At the start of May, the Bank of England found itself in the unusual position of raising rates while warning of a recession later this year.
The UK’s central bank said it could do little to prevent the cost-of-living squeeze, which was likely to see the economy reverse in the year ahead, but needed to act on inflation.
Is the outlook for the UK economy really as gloomy as the bank suggests?
The BoE’s prognosis was girm: “UK GDP growth is expected to slow sharply over the first half of the forecast period. That predominantly reflects the significant adverse impact of the sharp rises in global energy and tradable goods prices on most UK households’ real incomes and many UK companies’ profit margins.”
It said CPI inflation was expected to rise further over the remainder of the year, to just over 9% in the second quarter of 2022 and averaging slightly over 10% at its peak in the fourth quarter.
This peak is likely to be later than for many other economies.
In another blow, the BoE said economic output would dip again in the third quarter of 2023, as the government’s temporary incentives for business investment ended, leaving the economy 0.8% smaller than in the summer of 2022.
The BoE’s report echoes the finding of recent PMI data. For example, the most recent S&P Global/CIPS UK Services PMI showed new business growth slowing sharply, with business confidence dropping to its lowest level for a year and a half.
Andrew Harker, economics director at S&P Global, said: “The twin headwinds of the cost of living crisis and the war in Ukraine started to bite on the UK service sector during April, as evidenced by a sharp slowdown in new order growth to the lowest in the year so far. Worryingly, companies seem to be expecting impacts to be prolonged.”
Companies report a toll from increased fuel costs, higher energy charges and wages.
The UK consumer was already weakening, even before the worst of the inflationary pressures have been seen.
The Office for National Statistics (ONS) reported retail sales volumes in Great Britain down 1.4% month on month in March, after a decline of 0.5% the previous month.
Hopes that a the Covid ‘war chest’ of savings will be opened to support the economy appear misplaced.
The global picture
The UK economy is also likely to see little support from abroad. It is clear that the global economic picture is darkening.
According to the most recent advance estimate, US GDP contracted 0.4% in the first quarter of 2022, driven primarily by a widening of the trade deficit and weak inventory investment.
While economists were quick to point to the relative strength of underlying demand, including personal consumption, most investors are well aware of what happens when the US sneezes.
The US remains largely shielded from developments in commodity prices. The same cannot be said for Europe, where the dependence on Russian energy has been a major problem.
A recent note from Oxford Economics said: “the (Eurozone) economy is nearing a peak, which, based on previous historical episodes, suggests that risks of a recession in the near future are rising […] should inflation and uncertainty from the war surge further, the outlook for consumption could turn, triggering a recession.”
It said the risks of a downturn in the industrial sector were high, with an extended period of supply chain disruption and high energy prices.
China is the final problem area. A new wave of Covid cases has prompted lockdowns in a number of major cities, weakened an already challenging economic backdrop.
Luca Paolim, chief strategist at Pictet Asset Management says: “The country’s worst Covid outbreaks in two years are causing serious disruption to the world’s second largest economy. China is the worst-performing equity market, with investors increasingly worried about the economic slowdown at a time when the People’s Bank of China appears reluctant to deliver large-scale monetary easing.”
The view from financial markets
Financial markets are increasingly coming down on the side of recession, which has manifested in ongoing weakness for sterling, plus changing views on the likelihood of further UK rate rises.
Paul Angell, senior investment research analyst at Square Mile Investment Consulting & Research, says any debate around whether inflation is structural or transitory seems to have disappeared: “The war in Ukraine was the turning point in terms of embedding inflation expectations and the debate has now been parked. The question is now how bond managers manage in that environment.”
Increasingly, he says, certain bond managers are positioning for lower rates rather than higher rates, suggesting they believe a recession is plausible: “These managers point out that inflation is not moving higher because of a strong economy, so actually central banks shouldn’t look to raise rates to choke off any growth the economy may have. If anything they should be reducing interest rates regardless of inflation picture. We see some managers holding a lot of duration because central banks could be moving down in interest rate expectations rather than continuing to move higher.”
Schroders economist George Brown says: “We also believe that near-term economic momentum is more fragile than (the BoE) has concluded. Further hikes will hinge on how the data evolves over the coming months. In particular, whether the deterioration in consumer confidence sees spending scaled back.”
Reasons to be cheerful?
There are a few positive elements for optimists to cling to. The housing market shows no signs of slowing and may experience some upward pressure as buyers look to complete before higher mortgage rates kick in.
The picture on wages and employment generally looks good.
The S&P Global / CIPS UK Services PMI report pointed out that service providers continued to expand their staffing levels sharply in response to rising new business volumes. Employment increased for the fourteenth month running, albeit at a slightly slower pace.
It added: “Anecdotal evidence suggested that companies continued to benefit from the lifting of Covid-19 related restrictions, with a number of firms highlighting the positive impact of freer international travel.”
But perhaps the main reason to be cheerful is that the UK economy is not the stock market. The recent market rout has seen another wave of sell-offs for UK assets and they remain at a discount to the rest of the world. However, unless the outlook improves, that discount may be warranted.
