An improving U.K. economic backdrop
In recent months the outlook for the UK economy has been steadily improving. There is now a decent chance that the UK avoids a recession altogether during 2023. This is quite some reversal from last November when the Bank of England forecast the longest recession in a hundred years, and simultaneously warned of a “very challenging outlook”. Whilst the convention for a recession – two successive quarters of a shrinking economy – does not always represent the experiences of households and businesses, this evolving economic picture is cause for encouragement. It is a function of economics becoming dull. And long may that continue.
A combination of lower wholesale energy costs, the reopening of China’s economy from zero-COVID restrictions, and signs that interest rates are closing in on their peak all contribute to this cheerier backdrop. This will not translate immediately to greater business confidence, to higher levels of investment, or to more manageable household bills. However, as the year progresses these effects should begin to be emerge. Stock market investors, which have a reputation for grasping good news rather sooner than most, have certainly twigged. Only once in the last twenty-five years has the FTSE100 seen such a strong start to the year.
A duller global backdrop will also yield dividends for Prime Minister, Rishi Sunak, and his Chancellor, Jeremy Hunt at home. Signs that the US central bank may be considering an end to its recent interest rate increases has translated into lower lending rates. There are tentative signs that the UK housing market is regaining some of its composure. Inflation – the rate of change in consumer prices – has begun to slow from its peak. It is now expected to be below 4% a year by the end of the year. This all means that in April as twenty million UK adults get a 10% increase in one of their major sources of income – the State Pension, Universal Credit, or the National Living Wage – the value of this increase will go further. For households with broader shoulders – and more financial resources – data is emerging that hundreds of billions of pounds of excess savings built up during the pandemic are beginning to be spent. Travel companies, hospitality venues and the leisure industry are proving to be the main beneficiaries.
Times readers can be forgiven for reflecting on this upturn in the economic outlook with a rueful smile. Former UK Prime Minister, Liz Truss, and her first Chancellor, Kwasi Kwarteng, may reflect with a grimace. With the benefit of hindsight their attempts to reforge the UK economy with a tax cutting agenda and promise of reforms to planning, childcare and infrastructure now looks unfortunately timed. This is not to suggest that their institutional scorched earth policy would have worked against a more favourable backdrop. The “Mini Budget” of 23 September remains a textbook example of how not to instigate change. But the dramatic dislocation of European energy markets and fears over runway global inflation were at their pinnacle last autumn. Financial markets did not need much of an excuse to pick on the UK and punish her economy with higher interest rates.
Any UK economics column of the last six years almost inevitably attracts feverish comment on Brexit. When Brexit does not get a mention, those that favoured Remain cry foul. By contrast, giving Brexit top billing encourages those favouring Leave to point to the myriad of other influences on the performance of the UK economy. Right now, the most important facet of Brexit is whether Prime Minister Sunak can illustrate that the UK and EU can cooperate, foster trust, and show joint political leadership to make changes to the Northern Ireland Protocol. If the discounts applied to Sterling and to UK shares since 2016 – and similar chilling effects on trade networks and business investment – are to be reversed, then a stable negotiated settlement will be a key building block.
Despite this improved economic backdrop, huge challenges remain. Three are worthy of particular attention.
Firstly, there is considerable uncertainty on how quickly UK inflation will moderate next year. Even as gas prices, shipping rates and food supply chains put considerable downward pressure on prices this year, there is a risk that price growth will remain stubbornly high thereafter. Multi-year pay settlements, fears over escalation of the war in Ukraine, and a race to insource new technology and supply chains all risk embedding high inflation. We also learned last week that except for energy companies, UK company profits have been squeezed in recent quarters. As the economic backdrop improves it is reasonable to expect companies to try and rebuild those margins, locking in higher prices and sticky inflation.
Secondly, even if the short-term UK growth rate gets upgraded – the longer-term outlook hinges on whether the sick, the early retired and the discouraged workforce start to return to work to help ease pinch points in the jobs market. The UK looks like being one of the countries that has suffered the most from a recent deterioration in these trends. It will be hard to stay elevated on the global growth leaderboard if the UK’s labour force becomes stubbornly inactive. The lessons of the 1980s labour market – as large swathes of industrial Britain faced a managed decline – is that sustained inactivity is a very expensive and difficult trend to reverse.
Finally, there are global adjustments now underway to higher interest rates, fewer workers, reduced carbon intensity and diverse security threats. Each of these, in their own way, challenge the public finances. Adjusting to these new realities will require an honesty over the trade-offs that always existed but were cushioned by more than a decade of record Quantitative Easing from the world’s central banks. That cushion to a hard economic landing has had the stuffing knocked out of it from the post-pandemic surge in inflation.
Inflation has a history of providing a painful and sustained legacy. That the UK is now past peak inflation is encouraging. This alone justifies greater optimism. But the economy is not out of the woods yet. A further bout of dullness would be very welcome indeed.
Author: Simon French, Chief Economist and Head of Research, Panmure Gordon
Managing Director, Head of Research