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Modelling UK Investment The Saturday Economist . com Modelling Investment Forecasts for the UK economy 2015 - 2016 September 2015

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Modelling UK Investment

The Saturday Economist . com

Modelling InvestmentForecasts for the UK economy 2015 - 2016September 2015

40,000

50,000

60,000

70,000

80,000

90,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Total Investment £ million

The Saturday Economist.com Data Source : ONS Quarterly Data Gross fixed capital formation by sector and type of asset (£million at current prices seasonally adjusted)

We are forecasting an increase in investment of 4.4% in 2015 and 5.5% in 2015.

Q2 2015 Latest Data 4.9%

Up

year on year

Forecasts …4.4% 5.5%

2015 2016

-20.0-18.0-16.0-14.0-12.0-10.0-8.0-6.0-4.0-2.00.02.04.06.08.0

10.012.014.016.018.020.0

2000 2005 2010 2015 Untitled 2

The strong rally in investment is expected to continue …

% Change year on year

2014 2015 2016

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

9.3 9.8 8.9 6.6 5.0 4.9 3.7 4.1 5.7 5.4 5.3 5.5

From 2000 - 2008 investment increased rapidly at an average rate of growth of 3.6%. The average growth rate in the economy as a whole was 3.0%. The investment surge was driven by an increase in commercial real estate.

Total Investment £ million

Growth rate year on year

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling InvestmentSeptember 2015

21%

31% 22%

22%

5%

Transport EquipmentMachinery & EquipmentDwellingsCommercial Real EstateIntangible Fixed Assets

Averages 2000 - 2014

5%22%22%31%21%

Commercial Real Estate

Dwellings

Machinery & Equipment

IntangiblesTransport

In 2015 onwards, we anticipate a recovery in investment rising by 4.4% in 2015 and 5.5% in 2016. Strong growth is expected in business investment, including plant and machinery and transport equipment.

The strength of the housing market will contribute to growth in dwellings investment. Plus we expect the increase in corporate finance and M&A activity to provide a further boost to intangibles investment.

The forecasts reflect our survey based model, based on capacity and investment intentions, (notes slide 16 and chart slide 17), a recovery in corporate finance activity (intangibles) and growth in transport investment.

When modelling investment, it is important to remember that over 53% of investment, identified in the National Accounts, relates to property i.e. dwellings and commercial real estate.

A further 21% is classified as intangible fixed assets and 5% transport equipment.

22% is defined as plant and machinery, the major contributor to the concept of “capacity” within the economy.

The fall in overall investment in real terms and as a percentage of GDP is largely determined by the collapse post 2007 of the commercial real estate market.

The actual fall in investment plant and machinery and the potential loss of capacity tends to be over stated as our capital stock model, chart 4 suggests.

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling GDP(O)September 2015

150,000

160,000

170,000

180,000

190,000

200,000

210,000

220,000

230,000

240,000

250,000

260,000

270,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Gross fixed capital formation by sector and type of asset (£million at chained volume measures (reference year 2011) seasonally adjusted)

Four Year Capital Stock £million

6.0

6.5

7.0

7.5

2000 2002 2004 2006 2008 2010 2012 2014 2016

Capital productivity

GDP / Capital Stock

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling GDP(O)September 2015

12.0

13.0

14.0

15.0

16.0

17.0

18.0

19.0

20.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

18.5

17.8 17.817.6 17.7

17.5 17.5

18.0

17.2

15.4

16.0 16.1 16.116.4

17.317.6

18.0

Total Investment % GDP

Data Source : ONS Annual Ratios Gross fixed capital formation by sector and type of asset

Between 2000 and 2008, investment averaged 17.7% of GDP, rising to almost 18% in 2007.

In the recession, the investment ratio fell to 15.4% in 2009, rallying to 17.3% in 2014.

We expect a rally to over 18% by 2016.

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling GDP(O)September 2015

30,000

35,000

40,000

45,000

50,000

55,000

60,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Business Investment £ million

Data Source : ONS Quarterly Data Gross fixed capital formation by sector and type of asset (£million at current prices seasonally adjusted)

Excluding the surge in the first half of 2008 and excluding the spike in Q2 2005, business investment has averaged just over £35 billion per quarter.

We expect the strong recovery, evident since the end of 2011 to continue, increasing by 5.3% in 2015 and 6.2% in 2016.

