Report 2017.
The Only Certainty Is Uncertainty
It is usually the case that as an economic recovery matures and builds momentum, economic forecasts become more upbeat about the likely evolution of the economy in the following year. As 2016 marks the fourth calendar year of positive growth in both Irish GDP and employment, it might be expected that the mood for 2017 would be particularly buoyant-and it is, in some sectors of the Irish economy, but, overall, there is a fair measure of uncertainty and caution as to what the year ahead might bring.
This is not to suggest that a marked deterioration in Irish economic conditions is in prospect. The outlook remains encouraging. It is simply important to guard against complacency that the natural order for a now healthy Irish economic recovery must be to produce bigger, broader and better gains in activity and incomes in the year ahead.
Looking into 2017 there are very specific risk factors that bear watching, but another important consideration is the capacity of the global economy to repeatedly disappoint expectations in recent years, as diagram 1 above illustrates. This graph presents various vintages of IMF forecasts for global economic growth for the years 2012 to 2017, and highlights how initial optimism has consistently given way to a notably more downbeat assessment of global economic conditions. In this way, the diagram shows how the world economy has failed to develop sufficient ‘escape velocity’ to put the problems of the crisis that began in 2007 firmly behind it.
One important corollary of this sluggish growth landscape is that interest rates look set to remain low by historic standards. Diagram 2 below shows the current three month interbank interest rate and how financial market thinking has evolved on what level of rates might prevail at the end of next year and the end of each year from 2017 to 2010. Thinking has changed a little in the past couple of months but rates at end 2019 are expected to be only marginally higher than today and only reach zero at that point.
The sense that a changed emphasis in US policymaking when Donald Trump became president could lead to somewhat faster growth in the US and a step-up in inflation from historically low levels at present has seen a slightly firmer tone emerge in longer term market interest rates of late. This may imply a measure of upward pressure emerges on ‘fixed’ rates through the coming year. However, still sluggish growth in the Euro area and the persistence of inflation well below the European Central Bank’s target of ‘below, but close to 2%’ means we are still some distance from a turning point in ECB policy rates. So, the prevailing view is that the range of borrowing costs relevant to Irish businesses and households will remain low for a good deal longer, and certainly through, 2017.
One important reason why interest rates are expected to remain fairly low next year is the prospect of notable headwinds to global growth coming from a range of sources. These include continuing nervousness about emerging markets most notably China, increased uncertainty about the likely settings for fiscal and monetary policy in the US and what these might mean for the rest of the world, as well as, ongoing concerns about the health of the Euro area economy and its financial sector. Particularly important from an Irish perspective is the UK’s stated intention to trigger early next year the start of the Article 50 process leading to its exit from the EU.
Brexit Concerns Could Increase Dramatically But Clarity May Be Slow To Emerge
In an important respect, Brexit is already well underway from an Irish standpoint. A substantial drop in the value of the UK currency should be seen as the first of three distinct stages in the effects of Brexit on the Irish economy. Diagram 3 below hints how important currency movements are to the health of Irish exports to the UK. It suggests that adverse currency movements tend to be reflected quickly and substantially in weaker Irish export performance.
More generally, the almost ‘domestic’ nature of the business and social ties between the UK and Ireland mean significant effects spill quickly across broad swathes of Irish business well beyond those sectors directly engaged in trade with the UK. This key consideration is often underestimated in some analyses that concentrate almost exclusively only on businesses with direct trading links with the UK. Already, the fortunes of many domestic retailers as well as hotels, restaurants and bars are showing adverse effects because of swings in Sterling’s exchange rate resulting from concerns about Brexit.
It may be worthwhile considering the mechanics of the ‘second stage‘ of Brexit to highlight the issues involved, which, in turn, could make this a period of pronounced uncertainty for Irish business. The second ‘stage’ of Brexit is set to begin by March 2017 as this is the date the UK Government has indicated by which it will trigger the formal ‘article 50’ procedure to begin to exit the EU. Formally, this process allows a two year timeframe for negotiations on the post-exit relationship between the UK and EU as well as the mechanics of the exit itself to be concluded. If all the remaining 27 EU states agree, that timeframe can be extended but there are significant doubts that this will be agreed.
In practical terms, the effective negotiating time is likely to be notably shorter than two years. A formal EU response to the UK’s invocation of article 50 would entail formulating an agreed position between remaining EU states and could take several months. This process is likely to be lengthened and complicated by elections in several key EU states next year. Domestic political considerations and a desire not to encourage a rash of other countries’ departures may well translate into a hard line stance in negotiations. As an eventual deal may have to be ratified by some national parliaments, this would require a deal to be finalised possibly six months ahead of the two year deadline.
