February 20, 2023 -Equiti's outlook for the first half of the year for the UK and EU
The highest tax burden for over a generation and an unprecedented level of monetary tightening will combine with the large drop seen in real incomes to curtail consumption and drive the UK into a prolonged recession.
- The outlook for the UK remains downbeat as the economy struggles with the highest level of taxation since the second world war, a rapid increase in monetary tightening and trend growth and productivity levels that continue to lag its peers. Accordingly, a recession for 2023 is expected, with negative growth expected in H1 and possibly extending to end-year.
- The November fiscal statement reversed the tax easing measures announced by the previous Truss administration, with the original plans to hike corporation tax and freeze tax threshold rates from this April reinstated. In addition, support for energy prices will also be reduced in Q2, by £500 per year. After the next general election – required no later than January 2025 – a further fiscal tightening of approximately £55bn will be imposed on the economy, via a combination of additional tax rises and spending cuts.
- Accompanying this fiscal squeeze will be a further tightening in monetary policy as the BoE continues its fight to bring CPI back to target. Bank rate is forecast to rise to approximately 4.35% by June 2023 and to remain there for the remainder of the year, with no meaningful prospect of any cuts being seen until 2024. Rising from 0.25% in February 2022, the pace of tightening seen has been unprecedented and has added to the rising tax burden being borne by households and businesses via higher mortgage repayments and loan interest costs.
- Average household mortgage repayments as a proportion of income are forecast to rise from approximately 20% to 30% in 2023, with new mortgage rates for those needing to re-finance this year expected to be some 300bps higher than previously; business loan interest payments are seen nearly doubling from approximately £17bn to £31bn, leading firms to cut back on both capital expenditure and employment costs as they look to protect profit margins.
- Any weakening in the labour market will be welcomed by the BoE and will be a necessary condition before interest rates can be materially lowered. However, how much of an impact a worsening labour market will actually have on the level of unemployment is uncertain, given the contraction that has been seen in the overall size of the UK workforce. Inactivity due to long-term sickness has risen steadily since end-2019, a likely consequence of covid, while there has been a rise in the numbers of workers choosing to leave the labour market altogether. This reduction in the size of the workforce has been a key factor behind the strong growth in wages that is being seen (albeit in nominal terms only). Wages growth rose to 6.7% per year in December, some 4% above the level seen as consistent with a 2% inflation target. Until wages growth moderates the BoE will be unable to loosen policy.
- Inflationary pressures appear to be finally easing, albeit after the UK suffered the highest level of price increases seen in the developed world. A combination of easing supply chain pressures, excess inventory levels and falling energy prices are all expected to facilitate CPI falling back rapidly this year. From a peak of 11.1% in November, market consensus sees CPI easing back to around the 4.5% level by the end of this year.
- However, despite this fall in inflation, the outlook for real disposable incomes remains negative, as rising taxes and an expected slowdown in wages growth more than offset a lower rate of CPI. This will inevitably continue to suppress consumer spending and act as a significant drag on growth.
- So far there are no signs that consumers are prepared to maintain levels of consumption via recourse to savings stocks. November’s money and credit data showed households continuing to save more than the average levels seen in 2018-19, suggesting they remain cautious in their approach to managing finances. This reduction in spending will have a material drag on economic activity.
- The BoE looks set to raise interest rates further at its February meeting, the market currently pricing in a rise of approximately 37bps. Consensus currently sees rates peaking at around 4.50% by August before starting to fall again end-2023. However, question marks remain over how far monetary policy can be tightened in the face of the rapidly deteriorating growth outlook.
- The BoE will continue its hawkish rhetoric, driven in part by the need to provide support to sterling. But with two-year gilt yields (at the time of writing) around 3.66% - lower than base rate – the implication is that there is a degree of market scepticism regarding whether the BoE will be able to deliver on this hawkish message. Splits on the MPC already suggest some nervousness regarding the growth outlook, and despite survey data showing headline inflation to be at 7.4% in 12-mths time - 4% on a three-year horizon – concerns that the BoE will ultimately pivot policy in favour of supporting growth refuse to go away. Doubts over the strength of the BoE’s hawkish conviction will provide a significant headwind to sterling.
A slowdown in growth expected over H1, but thereafter signs of recovery should be seen. But the ECB will remain in tightening mode with no easing in monetary policy expected until 2024.
- The outlook for the euro-zone is positioned between that of the US and the UK. After narrowly avoiding an economic contraction in Q4 2022, a period of negative growth is expected in Q1 2023 before activity starts rising again from late H1 onwards, albeit moderately. One of the key drivers of this growth slowdown is Germany, where the negative impact of higher energy prices has been particularly acute and saw growth fall by -0.2% in Q4, an outturn that had been largely predicted by survey data. The outlook for German retail sales, industrial production and consumer confidence remains downbeat and this will act as a significant drag on aggregate euro-zone activity.
- As elsewhere, peak inflation appears to have now passed and the outlook looks to be finally improving, the headline rate of CPI now having fallen steadily since October. January’s CPI prints from Germany and France are continuing to show inflationary pressures easing, although a key factor behind these numbers have been energy price cap measures, where the experience of the UK shows this support can be removed as quickly as it is given. And with other prices such as food continuing to rise strongly, the ECB will maintain its hawkish stance. The rapid pace of tightening is expected to continue in Q1, with a further 50bps hike expected in March, but thereafter the pace of increase is seen dropping to 25bps increments.
- The December ECB forecasts saw CPI averaging 6.3% over 2023, remaining elevated over H1 but starting to fall steadily over H2 to decline to 3.4% in 2024. Although the ECB has iterated that rates must continue to be increased at a steady pace to bring CPI back to target, such a scenario does allow for a dovish tilt in H2 and the potential for interest rates to start being cut again late 2023/early 2024. The market currently sees rates rising to 3.55% by July with only a small chance of a cut being delivered this year. Early 2024 looks the most likely outcome.
- As with the US and the UK, the euro-zone labour market remains in a strong position, the rate of unemployment remaining at a record low of 6.6% in December. This will embolden the ECB to take the aggressive monetary action it sees as needed over H1 to damp down demand and bring inflation back to target. While some pick up in the level of joblessness can be expected as growth slows this year, the outlook is for the labour market to remain resilient compared to previous episodes of economic uncertainty.
- At the same time, the deteriorating geo-political situation in Europe has ushered in a new era of fiscal largesse, with broad political and public support for elevated spending and investment across the EU. This fiscal boost will provide support for employment levels and consumption but will make the ECB’s task that much more difficult and points to the need for monetary policy to remain tighter for longer. This fiscal boost is seen as a key factor behind the relatively short-lived downturn in growth expected.