The government has announced a £15billion budget to help households, which should reduce risks to the UK economy.
- The Bank of England is warning of a possible recession in the UK with peak inflation imminent. Its policy rate could exceed 2% by the end of 2022
- Prime Minister Boris Johnson’s future is in jeopardy after narrowly winning a no-confidence vote
- Political turmoil is not clouding the prospects for UK equities, which we are overweight. We maintain a neutral stance on equities, favoring value stocks and quality stocks in sectors and regions where companies can pass on rising costs or weather weaker growth.
To mark the 70th anniversary of Queen Elizabeth II’s reign, the government has announced stimulus measures aimed at protecting the economy and preventing the downturn from turning into a recession. These new tax breaks would allow the Bank of England to raise interest rates further to combat the highest inflation in four decades. For his part, Prime Minister Boris Johnson, who has just won a motion of no confidence, continues to fight for control of his party and its political survival.
Similar to its European neighbors, the UK economy is experiencing a supply shock caused by rising energy prices, which is reflected in a drop in consumer spending power and a “cost of living crisis”. Price increases undermine economic growth. UK gross domestic product (GDP) is growing at a slower pace than before the pandemic and the outlook is deteriorating.
The Bank of England (BoE) warns of a possible recession in the second half of 2022. We believe that GDP growth should not exceed 3.5% in 2022. That average belies the fact that full-year growth is almost entirely due to the exceptional 7% recovery in 2021 and the economic recovery that continued into the first quarter of 2022. Growth will stagnate in the second half of 2022, and we expect expansion to be less than 1.5% in 2023.
The UK government had planned to wait for the end of the Covid to start fiscal tightening. During the pandemic, the country’s budget deficit has risen to a peacetime record of £318bn in 2020/21, equivalent to 14.8% of GDP or £4,800 per UK resident. National debt as a percentage of GDP is over 94%, the highest level since 1962/63.
Cost of living, cost of survival
The UK saw consumer prices rise 9% yoy in April, the highest inflation rate in four decades. However, inflation has not yet peaked as UK households are yet to feel the full impact of rising gas prices. In fact, the national energy regulator only updates its price cap twice a year and forecasts a further 42% increase in October 2022. This would double the average energy bill compared to 2021 to bring it to £2,800 per household. This is bad news for consumers. UK inflation should therefore peak above 10% (see chart 1), well later than in the US and the eurozone.
The BoE became the first western central bank to raise interest rates in response to inflation. After four hikes since December 2021, we expect two more hikes of 25 basis points in June and August. Like Europe and the United States, the UK is experiencing a tight labor market, which could further push wages higher. The seasonally adjusted unemployment rate was 3.7% in March, a record low since 1973. Unless wages continue to rise, rising interest rates and falling incomes will threaten economic growth and eventually dampen inflation (see chart 2).
In view of the high inflation and its consequences for the economy and the population, the government reconsidered its goal of reducing public spending. On May 26, Chancellor Rishi Sunak announced a £15 billion scheme to help households weather price hikes. Two-thirds of this aid goes to the most vulnerable populations.
A third of the tax package will be funded by a 25% “deadweight tax” on recent profits from the oil and gas sector – a measure adopted by the opposition Labor Party. This tax, which is on top of the current 40% corporate tax rate, will be phased out when energy prices start falling again, but no later than the end of 2025. The other two-thirds of the program will be funded by new loans.
This deterioration in growth prospects, coupled with rising inflation, poses a challenge for the BoE’s monetary policy. To stem rising prices, we believe the central bank is willing to take the risk of pushing the economy into recession with further rate hikes. The government’s fiscal support for the economy will at least allow policymakers to raise interest rates further beyond the 1.5% originally forecast, making a policy rate above 2% possible before the end of the year.
Uncertainties over trade deals with the European Union are complicating the UK’s economic outlook relative to the rest of the world. The risk of a trade dispute remains as the EU and UK disagree over the application of controls to goods entering and leaving Northern Ireland. While the Brexit process has been plagued by the threat of a damaging trade war for several years, financial markets have largely priced this risk into asset prices.
The British Prime Minister, who officially took the country out of the EU on January 31, 2020, is in the hot seat. During her 70-year reign, Queen Elizabeth worked with fourteen Prime Ministers. Her Majesty may have to deal with a fifteenth Prime Minister before the UK economy recovers to pre-pandemic growth levels.
On June 6, Mr Johnson faced a vote of no confidence. He won, but with less than expected support from Tory MPs. A total of 41 per cent of his party members said they had lost confidence in the Prime Minister, a higher percentage than in the December 2018 vote against Theresa May but similar to the vote of no confidence in Margaret Thatcher in 1990. Both ended in the resignation. Mr Johnson has vowed to remain in office. On May 25, a government official’s report initially appeared to put an end to months of debate and police investigations into Partygate. Mr Johnson’s behavior during the Covid lockdowns has come under special scrutiny, with police fines the Prime Minister, his wife and Mr Sunak for attending a party in June 2020. The government must call general elections no later than January 24, 2025, with May 2024 mentioned as a possible date.
What about the British pound? The pound has halved against the US dollar since the Queen’s accession to the throne in 1952. As Her Majesty celebrates her platinum anniversary, sterling is trading around 1.25 against the dollar from its 2022 low of 1.216 currency and by the stabilization of the pound following the fiscal package announced by the UK government.
However, we believe that these latest stimulus measures do not change the fundamentals affecting the British currency. In fact, the balance of payments and interest rate differentials are the main drivers of the current forex market. The UK’s external deficit continues to worsen, further weighing on the currency. Even the BoE’s rate hike may not support the pound as the country’s slowing growth is complicated by ongoing uncertainties over its trade relationship with the EU. We maintain our view that the pound is weakening against the dollar and expect the GBP/USD exchange rate to end 2022 at 1.22.
The UK 10-year gilt yield is now at 2.15%, slightly above our 2% 12-month forecast. In the near term, investors question the ability of central banks to contain inflationary pressures, which will keep bond yields under pressure. Additionally, investors have been cautious since the BoE’s first rate hike in December 2021, which surprised markets. We remain cautious on nominal and inflation-linked bonds given high valuations and inflation-linked bond real yields of almost -2%.
The distinction between political turmoil and investment prospects is important. We believe the new tax package will reduce risks to the UK economy. Continued sterling weakness should support our preference for UK equities. The UK stock market benefits from a balance of value and defensive characteristics, more specifically a mix of energy, mining, materials and healthcare stocks. We also favor FTSE 100 index exporters over the more domestically focused FTSE 250 companies. Although relative valuations have fallen, we believe that in the current economic cycle it is worth focusing on large export-oriented companies.
We maintain a neutral stance on equities, favoring value style and quality stocks in sectors and regions, including the UK, where companies can more easily pass on rising costs to their customers or weather periods of slow growth. In this complex market environment, we continue to use option strategies on major equity indices to manage risk within portfolios.
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