investment insights

    The UK steps up spending to sidestep a slowdown

    The UK steps up spending to sidestep a slowdown
    Stéphane Monier - Chief Investment Officer<br/> Lombard Odier Private Bank

    Stéphane Monier

    Chief Investment Officer
    Lombard Odier Private Bank

    Key takeaways

    • The Bank of England warns of a possible UK recession, with peak inflation ahead. The BoE’s policy rate may reach more than 2% before the end of 2022
    • The government has announced a GBP 15 billion package to support households, which should reduce the risks to the UK economy
    • Prime Minister Johnson’s political future is at risk after only narrowly winning a confidence vote
    • Political turbulence does not cloud the prospects for UK equities. We keep a neutral equity position, preferring value and quality stocks in sectors and regions where firms can more easily pass on higher costs, or survive lower growth – including an overweight in UK names.

    As the UK marks Queen Elizabeth II’s 70th year on the throne, the country’s government has announced fiscal spending designed to insulate its economy from turning a slowdown into a recession. The package may let the Bank of England keep hiking interest rates to fight the highest inflation in four decades. In the meantime, Prime Minister Boris Johnson, having just won a confidence vote, is still fighting for control of his party and political survival.

    In line with its European neighbours, the UK economy is experiencing a supply shock driven by higher energy prices that is translating into a drop in consumers’ purchasing power and a ‘cost-of-living crisis.’ Price rises are undermining economic growth, leaving the UK’s gross domestic product (GDP) expanding less than before the pandemic, and the outlook is worsening.

    The Bank of England (BoE) is warning of a possible recession in the second half of 2022. We expect the country to record GDP growth of no more than 3.5% over 2022. That average disguises that full-year growth is almost entirely thanks to 2021’s exceptional 7% recovery, and the economic rebound carrying over into the first three months of 2022. Growth in the second half of 2022 will stagnate, and we see the economy picking up to expand less than 1.5% in 2023.

    The British government had planned to begin fiscal tightening after Covid. The country’s budget deficit rose during the pandemic to a peacetime record of GBP 318 billion in 2020/21, equivalent to 14.8% of GDP, or GBP 4,800 per UK resident. Public debt as a share of GDP is at more than 94%, its highest level since 1962/1963.


    Cost of living, price of survival

    The UK recorded a 9% rise in consumer prices in April, compared with a year earlier, the highest rate of inflation in four decades. But inflation has not yet peaked as the full effects of higher gas prices have not yet fallen on UK households. The national energy regulator updates its price ceiling only twice a year, and forecasts another 42% rise in October 2022. That would double average energy bills to GBP 2,800 per household compared with 2021. That is bad news for consumers and means the UK’s inflation rate will peak above 10% (see chart 1), and much later than in the US and eurozone.

    The BoE has been the fastest Western central bank in raising interest rates

    In response to inflation, the BoE has been the fastest Western central bank in raising interest rates. After four hikes since December 2021, we expect another two of 25 basis points each in June and August. In common with the rest of Europe and the US, the UK is experiencing a tight job market, which may pressure wages to rise further. The seasonally-adjusted unemployment rate was 3.7% in March, a record low since 1973. Unless wages continue to accelerate, higher interest rates and falling real incomes will undermine economic growth, and so eventually slow inflation (see chart 2).

    What goes up

    Faced with high inflation and its impacts on the economy and the public, the government has reversed its goal of cutting spending. On 26 May, Chancellor Rishi Sunak announced a GBP 15 billion package designed to help households weather price rises. Two-thirds of the support is means tested to target the most vulnerable parts of the population.

    To pay for one-third of the fiscal package, the Chancellor simultaneously imposed a ‘windfall tax’ of 25% on the oil and gas sector’s recent profits – a policy adopted from the opposition Labour Party. The tax, which is in addition to the current 40% corporate rate, is scheduled to expire once energy prices fall again, or by the end of 2025 at the latest. The other two-thirds of the package will be financed with new debt.

