United Kingdom: Back Off The Bottom

17 Oct 2023

Since the pandemic, or probably even since Brexit, there has been a big question mark over the UK. What exactly went wrong?

We’re on our fourth Prime Minister in as many years, the previous one having managed to trash the attractiveness of UK assets to the extent that the BoE had to step in to save the country’s pension funds (on the bright side, the word Kamikwasi was fun for a while). Inflation peaked higher than in similar markets and stayed higher. Our geopolitical heft has taken a battering – leaving the EU, shunning the UN where we are one of five permanent members (with only 0.8% of the world’s population), and cutting our 0.7% of gross national income aid target were bound to hit influence. Productivity growth never recovered following the great financial crisis and society is less equal than it was at any time in the 1970s-1990s per the Gini coefficient.

But Things Are Looking Up?

Let’s be clear at this point, the UK is not in great economic straits. However, things are a bit better, and it’s a good time to engage in some whataboutery. In part just to make us feel better, but also recognising that markets and the economy work for a large part in relative terms: a less shoddy isle is a more attractive one, even if just marginally.

“But now I’m happy to see that #bringbackboring is making some progress.”

First, the politics. 

Now I say this tentatively. It finally appears there are adults back in the room (the room being a shiny, important one in Whitehall). While dysfunctional, UK politics has been pretty exciting in recent years. A hard-left, anti-establishment republican vs a shaggy-haired populist with an unknown number of children probably would make a great film (I’m picturing Will Ferrell), but is hard to argue it has not been a proper Eton mess, especially given the latter was left in charge of our pandemic response. But now I’m happy to see that #bringbackboring is making some progress.

It’s probably easier to start with Labour, and maybe makes sense given the 15-20pp lead they have enjoyed in polls over the last year or so would be hard to lose before elections expected in the second half of 2024 – I expect a Labour-led coalition, probably with the Lib Dems (who do really well in coalitions). Labour leader Keir Starmer seems pretty boring, which is great. It’s hard to judge right now given Labour seem terrified of releasing detailed policies before everything is fully budgeted (which is good for limiting eventual areas of attack from the Tories, bad for capitalising on polls), but it appears that Labour are set to bring in serious government. For example, Starmer’s proposed deal with the EU targeting illegal channel crossing looks set to take the debate above the political fray – the proposition being the UK taking more asylum seekers via proper channels and being able to return those who cross illegally.

Election Is Labour’s To Lose

UK – Parliamentary Election Polling, % of voters

Source: Various National Pollsters, JB Macro

Now the question remains as to whether the Conservatives under Sunak have also grown up, to which the answer is mostly. Johnson was the party in its most infantile phase, with Truss perhaps the teenage iteration (lots of ideas no real world experience). Sunak maybe is the just-turned-21 version – mature 95% of the time to the point you might call them a statesman (stretching the metaphor – stick with me) but then a random outburst reminds you they still aren’t a fully-fledged grown up yet. For example, Sunak abandoned the Truss France = Friend or Foe? stance with some smooth talking with Macron back in March which brought a reset in relations but then obsessions with small boats, sending refugees to Rwanda, and dubbing Starmer “Sir Softy” show a childish streak. The troubling thing is that a 21 year old can bring a less mature streak out of the adults in the room – i.e. the next election will see some low blows from both Sunak and Starmer, even if the latter doesn’t look as comfortable doing them.

“Sunak abandoned the Truss France = Friend or Foe?”

Also to watch in the run up to the election is some likely unpredictable policy pivots from the Tories (like that Net Zero U-turn and the reversal on HS2) which should do wonders for the business environment (car makers are struggling to make head or tail of continued targets for them on electric vehicle (EV) sales while EV demand will be hit by the delay on the ban of sales of petrol and diesel (also known as ICE) cars being pushed from 2030 to 2035).

And now, the economy.