Even if political factors did not impinge on the exit talks, the scale and range of technical considerations involved in these negotiations mean it seems very unlikely that a comprehensive set of trade agreements between the UK and the EU could be put in place within a two year timeframe. Some estimates suggest this process could take five to seven years. It is likely that a notable deterioration in economic and financial conditions would occur if, after a two year negotiation period, the UK’s exit became operational without a robust alternative framework in place.
These considerations suggest that (i), uncertainty about the precise terms of ‘Brexit’ could continue for a number of years, implying a correspondingly prolonged period of uncertainty about the precise economic consequences and (ii), as the status quo would continue to operate for some significant time, no immediate changes of a technical nature would impinge on Irish business. However, potentially wide gaps between the negotiating positions of the UK and the EU mean businesses might need to prepare itself for a wide range of potential outcomes in terms of the technical and legislative changes that might affect economic relations between Ireland and the UK. In turn, this is likely to cause businesses to postpone a range of decisions related to investment and activity that might even be peripherally affected by the UK’s post-exit relationship with the EU.
The third stage of Brexit relates to the period of the post-exit relationship between the UK and the EU. While various ‘models’ such as those implied by the EU’s relationship with Switzerland or Norway have been cited, there is no precedent that would provide a reliable blueprint for the UK’S future relationship with the EU. The precise nature of this relationship is almost impossible to predetermine at this point. The prioritisation of political considerations might lead to a radically changed and potentially much more unfavourable business environment while an emphasis on economic aspects would likely entail more limited regime changes.
UK demands for selective and differentiated controls in regard to each of the EU single market’s ‘four freedoms’ (guaranteeing the free movement of goods, services, capital and people) are at odds with the basic principles of the EU. As a result, uncertainty about whether and where compromise might be struck means the final deal struck could lie anywhere on the spectrum from a ‘Hard Brexit’ entailing a substantial severing of current ties and their replacement by substantial tariffs and other barriers to trade to a more nuanced ‘Soft Brexit’ that retains many key features of the current regime.
In view of these many sources of uncertainty, it is not readily possible to suggest any detailed picture of the precise economic impact of Brexit on Ireland although it is generally agreed that the net effect would be negative and significant. A number of studies by the ESRI, Central Bank of Ireland and other agencies outline scenarios based on various assumptions that suggest the impact of Brexit over time would be to lower Irish GDP by between 2% and 4% compared to a ‘no Brexit’ alternative. These seem broadly plausible estimates and imply a large but not entirely catastrophic scale of impact. However, these calculations probably understate the nature and extent of disruption that volatile and uncertain business conditions might have on the typical Irish company.
It should also be emphasised that the prospect of a fundamental change in the nature of the UK’s economic links to the EU will throw up opportunities as well as threats for Irish business. In this context, the risk of postponed or curtailed construction spending as a result of a somewhat weaker trajectory for the Irish economy may be partly offset by the construction requirements that would follow from the relocation of some international or EU focused activities from the UK to Ireland.This would suggest that the impact on the Irish construction industry could vary significantly across parts of the sector with activity associated with businesses or parts of the country for which trade with the UK is important particularly vulnerable and some areas seeing offsetting impacts from the relocation of activities from the UK. However, it may take some time for the precise nature and extent of these differentiated effects to become clear.
The Brexit process may well be the most important external development influencing Irish economic conditions in the next year or two but it is far from being the only one. Fortunately, the Irish economy has improved dramatically over the past four or five years to the point where the prospect of Brexit raises serious concerns but does not automatically imply a catastrophe. In this regard, we would highlight encouraging developments in two areas that should at least partly offset any adverse effects from external developments in the coming year.
An Improving Jobs Picture Is A Major Positive
Probably the most positive feature of the Irish economic upswing in recent years is evidence of a broadening recovery in employment. Recent data for the4thrd quarter of 2016 suggest the Irish jobs market has continued to show strong momentum of late with robust jobs growth prompting a further significant fall in unemployment as diagram 4 below indicates. The monthly unemployment rate for January 2017 is now estimated at 6.8%. So, unemployment is now comfortably less than half of the January 2012 peak of 15.2% and notably less distant from the low-point of just under 4% seen a decade earlier.
The pace of jobs growth continues to be notably faster in Ireland than elsewhere. Numbers at work in the Irish economy were 65k5k higher in the 4thd quarter of 2016 than a year earlier. This 3.3% pace of increase compares with increases of 1.6% in the US and 1% in the UK over the same time period. The latest available data for the Euro area show jobs growth of 1.2% in the year to the third quarter of 2016.