    The worsening outlook for growth and rising inflation creates a challenge for the BoE’s monetary policy. In an effort to contain price increases, we expect the BoE to continue choosing to run the risk of tipping the economy into a recession with further interest rate hikes. The government’s fiscal support to the economy will at least allow monetary policymakers to continue hiking interest rates beyond the 1.5% that we initially expected, making a policy rate of more than 2% a possibility before the end of the year.

    …a policy rate of more than 2% is a possibility before the end of the year

    A complication for the UK’s economic outlook, compared with the rest of the world, is the uncertainties around trading arrangements with the European Union. The potential for a trade dispute continues as the EU and UK wrangle over the application of controls on goods moving in and out of Northern Ireland. While the threat of a damaging trade war has consistently hung over the Brexit process for many years, markets have largely priced this risk into assets.


    20 / 20 confidence

    The survival of the UK prime minister, who formally took the country out of the EU on 31 January 2020, is now in doubt. In her seven decades on the throne, Queen Elizabeth has worked with 14 prime ministers. Given the questions around Mr Johnson’s leadership, it is possible that before the UK economy recovers to its pre-pandemic growth levels, Her Majesty will have worked with another.

    Mr Johnson faced a vote of confidence in his leadership on 6 June, which he won, but with fewer of his Conservative Members of Parliament (MPs) backing him than expected. In total, 41% of his own MPs said they had lost confidence in the prime minister, a higher proportion than voted against then-PM Theresa May in December 2018, and a similar share to the vote against Margaret Thatcher in 1990. Both eventually resigned. Mr Johnson has vowed to continue in office. A 25 May civil servant’s report seemed, initially, to wrap up months of debate and police investigations into ‘Partygate.’ His conduct during Covid lockdowns has come under particular scrutiny, and included police fines for the prime minister, his wife and Mr Sunak for attending a party in June 2020. The government must call a General Election no later than 24 January 2025, with May 2024 mooted as a possible date.


    Sterling platinum

    What about sterling? Since the Queen took the throne in 1952, the pound has halved in value against the US dollar. On Her Majesty’s platinum jubilee, sterling currently trades around 1.25 against the dollar, up from a 2022-low of 1.216. That is explained by the recently weaker dollar, as investor demand for a haven currency declined, and the UK government’s fiscal package helped to stabilise the pound.

    Still, in our view the latest spending package does not change the fundamental factors affecting sterling. An economy’s balance of payments and interest rate differentials are the main drivers in today’s currency markets. The UK’s balance of payments deficit continues to deteriorate, further weighing on the currency. Even the BoE’s rising rates may not support sterling because the country’s slowing growth is complicated by continuing uncertainties over its trading relationship with the EU. We maintain our view that the pound will weaken against the dollar, and see the pound-dollar exchange rate at 1.22 by the end of 2022.

    The new fiscal package does… reduce the risks facing the UK economy…

    UK gilts have repriced significantly higher, with 10-year yields at 2.15%, slightly above our 12-month forecast of 2.00%. In the shorter term, investors are uncertain whether central banks can contain inflationary pressures, keeping bond yields under pressure. Investors also remain wary since the BoE’s first rate hike in December 2021 surprised markets. We are therefore cautious on nominal bonds but also on inflation-linked bonds, given elevated valuations with real yields on the 10-year inflation-linked gilts close to -2%.

    We are careful to distinguish between political turbulence and investment prospects. The new fiscal package does, in our view, reduce the risks facing the UK economy and the pound’s continued weakness should further support our preference for UK equities. The UK market has the advantage of including a balance of value and defensive characteristics, specifically a mix of energy, miners, staples and healthcare stocks. Within this market, we prefer exporters on the FTSE 100 index, rather than the FTSE 250’s more domestically-oriented companies. While relative valuations have narrowed, we believe that it still makes sense to focus on larger, export-oriented companies in today’s economy.

    We maintain a neutral portfolio position on equities, with a preference for value and quality stocks in sectors and regions including the UK, where we think firms can more easily pass on higher costs to their customers, or survive periods of lower growth. In this challenging market environment, we continue to use options strategies on major indexes to help manage portfolio risks.

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    This is a marketing communication issued by Bank Lombard Odier & Co Ltd (hereinafter “Lombard Odier”).
    It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication.
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