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling GDP(O)September 2015

5,000

6,000

7,000

8,000

9,000

10,000

11,000

12,000

13,000

14,000

15,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

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Government Investment £ million

Data Source : ONS Quarterly Data Gross fixed capital formation by sector and type of asset (£million chained volume measure seasonally adjusted)

Government investment, experienced a trend rate of growth of over 8% in the period from 2000 to 2010.

The slow down in expenditure, since 2010, resulted in a total spend of £10 billion in 2013.

We are forecasting zero growth over the next two years.

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling GDP(O)September 2015

5,000

7,500

10,000

12,500

15,000

17,500

20,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Private Sector Dwellings £ million

Data Source : ONS Quarterly Data Gross fixed capital formation by sector and type of asset (£million at current prices seasonally adjusted)

The high levels on investment in private sector dwellings, ended in 2008.

Given the strength of the housing market, we expect an increase of 3.0% in 2015 and 4.7% in 2016.

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling GDP(O)September 2015

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

11,000

12,000

13,000

14,000

15,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Ownership Transfers £ mn

Data Source : ONS Quarterly Data Gross fixed capital formation by sector and type of asset (£million at current prices seasonally adjusted)

Modest recovery envisaged in ownership transfers …

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling GDP(O)September 2015

0

1,000

2,000

3,000

4,000

5,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Transport Equipment £ million

Data Source : ONS Quarterly Data Gross fixed capital formation by sector and type of asset (£million at current prices seasonally adjusted)

Investment in transport equipment averaged £3.5 billion per quarter in the period 2001 to 2010.

A recovery from the low in Q3 2012 is evident. We are projecting a strong rally to pre recession norms over the forecast period.

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling GDP(O)September 2015

5,000

7,500

10,000

12,500

15,000

17,500

20,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

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Analysis by Asset - Machinery and Equipment £ million

Seasonally  adjusted  £  million  at  chained  volume  measures  (reference  year  2011)

Data Source : ONS Quarterly Data Gross fixed capital formation by sector and type of asset

Investment in machinery and equipment has averaged around £14.3 billion per quarter over the period 2000 to 2014.

We are forecasting an increase in 2015 of 5.0% and 7.2% in 2016.

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling GDP(O)September 2015

8,000

10,000

12,000

14,000

16,000

18,000

20,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

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Analysis by Asset - Dwellings £ million

Seasonally  adjusted  £  million  at  chained  volume  measures  (reference  year  2011)

Data Source : ONS Quarterly Data Gross fixed capital formation by sector and type of asset

Total investment in dwellings has clearly slumped from the highs of 2003 and 2007.

The nadir of Q4 2009 is marked, as is the subsequent recovery. We expect the rally to continue with growth of 3.1% in 2015 AND 3.8% in 2016.

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling GDP(O)September 2015

6,000

10,000

14,000

18,000

22,000

26,000

30,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

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Analysis by Asset - Commercial Real Estate* £ million

* Other Buildings and Structures

Seasonally  adjusted  £  million  at  chained  volume  measures  (reference  year  2011)

Data Source : ONS Quarterly Data Gross fixed capital formation by sector and type of asset

From the highs of 2006 to 2008, the setback has averaged around £21 billion per quarter from 2009 onwards.

We expect a moderate rally over the next two years, increasing by 1.4% in 2015 and 3.4% in 2016.

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling GDP(O)September 2015

10,000

11,000

12,000

13,000

14,000

15,000

16,000

17,000

18,000

19,000

20,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

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Analysis by Asset - Intangible Fixed Assets - £ million

Data Source : ONS Quarterly Data Gross fixed capital formation by sector and type of asset

Seasonally  adjusted  £  million  at  chained  volume  measures  (reference  year  2011)

Strong growth to continue, we forecast growth of 5.9% in 2015 and 5.6% in 2015

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling GDP(O)September 2015

Data Based on the ONS Business Investment Q2 : 28th August 2015

Notes on Investment Models : Saturday Economist

1 Survey Model ; The Manchester IndexOur model is derived from the GM Chamber of Commerce Quarterly Economic Survey “Manchester Investment Index”. Data is derived from capacity and investment intentions in the manufacturing and service sectors. Highest correlations and predictive fit are derived from capacity (-4) lagged by four quarters and investment intentions (-2) lagged by two quarters.