The details of recent jobs data are encouraging in many respects. All 14 industrial sectors posted year-on year gains in the third quarter of 2016 as didall planning regions, with jobs growth in Dublin marginally slower (+3.2%) than elsewhere (+4.3%) and areas of relative weakness through 2015 such as the west and mid-east regions showing a notably stronger trend of late. There has also been some improvement in the ‘reach’ of the recovery across educational levels. This likely reflects the improvement in domestic spending and the allied pick-up in employment in areas such as construction and accommodation and food services.
It is likely that jobs growth will ease somewhat in coming quarters as the impact of weaker Sterling and more broadly based uncertainty about global economic developments prompt a more cautious approach to new hiring. However, the spread of job gains seen in recent data hints at a capacity to weather potentially more difficult economic conditions in the coming year.
Stronger than expected labour market indicators of late data have led us to raise our forecast for employment growth for 2017 from 2% to 2.5%. An emerging recovery in the workforce is being boosted by the return to net inward migration (potentially picking up once the UK invokes Article 50 to leave the EU) and some increase in participation rates, job gains of this magnitude could result in the average unemployment rate falling close to 6.5 this year %.
Healthier Public Finances Will Help—If We Keep Them That Way
Another notable positive for the Irish economy which should support activity in coming years is the turnaround in Ireland’s public finances achieved after a prolonged and painful adjustment. The latest IMF projections suggest that only three EU countries will have a smaller deficit as a percentage of GDP in 2017 than Budget 2017 data envisage for Ireland. Diagram 5 below highlights how remarkable the improvement in Ireland’s fiscal position has been.
While concerns about public deficits and debt must remain a key influence, they no longer need to be the exclusive focus of Irish economic policy. As a result, the delivery in Budget 2017 of a package of measures that keeps Ireland’s public finances on an improving trajectory while providing some modest support to activity and incomes in a still recovering Irish economy marks a significant achievement and one that should provide some offset to other less supportive developments in the year ahead..
The relatively modest measures announced in Budget 2017 amount to just under a half a percent of 2017 GDP. The envisaged scale of adjustments to public spending and income taxes goes only a little further than ‘indexing’ these aggregates to expected increases in relevant prices and wages thereby preventing a deterioration in the real level of public services or an increased effective rate of taxation for workers getting even modest pay increases. Even after the substantial progress of recent years, only modest assistance is feasible in future Budgets. There is no scope for substantial ‘giveaways’. In this regard, a notable risk for the next couple of years is that expectations run far ahead of reality in terms of what the public purse can deliver by way of reversing cutbacks made in the downturn.
With resources still relatively limited, substantial demands for increased public services in a range of areas and significant uncertainty about the likely strength of economic conditions in the next couple of years, we need to be very careful about how far and how fast ‘austerity era’ measures are reversed. What is clear is that the faster public sector pay is increased or taxes cut or spending programmes boosted, the greater is the risk that we run into problems with the public finances in the future. The task is to agree a safe pace of improvement in living standards is achievable across society and where priorities lie. A fractious industrial relations climate is likely to worsen outcomes for most if not all.
Rising House Prices Reflect ‘Macro’ Gains And Sectoral Strains
House price data for the third quarter of 2016 have shown somewhat stronger than expected month on month increases. In turn, this means that the annual rate of residential property price inflation has picked up notably since June and is now running at the fastest pace nationwide (+7.3%) in fifteen months. The trend in Irish housing prices of late is slightly stronger than we anticipated.
A notable feature of the recent trend in CSO property price data is the extent to which it has been felt across the country as a whole. Some sense of how broadly based the uptick in prices has been in recent months is given by diagram 6 which shows the trend in the CSO’s index of house price levels for various regions of the country. Admittedly, the pace of increase varies notably across regions at present but this graph emphasises that a wide reaching pick-up in prices has become established of late.
In circumstances, where many other domestic pointers towards Irish economic conditions, including retail sales and consumer sentiment, have shown a somewhat weaker trend of late, the stronger trend in house prices may seem slightly surprising. We think a wide range of factors may explain this divergence.
First of all, it should be noted that the typical time lag between offers being made and home sales being completed and registered means that the latest house price numbers reflect purchase decisions made in the late spring and early summer, a period when economic confidence was strong and improving and Brexit seemed extremely unlikely. One would expect that a notably less certain economic outlook at present will have some cooling effect on price trends that will show up in house price data for the final months of 2016 and the beginning of 2017.
