UK services growth beats expectations, lifting rate hike expectations

Output from the UK's key services industry picked up more strongly than hoped last month, according to a survey released on Tuesday.

IHS Markit's services purchasing managers' index for May rose to 54.0 from 52.8 the month before, the fastest growth for three months and better than economists' consensus estimate of 53.0. A PMI reading above 50 indicates growth.

As a result, the UK composite PMI, including better than expected manufacturing and construction indices, for May rose to 54.5 from 53.2 versus the market's expectations of 53.4. For the services sector, the two PMIs so far in the second quarter point to quarterly growth in services output of around 0.5%, which would be an improvement from 0.3% in the first.

May's three PMI surveys indicate that UK gross domestic product looks set to rise by nearer 0.4% than 0.3% in the second quarter, economists said, a welcome improvement from the 0.1% crawl in the first.

Sterling quickly gained 0.5% to $1.3375 after the release of PMI report.

However, while services companies reported business rebounded from the weather-disrupted first quarter as well as growth of incoming new work, new business volumes picked up a little but were still relatively subdued, with respondents blaming Brexit-related uncertainty for holding back decision-making among clients.

Cost pressures were also said to be coming from rising oil prices and tight labour market conditions pushing on wages, while service sector employment growth was the second-weakest in over a year.

Subdued demand means firms are struggling to pass these higher costs onto customers, too, with May seeing average selling prices for goods and services marking the smallest rise for 11 months.

“The improvement in service sector activity adds to evidence that the economy is on course to rebound in the second quarter but, like the earlier manufacturing and construction surveys, raises questions about the outlook," said Chris Williamson, Markit's chief business economist.

However, he added that disappointing inflows of new work suggest that growth could wane in coming months, with new order growth across the three sectors in the second quarter so far running at the weakest since the third quarter of 2016.

“The signs of economic growth rebounding in the second quarter will likely up the odds of the Bank of England hiking interest rates again in coming months, likely August, but with the forward looking indicators suggesting that the economy could relapse, a rate rise is by no means assured.”

Economist Ruth Gregory at Capital Economics said the survey suggests that the sector has shaken off its weakness at the start of the year and pointed to UK GDP growth of "0.4% or so" this quarter.

"Note too that the service sector PMI does not account for activity on the high street, which has rebounded in Q2 so far. So if anything, it might be understating growth. Overall, then, the survey provides further reassurance that the weakness in Q1 was temporary and keeps the chances of a rate hike at the MPC’s next big meeting in August above 50% in our view."

Sam Tombs at Pantheon Macroeconomics agreed GDP was on track to increase by 0.4% in the quarter. "This slightly above-trend rate, alongside a pick-up in inflation in June, likely will convince the MPC to hike interest rates in August, provided Brexit doesn’t throw a wrench in the works before then."

But looking ahead, Tombs said it "appears increasingly likely" that GDP growth will slow again in the second half of this year, with the new orders balance only up to 53.1 in May from 52.9 in April and a decline in the balance of firms expecting better activity over the next 12 months.

"In addition," he said, "services firms barely increased their headcounts, partly due to continued labour shortages. So if the MPC forgoes the opportunity to raise interest rates in August, the activity data – plus a Brexit showdown in the autumn –likely will mean that the next hike is put on hold until next year."