The model over predicts overall investment, we assume this is because of the current state of over investment in commercial real estate. A better performance is obtained when forecasting “Business Investment”. The model is similar but an enhancement to model 6 in the Bank of England suite of investment models identified in Burgess et al (2013).

2 ARIMA and Box Jenkins ModelWe also use a conventional ARIMA and Box Jenkins models forecasting investment as a function of lag dynamics. [See Section 2]

3 A disaggregated ModelA disaggregated model accepts that over investment in the commercial real estate market may have a significant overhang in the resumption of our long term [I (f) Y) relationship. Reflecting a Hyman Minsky distortion.

4 Cost of Capital and Forecast Horizon Our model accepts that cost of capital is a relatively low factor in the investment payback calculation and the investment decision process. Relative certainty of demand over the forecast horizon is a key factor in the investment decision. Akin to the confidence fairy proposition, reflected in Krugman 2010, Bloom, 2009, MacCaferty 2014

5 Disaggregated Pattern recognition Our models are reconciled with a “pattern recognition” of the forecast outlook for the disaggregated variables before final model build and projection is made.

The Bank of England Investment Models.

According to Burgess et al, 2013, there are seven models in the Bank of England Model investment suite, described below. Figure 8 shows a comparison of the forecasts from these seven models.

1. ARMA model: A simple baseline model, expressing business investment as a function of lag dynamics (see Box et al. (1970)).

2. Simple financial accelerator model: An ECM which assumes that in the long run, the level of investment depends on the level of GDP, the capital stock and the cost of capital, but that in the short run, financial channels such as firms’ cash flow, interest payments and net financial assets play an important role.

3. Gearing model: An ECM, which assumes that in the long run, investment is determined by GDP, the cost of capital and the *gearing disequilibrium: *the extent to which firms' debt levels are away from a target" level determined by tax incentives and the risks of distress (Bunn and Young (2004)).

4. Money, lending and investment system: A three-equation VECM which jointly models business investment, non-financial companies' money holdings and M4 lending to non-financial companies. A range of other explanatory variables are included, such as spare capacity and firms' retained earnings. See Brigden and Mizen (1999)

5. Tobin's Q model: A model for the ratio of investment to the capital stock, which in the long run depends on a proxy for Tobin's Q, the value of the firm. (see Kapetanios et al. (2006)).

6. Survey model: This uses the investment intentions balances in the BCC Quarterly Economic Survey to project investment in the year ahead.

7. VECM: A four-equation system embodying two assumed long-run relationships. One relates investment to the size of the capital stock; the other is based on a profit-maximising condition and links the capital-output ratio to the real cost of capital. See Ellis and Price (2004).

ReferencesBloom, N (2009), ‘The impact of uncertainty shocks’, Econometrica, Vol. 77, pages 623–85. Box, G., G. Jenkins, and G. Reinsel (1970): Time series analysis: forecasting and control, Wiley.Brigden, A. and P. Mizen (1999): Money, credit and investment in the UK corporate sector, Bank of England Working Paper 100, Bank of England.Bunn, P. and G. Young (2004): Corporate capital structure in the United Kingdom: determinants and adjustment," Bank of England Working Paper 226, Bank of England.Burgess, S., Fernandez-Corugedo, E., Groth, C., Harrison, R., Monti, F.,Theodoridis K, and Waldron, M., The Bank of England’s forecasting platform: COMPASS, MAPS, EASE and the suite of models. Working Paper No. 471 May 2013Dixit, A and R Pinkyck (1994), Chapter 2 of Investment Under Uncertainty, Princeton University Press, Princeton. Kapetanios, G., V. Labhard, and S. Price (2006): \Forecasting using predictive likelihood model averaging, Economics Letters, 91, 373-379.Krugman P, (2010) Myths of Austerity, New York Times. McCafferty, I., Achieving a sustainable recovery: where next for business investment? January 2014 Bank of England Speech 703. Minsky, H.P. The Financial Instability Hypothesis Working Paper No. 74 The Jerome Levy Economics Institute of Bard College, May 1992.

Data Based on the ONS Business Investment Q2 : 28th August 2015

Modelling UK Investment

The Saturday Economist . com

Modelling InvestmentForecasts for the UK economy 2015 - 2016September 2015