The post-pandemic period saw the UK labelled as the “Sick-Man of Europe” as output failed to regain 2019 levels for way too long. BUT, an unexpected output from the ONS revised away the narrative, showing that by the end of 2021, the economy was actually 0.6% bigger than in Q4 2019 vs the previously understood 1.2% smaller. As of Q2 2023, the economy is 1.6% bigger than before the pandemic, which is definitely a win and alleviates some of the soul searching.

Now the whataboutery. The UK is looking a bit better, but what about Germany? As of Q2 2023, output is only 0.2% above Q4 2019. The German economy is facing fundamental challenges, having spent years supressing domestic demand and focussing on exports the entire economic model is in question and China is swiftly moving up the value chain (Chinese auto exports are growing at a ridiculous pace for example). Introducing your new sick man of Europe…

Economy Rebooted (Technically)

Select Europe – Real GDP, Q419 = 100

Source: ONS, Eurostat, JB Macro

So after that bout of optimism, let me bring things back down to Earth.

Fundamentally, the economic outlook still looks pretty bad. Think more blip than crisis (we’re not doing 2008 again) but bad enough for firms to go out of business, profit margins to feel the squeeze, and households to struggle. UK growth looks set to slow significantly from the 4.3% recorded in 2022, with Bloomberg Consensus predicting 0.4% for 2023 then 0.5% for 2024. Recession is likely on the cards sometime in 2024, with the Bloomberg panel of economists putting the probability at 60.0%. The yield curve is still heavily inverted (rates on short-term debt are higher than on long-term), which is a pretty sure sign of upcoming contractions in output if historical records are anything to go by.

The UK is not alone here, all major developed markets are expected to go into slowdown in 2023 and 2024. Consensus has Germany reversing from growth of 1.8% in 2022 to a 0.3% contraction in 2023 and then a poor rebound at 0.6% growth in 2024, France slowing from 2.5% growth in 2022 to 0.8% then 0.9% and the US from 2.1% in 2022 to 2.0% then 0.9%. While not being in this alone might make us feel a bit better, it’s for the worst given it implies we can’t look to exports to support a rebound.

Yield Curve Signalling A Recession Is Likely To Come

UK – 10yr – 2yr Gilt spread Vs Recession Indicator

Note: The shaded area indicates recession.
Source: Bloomberg, FRED, JB Macro

The prevailing narrative here is that things are not quite as terrible as they looked but are still not good, and that’s the theme which economic data seems to stick to.

First up is inflation. September 20th delivered a downside surprise as price rises declined from 6.8% y-o-y in August to 6.7%, coming in well below Bloomberg Consensus expectations of a rebound to 7.0%. This clearly surprised markets which quickly repriced for a less hawkish BoE. September 21st  then delivered on that, as the BoE gave us an unanticipated hold at 5.25% with the split on the policy committee of 5 vs 4 much more divided than usual (a nail biter if macroeconomics can give us one of those).

GBPUSD repriced down on the new yield outlook, trading around 1.22, well off the dizzying heights (sarcasm) of 1.31 hit back in July. Over the period, we’ve seen markets reprice terminal Bank Rate from touching on 6.5% to 5.4% (over the next 6 months) at the time of writing. Astute readers will notice that 5.4% isn’t the same as the 5.25% we have now – upcoming policy meetings and any rate relevant news in the meantime (think wage and CPI figures especially) should see yield expectations move, and bring the GBP with it. GBPEUR also traded down fairly notably over the period on the UK yield narrative for any who care to point to a storming USD off the back of the prevailing higher for long message from the US Fed (which triggered a broad risk asset sell-off).

Yields Topple Sterling

GBPUSD Vs UK 2 Yr Gilt Yield, %

Source: Bloomberg, JB Macro

Let’s not get tempted to think a weaker pound is bad news here – it definitely isn’t. Markets are pricing lower inflation, lower rates, and a generally easier time. The yield curve inversion even pared back a fair bit on the developments. A weaker pound (plus higher oil prices) might even give the FTSE 100 a boost given the high exposure to external markets – profits will be repatriated at more advantageous rates.

“The vast majority of consumers are yet to be hit by the higher rate backdrop with only around 27% of households mortgaged, while 37% own outright.”

