UK economic outlook
Conall MacCoille
Chief Economist
A bleak economic outlook for the UK
The current consensus forecast average indicates that the UK economy will suffer a 0.5% contraction in 2023, the clear underperformer amongst the G7 this year.
Why this bleak view? Firstly, UK CPI (Consumer Price Index) inflation was still in double-digit territory, at 10.4% in February, far higher than in other countries. This means that UK households will face an unusually sharp squeeze on real incomes, accentuated by the Chancellor of the Exchequer Jeremy Hunt’s austerity measures, to bring public borrowing under control.
Indeed, the March budget provided little respite. True, the energy price guarantee was extended for another three months. This means that average household bills will stay at £2,500, rather than rising to £3,000. Crucially, however, there was no change to income tax bands and thresholds, which will stay frozen, despite rising wages – effectively a stealth tax on households struggling with rising prices.
The corporation tax rate will also rise as scheduled, to 25% from April 2023, up from 19% previously, undoubtedly hurting companies. This move had attracted heavy criticism from Conservative MPs, but is now seen as essential, following the disastrous ‘mini-budget’ last autumn. In short, with the borrowing of almost £152bn, 6% of GDP (Gross Domestic Product) expected this budget year 2022/2023, Jeremy Hunt had little room for manoeuvre.
For now, consumer spending and retail sales have proved surprisingly resilient. However, consumers may literally be living on borrowed time. Credit card lending grew by 13% in the year to February, the fastest seen growth since 2018. This is a worrying trend. The clear concern, is that households will eventually have to stop dipping into savings and take on debt to sustain spending.
How high will the Bank of England raise rates?
The second headwind facing the UK economy is that the Bank of England has now raised official interest rates to 4.25%. Markets are split on whether the Monetary Policy Committee (MPC) will raise rates further, to a peak of 4.5% by mid-2023. Of course, this all depends on whether the Bank of England will see any tentative evidence in the coming months, that CPI inflation is returning to 2%.
For now, the signs are at best, mixed. Thankfully, the decline in wholesale gas prices means household average energy bills will soon fall to £2,150. However, in February, services price inflation accelerated to 6.6%. This is a worrying sign that the acceleration in pay growth, to 6%, is being passed through to consumers, creating persistent inflationary pressures.
Lurking beneath the surface here, is Brexit. UK employment is still marginally below pre-pandemic levels, but the unemployment rate is still at a very low 3.7%. The decline in net migration, but also weak participation amongst older age groups has contributed to labour shortages, which won’t be easily resolved.
Hence, in its February projections, the Bank of England forecasted that CPI inflation would likely fall below 2% in 2024 and 2025. However, at the same time, the MPC said the upside risks to its CPI inflation forecast had never been greater.
The housing market in the doldrums
Fixed rates on UK mortgage products have receded from the eye-watering levels above 6% late last year. However, in February the average quoted 2-year fixed mortgage rate was still 5.38%. At these levels of interest rates, affordability in the UK housing market is clearly stretched too far. Something has had to give – so sharp declines in both transactional activity and house prices are expected in 2023.
Mortgage approvals in February were 43,500, down 37% on the year. This is one of the weakest levels of lending activity since the mid-1980s. Approvals last fell to these levels during the COVID-19 pandemic and before that in 2009, following the global financial crisis when UK house prices declined by 15%.
The current median forecast is that UK house prices will see a 5% decline through 2023. This follows a 3-4% decline through September to December, according to the Halifax and Nationwide indices. So arguably, a circa 10% peak-to-trough decline is expected.
However, it is not only UK house prices that are at risk from higher interest rates. Close to an additional two million households will have to refinance their existing fixed rate mortgage deals by the end of 2023. Many will now face paying interest rates above 5%, rather than the 1-2% rates they are currently on.
In December, the Bank of England calculated that once they re-finance, 670,000 households might face spending 70% of their disposable incomes (after essential items such as food and energy) on their monthly mortgage payments. Since December, energy prices and mortgage rates have fallen back. However, many households will still face a very difficult period for their personal finances.
The current median forecast is that UK house prices will see a 5% decline through 2023
Some good news on Brexit
Brexit has no doubt created unwelcome uncertainty for investors. The standoff on the Northern Ireland protocol meant there was still a risk that the existing EU/UK trade deal, as part of the Withdrawal Agreement, might suddenly unravel. These fears were justified, given the European Commission had drawn up a list of retaliatory trade measures, should the UK refuse to implement the protocol.
However, Rishi Sunak has managed to see off any lingering opposition within the Conservative party to the new ‘Windsor framework’, despite his predecessors Boris Johnson and Liz Truss and the Democratic Unionist Party (DUP) voting against the deal.
The deal is clearly perceived in Britain to have been a success, securing unexpected concessions from the EU. There is little appetite to restart negotiations or extend political capital to support the DUP. While dysfunctional politics in Northern Ireland may continue, a breakdown in the EU/UK relations now seems unlikely.
However, it remains to be seen whether this progress will be sufficient to stimulate business investment in the UK. The existing trade deal is far from perfect, still implying much red tape and regulatory barriers for UK businesses.
An improved ‘Swiss-type’ deal had been mooted in the British press during the autumn but was met with opposition from Conservative MPs. Labour leader Keir Starmer is unlikely to press the issue ahead of the next general election, determined to win back Brexit voting ‘red-wall’ seats.
Warning: Past performance is not a reliable guide to future performance. The value of your investment may go down as well as up. These products may be affected by changes in currency exchange rates.
Warning: Forecasts are not a reliable indicator of future performance.