investment insights
Spring is in the air for the UK economy
Key takeaways
- Falling inflation, recovering manufacturing and business activity, and the prospect of rate cuts ahead have brightened the UK outlook; we expect a limited growth recovery in 2024
- We forecast a cumulative 100 basis points of interest rate cuts in 2024, starting in June, with a weakening labour market expected to bring down wage growth and high services inflation
- The Labour Party looks set to win national elections that will likely be held in autumn. We do not see it launching radical tax or spending plans that would alarm markets
- We maintain our overweight exposure to gilts and remain neutral on UK stocks. We expect sterling to depreciate as the Bank of England kicks off its easing cycle.
An improving economic outlook in the UK could be boosted by interest rate cuts from June. A likely change of government in the autumn should not derail market confidence. We remain positive on gilts and see further falls ahead for sterling.
The UK economy has endured a series of shocks in the past decade. Most recently, the energy shock that followed Russia’s invasion of Ukraine took a heavy toll, pushing inflation to double digits and growth below zero. The outlook has finally started to brighten in recent months, with the arrival of more encouraging economic and financial market news. The FTSE 100 hit a series of record highs in April. Surveys of UK purchasing managers in March showed manufacturing expanding for the first time since July 2022, while measures of overall business activity were stronger than in other developed economies, including the US, Japan and the eurozone.
Meanwhile, the consistently wide polling lead of the opposition Labour Party suggests a change of government is likely at national elections which we expect will be held in the autumn. The large number of seat losses for the Conservative Party in last week’s local elections and the defeat in some key mayoral races were a visible reminder of this. While the exact contours of Labour policies are still unclear on several fronts, we would not expect them to result in market turbulence. Unlike its most recent predecessors, the current Labour Party leadership has an emphasis on prudent economic management and retaining existing fiscal rules.
Real incomes rising again
The UK economy barely grew in 2023 under the pressure of monetary policy tightening and very high inflation, which only fell below 4% in October. Notable progress on disinflation in recent months is a key driver of improved sentiment. Consumer confidence appears to be slowly recovering and real incomes expanding again, easing the ‘cost of living crisis’ slightly. Yet even though the peak drag from higher interest rates is past, tight financing conditions are still curbing a sharp demand recovery. Over half of the UK mortgage stock is on fixed deals of over two years’ duration, which are steadily resetting onto higher rates.
Upcoming Bank of England (BoE) rate cuts should help change this dynamic as inflation falls. The maximum amount energy suppliers can charge per unit of energy will be cut this month, which could finally bring April’s consumer price index (CPI) reading below the 2% inflation target, paving the way to monetary policy easing ahead. Meanwhile, the fiscal easing announced in the Spring Budget should also be a positive contribution to growth in the near term, even if relatively limited in scale (we expect a near-term growth boost of approximately 0.2% of GDP). We expect rising real incomes, falling interest rates, and improving confidence to help push UK growth close to 1% in 2024 – not a particularly impressive outcome, but certainly an improvement over the meagre 0.1% growth rate of last year.
Bank of England preparing for rate cuts
The BoE was until recently viewed as one of the more hawkish developed market central banks. Two members of its nine-strong Monetary Policy Committee were still voting for rate hikes in February. Yet the voting split was more balanced in March, with eight votes to hold rates, and one to cut them. We expect the vote-cutting contingent to broaden this week and, given signs that inflation is now falling sustainably, policy easing may begin as soon as June. We forecast a total of 100 basis points (bps) of rate cuts this year and the easing cycle continuing until end-2025.
Labour market tightness has been a prominent concern for UK policymakers, as the risk of a wage-price spiral would pose significant challenges to their fight against inflation. Developments on this front have been broadly constructive. While wage growth still looks too high for comfort, it has fallen from a peak of 8% to around 6% now and forward-looking indicators suggest further drops are likely. Along with the number of unfilled vacancies having come down significantly from the peak and the unemployment rate drifting up since late 2022, the UK labour market looks far from overheating territory. This is a good indicator that even the stickier components of services inflation are likely to normalise going forward.
What would Labour change?
What would we expect to change under a Labour government? The Party is at pains to demonstrate its commitment to fiscal discipline and a stable policy environment, recently reinforced by the halving of a flagship GBP 28 bn green investment pledge on affordability grounds. We would expect some increased spending on public services, notably health, in line with campaign promises and public opinion trends.
The challenge for an incoming Labour government would be finding the revenues to finance this agenda. While improving growth and falling interest rates can help at the margin, some tax increases look inevitable. Given a commitment to steer clear from a wealth tax or income tax hikes, the focus will likely be on less prominent measures like carried interest and VAT on private schools. An open question is whether the revenues these might bring would suffice. Given recent Labour messaging, we think limiting the ambitions of its spending agenda is more likely than large tax increases.
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Risks to the UK outlook include higher than expected inflation derailing the prospect for rate cuts, or greater spending promises translating into post-election tax rises, endangering growth prospects, and possibly bringing some volatility into UK government bond (gilt) markets. Yet, in our base case, the macroeconomic outlook for the UK economy looks more promising after a tough 2023. How are these expected developments reflected in our market views and portfolio positioning?
Favouring gilts
We are overweight gilts within our broader preference for developed market sovereign bonds, and favour those with five-to-seven-year maturities. In an environment of disinflation and impending rate cuts, we believe now is the time to lock in high UK government bond yields; we see five-year gilts yielding around 3.60% by year end. Pre-electoral promises of greater public spending could trigger some volatility in gilts. In a scenario of post-electoral tax rises, a more subdued growth path could weigh on gilt yields.
Meanwhile, the FTSE 100’s recent rise echoes records hit by stock indices in the US, Japan, and parts of Europe earlier this year. It has been helped by gains in energy firms amid higher oil prices, defence stocks in a tense geopolitical environment, and sterling weakness. We have a long-standing tactical overweight to global energy stocks. Our current preference for cyclical sectors, and the more defensive nature of the UK market compared to the US, prevent us from raising our UK equity exposure at this point.
So far this year, sterling has lost ground versus the US dollar, while gaining against the euro on rising global risk appetite and market expectations for more restrictive BoE monetary policy. Historically, BoE policy rates have mattered more than global risk appetite for sterling. Interest rate differentials suggest that EURGBP could reach 0.87 in three months, while our forecast is for GBPUSD to fall closer to 1.20. We note that risks surrounding the eventual UK general elections, notably higher public spending and/or plans to raise taxes, create further downside risks to the currency.
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