Now that can easily bring us round to one of the more rate sensitive parts of the economy – housing. So on the positives, lower rates mean credit costs will stop rising. However, we probably shouldn’t get ahead of ourselves here. The vast majority of consumers are yet to be hit by the higher rate backdrop with only around 27% of households mortgaged, while 37% own outright. Only 14% of households are on variable rates, with 25% on fixed with two years or less to maturity – the data is from Q322 so slightly aged so maybe notch those up slightly in your head but the point still stands.

What this means is that those select households who are on variable rates or are buying a new property will enjoy the effects of a just over 100bps discount from the worst case markets put before us (Bank Rate at 6.50%) to that which we have at present (5.25% or maybe 5.50%). However, that bigger chunk of borrowers that are rolling off fixed contracts will still have a big shock to disposable incomes, people will put off buying houses for a couple of years until rates are lower, and those who are still looking to buy will be more likely to put in a cheeky offer. Even with the new rate narrative, that still doesn’t sound great for house prices, which are already down 5.3% off their peaks late last year (per Nationwide and Lloyds). That’s also not great news for the Tories (whose base loves high house prices) but maybe welcome for (reader to insert joke about London house prices).

House Prices Falling

UK – Average House Price, GBP

Source: Nationwide, JB Macro

Now we’ve done houses, what about the people who live in them. Decent wage gains, falling inflation, rising confidence, a late 2024 election (think handouts), it doesn’t sound so bad for households. Just make sure you’re not on a variable rate mortgage for the next 18 months, not renting, and not part of the labour market which is getting hit as unemployment rises (think construction or those bar/restaurant jobs we had shortages of last year). Basically just don’t be young. The added impact of this will be a downside to demand (lower spending from households implies lower activity for firms), which will be felt by businesses more broadly, so maybe you won’t get off so scot-free.

Real Wages Back In The Green

UK – Pay Growth, SA, 3 Month Ave, Vs CPI Inflation, % chg y-o-y

Source: ONS, JB Macro

On unemployment, we should probably be a little concerned about the labour market. Especially given the outlook for credit. Don’t forget, rate hikes work with long and variable lags (often 6 to 18 months). The banking sector’s total loan book is already in contractionary territory compared to December last year, probably as businesses are paring back costs/not expanding capacity against the high rate/uncertain demand backdrop. Corporates refinanced at low rates during the pandemic as they hunkered down as things looked terrible and those loans are starting to need rolling over. So we’re seeing this already for bank debt, and maturity profiles indicate that this will start to pick up for listed debt (bonds) next year, although 2025 is the doom year for bond rollovers.

What that means is that firms will postpone investments and some will straight up go out of business as credit costs get too high. Besides implying fewer employment opportunities, it also implies some headwinds for the banking sector (think rising non-performing loans, ie those with repayment issues).

Labour Market Is Turning

UK – Unemployment & Employment Rates, %

Source: ONS, JB Macro

All of the above roll into what are some pretty terrible purchasing manager’s index (PMI) figures which are a strong indicator of economic activity and have generally been deteriorating each month. September saw the composite PMI drop from 48.6 in August to 46.8 (below 50.0 is consistent with a contraction in activity). The services PMI fell from 49.5 to 47.2, which really ruins the services will drive growth narrative we might have had.

A further key downside risk to the outlook here derives from escalations between Israel and Gaza beginning on Saturday 7 October Downside risks to the GBP are elevated – oil traded sharply upward at the next market open on Monday 9 October as risks related to especially Iranian but also Saudi supply were priced. A sustained higher price for crude would increase upside to inflation, and poses risks of a stronger USD vs the GBP both due to the US’ energy independence and safe haven status for the greenback. It is worth noting that these risks are only slight at the moment, and it appears unlikely that the situation could lead to a meaningful enough rebubbling of inflation to trigger further rate hikes.


James Bennett

Guest Economist

Views expressed in this article are by James Bennett, JB Macro, guest Macroeconomist.

Related Articles