It was a truly gloomy update from the Bank of England last week, as it declared its first half-point interest rate increase in nearly three decades. It warned of higher and more persistent inflation, with price rises reaching 13% this year, rather than the 11% previously predicted. This is likely to put unprecedented pressure on household budgets and push the UK into multiple quarters of sliding GDP, starting in the fourth quarter of 2022.
It is not just the Bank of England that is predicting weakness. The latest UK S&P Global Composite PMI came in at 52.1 in July, the slowest rate of expansion since February 2021.
Last month, Chris Williamson, chief business economist at S&P Global Market Intelligence, said: “Although not yet in decline, with pent-up demand for vehicles and consumer-oriented services such as travel and tourism helping to sustain growth in July, the PMI is now at a level consistent with just 0.2% GDP growth. Forward-looking indicators suggest worse is to come.
“Manufacturing order books are now deteriorating for the first time in one and a half years as inflows of new work are insufficient to keep workforces busy, which is usually a precursor to output and jobs being cut in coming months. Raw material buying has already slumped and hiring has slowed as companies reassess their requirements for the coming months in the face of worsening demand conditions.” It is worth noting that this is before higher interest rates have started to have an effect.
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Consumer confidence has fallen off a cliff
The strength of the UK jobs market has been an important ballast, helping support households and consumer spending. However, this has a sting in its tail. The Bank of England has warned that the labour market remains tight, which will push wages higher. Companies aim to pass those costs onto their customers, pushing inflation still higher.
Anthony Willis, investment manager on the Columbia Threadneedle multi-manager people team, points out that the UK is currently experiencing the lowest consumer confidence numbers on record with data going back to the 1970s. “The consumer outlook has fallen off a cliff quite quickly,” he adds.
The economy may also have to contend with a withdrawal of liquidity through quantitative tightening.
Azad Zangana, senior European economist and strategist at Schroders, says: “The BoE also announced that the MPC would take a vote at the September meeting to decide whether or not to start actively selling its holdings of gilts, in order to shrink the size its balance sheet faster. This is known as quantitative tightening (QT), or the reverse of the quantitative easing seen over the past decade.”
This will reduce the amount of liquidity and should, in theory, curb inflation pressures, but it means a valuable support for UK assets will be withdrawn.
This is set against the backdrop of a zombie government and a distracting Tory leadership campaign. In spite of a small bounce for sterling in the wake of Boris Johnson’s resignation, the uncertain political situation is likely to exert downward pressure on sterling. The UK currency tends to be more cyclical, and benefits from stronger global growth as investors move out of safe havens such as the dollar.
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Reasons to be marginally less pessimistic?
This is a grim backdrop for investors in UK assets. Are there any reasons for, if not optimism, then marginally less pessimism?
Zangana says that the recession is likely to be relatively shallow: “Despite the obvious concerns over inflation in the near term, the Bank’s forecast out to 2025 gave a far more dovish story. The recession included in the forecast lasts for seven quarters, with output falling 2.2% from peak to trough.”
The Bank of England suggests that inflation should be back to normal within two years.
The most recent PMI data from S&P said that there had been some moderation in rising input costs for companies. It said: “Input cost inflation eased considerably since June and was the lowest for ten months. Survey respondents often commented on lower commodity prices and a stabilisation in fuel costs.” Commodity prices have stabilised somewhat as governments have sought to tackle their dependency on Russian fossil fuels.
Equally, there is little optimism built into the price of UK assets. The UK market had been relatively strong, but this changed at the end of June.
Willis says this weakness is really a function of commodity prices: “That took out some of the large-cap commodity names lower.” The UK stock market still looks lowly valued relative to its peers, with the FTSE All Share on a dividend yield of 3.4% and a P/E of 15x. Only European large cap can boast a similar dividend yield.
From a relative investment point of view, it’s not just the UK experiencing problems – even if its position is notably weaker than other equivalent countries. The most recent IMF Economic Outlook report points out that global inflation is anticipated to reach 6.6% in advanced economies and 9.5% in emerging market and developing economies this year. In 2023, disinflationary monetary policy is expected to bite, with global output growing by just 2.9%.
However, these are slim pickings amid a gloomy picture. It is difficult to disagree with Luke Bartholomew, senior economist, Abrdn, who said: “It is hard to see how the combination of falling real incomes, very poor business and consumer sentiment, supply disruptions, tighter and high energy prices won’t eventually see the UK falling into recession. What’s more, it may be the case that a recession is necessary to rid the UK of its underlying inflation pressure…investors and markets need to prepare for a long series of negative pieces of economic news.”