A second factor likely to contribute to a moderation in price growth in coming months is a normal seasonal pattern that tends to result in stronger prices during the spring/summer home-buying season. That said, the recent firming was clearly stronger than a year earlier which suggests other factors may be at work of late.
One important element influencing prices at present is the re-emergence of pent-up demand as the dearth of ‘normal’ purchasing activity through the past six or seven years translates into a bulge in buying intentions. A strong jobs market, renewed net inward migration and the continuing buoyancy of rents are offering increasing support to purchasing demand at present. As diagram 7 illustrates, the gap between new mortgage drawdowns, a barometer of incremental demand and new completions, a measure of additional supply, has been increasing of late in a manner that would underpin growth in property prices.
The recent trend in Irish property prices might also reflect the manner in which the market is adapting to a couple of important policy interventions. One possibility is that that the market might now have significantly adjusted to the ‘shock’ of the initial introduction of CBI lending limits which contributed to the sharp deceleration in property price inflation seen through the second half of 2015. Through the nearly two years since the introduction of lending constraints was first announced, prospective purchasers, affected by CBI rule changes, could have built up larger deposits, opted to purchase smaller properties or extended their search across a wider area. As a result, it may be that the initial impact of the Central Bank’s tightening of lending conditions is lessening. The slight loosening of the CBI constraints announced in November 2016 should further underpin residential property prices in the year ahead.
It could also be that some anticipation of the likely impact of Government measures to assist homebuyers first mooted in May in the ‘Programme for a Partnership Government’, signalled in July’s action plan on housing and set out in Budget 2017 might also have contributed to the firmer trend in house prices of late. The latest property price data would only reflect expectations in relation to the recently confirmed measures but asset prices typically move quickly to discount such interventions. It seems likely that the formal announcement in Budget 2017 of a tax rebate of up to €20k for first-time buyers of new homes will provide some further support to house prices in coming months.
A final and important consideration in terms of the outlook for Irish housing prices is the extent to which current valuations are aligned with ‘fundamentals of the Irish economy’. There is no perfect metric in this regard but some perspective is provided in a report released by the European Systemic Risk Board in late November. The chart reproduced below from that report suggests that on a range of traditional metrics, Irish house prices may still be somewhat undervalued. The chart suggests various measures imply that Irish house prices were roughly between 10 and 25% undervalued in the 3rd quarter of 2015 with a central estimate of undervaluation between 15 and 20%. Increases in the interim may have removed about half of that undervaluation. However, this and a number of similar recent studies suggest that, in the absence of notably adverse shocks to the Irish economy in 2017, Irish house prices could see further solid gains.
Our best guess at present is that a gradual, if possibly uneven, easing in Irish house price inflation will become established through 2017. The scale of slowdown will be significantly influenced by the extent to which downside risks to the Irish economy posed by Brexit or marked changes in US economic and tax policies crystallise into notably weaker conditions than are now envisaged. However, with new housing supply improving but still constrained, and a significant element of pent-up demand now emerging, factors specific to the Irish property market remain supportive of further if more modest increases in Irish property prices.
GDP Growth Data May Not Reflect What Is Happening ‘On The Ground’
It is usual in commentaries such as this to focus much of the attention on current and prospective developments in some summary measure of economic activity such as GDP. For a variety of reasons but primarily, the relocation/reclassification of a substantial element of one multinational’s activity to its Irish operations, GDP data for 2015 bore no resemblance to the conditions experienced by most Irish businesses or households. Diagram 9 below highlights the extraordinary divergence in 2015 between measured GDP and jobs growth-an important barometer of economic conditions. This gap makes us reluctant to go beyond a very general description of current GDP trends at this point.
Our current forecasts assume no major distortions from the activities of the multinational sector to measured growth in GDP for 2016 or 2017. On this basis, a growth rate for 2016 in the region of 4% is probably reasonably representative of conditions in the Irish economy at present but we would caution that the detail of the national accounts data continue to reflect the heavy influence of particular developments in the multinational sector that may not always mirror conditions right across the Irish economy.
Our forecasts and those of most analysts suggest Irish economic growth will slow materially through the coming year. A GDP growth rate of around 3% that we currently envisage for 2017 is reasonably healthy but far from white hot. Reflecting spare capacity and intense competition, the trend in Irish wages and consumer prices has remained consistently soft even relative to subdued international trends and we see slightly negative inflation in 2016 giving way to a very limited rise in consumer prices of about 0.5% in 2017.