investment insights

    After a peak in UK interest rates, what’s next?

    After a peak in UK interest rates, what’s next?
    Bill Papadakis - Senior Macro Strategist

    Bill Papadakis

    Senior Macro Strategist

    Key takeaways

    • The BoE’s monetary policy cycle has now likely peaked in response to slower UK inflation. We do not expect a first interest rate cut before June 2024
    • The UK should avoid recession this year, but a less flexible labour market makes the economy more vulnerable to shocks
    • There is margin for new fiscal spending in the 22 November budget to boost growth. A potential Labour Party win at the next general election is unlikely to see major macroeconomic policy changes, but may see higher taxes to fund investments in public services
    • While the FTSE 100 is weighted to defensive stocks, we retain a neutral view on UK equities. We see sterling staying weak against the euro and US dollar through the rest of 2023.

    UK economic growth is weak, but the inflation outlook has finally started to improve. This combination suggests that interest rates have peaked and we expect the Bank of England (BoE) to leave rates unchanged for a second consecutive meeting when its monetary policy committee next reports on 2 November.

    The end of an unusual hiking cycle with a peak policy rate of 5.25% is still a very restrictive monetary policy, as it is the highest rate level since the global financial crisis of 2008. Nevertheless, it is a more benign outcome than looked likely just a couple of months ago. At that time, a series of high inflation readings meant money markets anticipated policy rates peaking at 6.50% (see chart 1). That was even higher than expectations during the sharp market sell-off that followed the ‘mini-budget’ of the short-lived Liz Truss government in September 2022.

    While the UK’s 6.7% inflation in September 2023 was higher than most other advanced economies, it has fallen from above 11% a year ago. It is set to fall even further in October, thanks to a ‘base effect’ of comparing high rates with 12 months earlier, and the lowering of a cap on household energy bills.

    A first BoE rate cut may come next June, which is broadly consistent with money markets’ expectations

    While the UK economy should narrowly avoid recession in 2023, we still only expect real gross domestic product (GDP) growth of just 0.2% for the full year. High interest rates will be a drag on growth over time, even if the lags are likely to be longer this time around given the notable increase in fixed-rate mortgages since the financial crisis.

    Against a backdrop of anaemic growth and falling inflation in the months to come, we believe that the BoE will switch from tightening to loosening policy by mid-2024. We think the first rate cut may come next June, which is broadly consistent with money markets’ expectations.


    Labour pressures

    With access to European labour now reduced post-Brexit, the UK economy has become less flexible and more sensitive to shocks, complicating its post-Covid recovery. Issues in the labour market have been both a cause and effect of high inflation, as workers struggle to recover some purchasing power by negotiating wage rises. Labour market shortages have also constrained growth, with a record 2.6 million people now out of work suffering long-term health issues. This trend may be related to Covid complications and long waiting lists for treatment.

    However, fears that rising wages would translate into spiralling prices have diminished. The unemployment rate in the UK has risen from a low of 3.5% in 2022 to 4.3% currently, and job vacancies have been steadily declining for the last 15 months. The labour market overheating of last year appears to be behind us, and further rebalancing is likely, as demand in the economy cools further. While UK wage growth has been strong so far, forward-looking indicators such as the REC survey point to a substantial slowdown in the coming months.

    Rising tax revenues may give the government some margin to add fiscal stimulus

    Budget windfall?

    In the meantime, Prime Minister Rishi Sunak’s administration is scheduled to deliver a budget on 22 November. Rising tax revenues, forecast to reach a record 37.7% of GDP by 2027/28 largely as a function of high inflation, may give the government some margin to add fiscal stimulus next year, against the backdrop of weak growth. Additional spending room comes from an announcement in early October to scrap part of a high-speed rail extension (‘HS2’), saving an estimated GBP 36 billion (USD 44 billion). We would not expect such stimulus measures at a time of still-high inflation to boost growth, however, as the likely reaction by the BoE would be renewed rate hikes. Tighter monetary policy would then offset any growth-positive effects of looser fiscal policy.

    The UK is scheduled to hold a general election before the end of January 2025, although a vote is more probable in the last quarter of 2024. After Mrs Truss’s 49-day Conservative government ended in October 2022, polling and losses in regional parliamentary votes suggest that a national election may see a win for the opposition Labour Party.

    That prospect does not appear to worry markets. Keir Starmer, the Labour Party’s leader, has pledged to build on improving trade relations with the EU, not raise income taxes, social charges or value added tax, indicating a will to demonstrate fiscal discipline. While we agree that a Labour government is unlikely to make a radical departure from macroeconomic orthodoxy, we think some tax increases over the term in office are likely. Current public polling suggests significant concern with the state of UK public services, and rising support for tax increases in order to improve these (see chart 2). After the Truss government’s ‘mini-budget’ led to a spike in gilt yields and stresses in the UK pension system, unfunded increases in government spending look unlikely. This leaves a rise in government revenues as the only alternative.

    We expect sterling to remain weak against the single currency and the dollar through the rest of 2023

    Gilts, sterling and stocks

    One consequence of higher-for-longer inflation and restrictive monetary policy is that UK sovereign debt now offers a higher yield than most of its neighbours. Ten-year gilts now yield 4.50%, their highest level in more than 15 years, compared with 2.78% and 3.39% respectively on the equivalent German and French government bonds.

    While FTSE 100 stocks trade on cheaper earnings multiples than those in other developed markets, we see few catalysts for this difference to narrow. However, the UK index is weighted towards stocks where earnings may prove more resilient in an environment of slowing global growth – including energy, mining, banks and pharmaceutical companies. We retain a neutral view on UK equities.

    Since the start of September, sterling has depreciated against the euro, Swiss franc and US dollar. The main driver has been markets’ reassessment of how high UK interest rates will rise. Stubborn inflation and low growth are also weighing on the currency. We expect sterling to remain weak against the single currency and the dollar through the final months of the year.

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