Low growth and high inflation cement the UK as stagflation nation
The UK economy has proven more resilient than expected – similar to many other European economies – as it is battling with high inflation, rising interest rates and diminished real wages. This resilience has until now been driven by a strong labour market that has supported a service sector that is still recovering from the pandemic. The economy has avoided a recession so far but has been seeing an almost stagnating level of activity since early 2022.
Headline inflation is coming down from its late-2022 high and is expected to continue to gradually ease until mid-2024 as energy is pulling inflation down while food and other goods see their price pressures alleviate. However, this will be a slow process as service inflation – highly correlated with wage growth – are proving more persistent due to a tight labour market. Inflation will come down substantially in 2024 compared to the 2022 and 2023 levels but is still expected to remain above the 2% target of the Bank of England (BoE).
The labour market remains tight but is already showing signs of weakening with vacancies slowly coming down from their historic high and unemployment coming up, albeit still at a very low level. A weakening labour market will affect wage growth, but it is still expected to remain high in 2024. The national minimum wage will increase by at least 5.6% in April 2024. This could, along with some unions only reluctantly agreeing to the 2023/24 increase, cause nominal wage growth to average around 5-6% in 2024, and real wages to eventually rise.
The resilient labour market, high wage growth and persistent inflation is forcing the BoE to keep interest rates higher for longer to cool down the economy. The Bank rate, its key interest rate, is expected to end 2023 around the current level 5.25% and remain at this level to at least late 2024, potentially even early 2025.
Despite a fall in real wages over the past year, household demand was relative stable in 2022 and most of 2023 as households were using some of their excess savings accumulated during lockdowns. However, as the excess savings are depleting and unemployment rising, consumption will slowdown in the last part of 2023 and early 2024, but slowly start recovering in the latter half of the year as real wage growth improve purchasing power.
Trade is still slowly recovering from the pandemic and post-Brexit hurdles as overall trade was still lower in the first half of 2023 compared to its pre-pandemic levels. The overall fall is due to trade in goods, which is still 5% below the volume in the first half of 2019, and more specifically trade in goods to European Union (EU) countries as this remained 11% lower. While some of this is expected to gradually recover, smaller and medium sized companies have lost competitive advantages given the higher costs of trade.
Businesses will continue to struggle with tepid demand, resulting in further difficulties in passing on costs – particularly financial and labour costs – to consumers which also will be reflected in low investments. This will affect margins, that until now have been relatively stable (net rate of return for UK non-financial companies only fell by 0.3pps to 9.9% in Q1 2023 compared to a year prior). Tighter margins and high interest costs will challenge the zombie companies that have been persistent in the economy since the low interest rate environment following the Great Financial Crisis. Insolvencies rose rapidly in 2022 to surpass 2019-levels, following two years with historically low amounts of insolvencies. Insolvencies have and will continue to rise in 2023 (+14% higher in the first nine months of 2023 than a year prior) and is expected to increase further in 2024, albeit at a slower rate.
Stable fiscal policy in response to rising debt financing costs
After a tumultuous 2022, the Spring Budget of 2023 was a relatively safe affair that continued the promise of responsible spending and only minor tax and subsidy changes. It confirmed the rise in the corporation tax (19 to 25% from April 2023) and scaled down the previous ‘super-deduction’ scheme (where businesses could claim 130% capital allowances on qualifying plant and machinery investments) to a ‘full expensing’ scheme, a 100% capital allowances (+GBP 8 billion, 0.3% of GDP). The extension of the Energy Price Guarantee for households (to June 2023), the Energy Bills Discount Scheme for companies (to March 2024) and the extended cut to the fuel duty were among the more expensive measures to ease inflation (GBP 8.2 billion, 0.3% of GDP).
This is resulting in the fiscal balance deficit expected to rise slightly and public debt to rise further as expenditures are expected to outgrow receipts.
After completing the announced reduction of their stock of government bonds and non-investment grade corporate bonds – stemming from the Asset Purchase Facility (APF) – in September 2023 (reducing by GBP 80 billion), the BoE announced a further reduction of GBP 100 billion from October 2023 to September 2024, planning to reduce its holdings to GBP 658 billion.
Both exports and imports are expected to drop in 2023 and only somewhat recover in 2024, but the recovery will be slow and while the Windsor Framework improved the relationship with the EU, the trade frictions are still there, and automotive exports may not recover. The current account deficit will remain stable in 2023 and gradually narrow in 2024. However, it will remain negative with the balance of goods showing a deficit, despite improvements, whereas the balance of service will have a surplus as it remains a key part of the global financial sector.
Campaigning is slowly beginning as 2024 will likely be an election year