10 February 2023
The UK has avoided falling into recession by the skin of its teeth, but the worst is yet to come. There are clear signs that the economy has deteriorated over the last few months; GDP fell by 0.5% in December after growing by 0.1% in November. The combination of double-digit inflation, the huge rises in interest rates over the last year and less fiscal support means households real disposable incomes are set to shrink sharply in the first half of this year. That will lead to falling consumer spending and a shrinking economy. As a result, we think the recession has just been delayed, rather than totally avoided.
Of course, narrowly avoiding a recession doesn’t change much on the ground. For businesses operating in the real economy a rise in GDP of 0.1% doesn’t feel much different to a drop in GDP of 0.1%. But a milder recession would mean that unemployment rises more slowly, wage growth stays strong and domestically generated inflation falls at a slower pace than expected. This could result in the Bank of England (BoE) raising rates by more than expected.
Now that we have a fuller picture of the economy over the last year, it’s worth pausing to take stock of where we are. Unfortunately, it’s not a great picture.
The UK grew by 4% in 2020, but is still the only G7 country in which GDP has not yet fully recovered to its pre-pandemic (Q4 2019) level. Indeed, GDP was still 0.8% lower than three years ago in the UK, whereas it was 5.1% higher in the US, 1.2% higher in France, 0.1% in Germany and 3.1% in Italy. Among other G7 economies, Japan and Canada have not reported Q4 figures yet. That said, the margin of underperformance did not grow materially in Q4 relative to other European countries, which are also struggling to adapt to higher energy prices.
Resilience giving way to recession
The economy had been surprisingly resilient over the last few months, even in the face of growing economic and geopolitical headwinds in both October and November. Although it is worth noting that the significant 0.5% month on month (m/m) bounce in GDP in October was more related to the extra Bank holiday in September than strong underlying growth. However, there were clear signs of deterioration in December.
The weakness in December was concentrated in consumer-facing services, which fell by 1.2% m/m. They remain about 9% below their pre-pandemic level. The arts and recreation sector fell by a whopping 7.8% m/m as consumers pulled back on discretionary spending. On top of that, strike action probably knocked about 0.2% off GDP in December.
Over Q4 as a whole, the economy flatlined. Household consumption eked out 0.1% growth, that’s better than the 0.4% drop in Q3, but still points to very weak underlying momentum. More positively, business investment rebounded by 4.8%, after falling by 3.2% in Q3. Increasing business investment will be key to the UK catching up with its peer nations. But collectively, the net trade, inventories and net acquisitions of valuables components subtracted 0.5 percentage points (pp) from quarter-on-quarter (q/q) growth in GDP.
The period of resilience is probably now at an end. December’s data makes it clear that consumers pulled back sharply at the end of last year and the data we’ve had so far in 2023 suggests that has continued.
We continue to think that GDP will drop substantially in Q1 and Q2. The Government has temporarily stopped paying cost of living grants to low-income households in Q1, and will substantially reduce its energy price support in Q2. What’s more, consumer confidence is still near its-record lows, which will prevent households from lowering their still high saving ratio.
Meanwhile, the Monetary Policy Committee’s rapid rate hikes have dramatically increased the cost of external finance for corporates, who mainly have floating rate loans.
However, the recession we expect in the first half of 2023 will be mild by historical standards. We expect this recession to see a peak-to-trough drop in GDP of roughly 1%. That would be roughly half the size of the early 1990s recession, significantly smaller than the Global Financial Crisis (which had a peak-to-trough drop in GDP of around 6%), and a fraction of the pandemic, when GDP fell by a massive 22%.
Admittedly, the recent collapse in wholesale energy prices suggests that households’ real expenditure will be picking up in the second half of this year, and dragging GDP up with it. But, the big picture is that the economy could be no larger in 2025 than it was in 2019, before the pandemic.
We don’t think today’s data will have much impact on the Bank of England’s thinking. The Q4 result was only marginally worse than the Bank’s latest forecast.
If the economy evolves exactly in line with the Bank’s forecast and wage growth and services inflation start to show clear signs of easing over the next few months, then interest rates may not have to rise any higher. But, the committee made it clear that they very much feel that the risks are skewed very heavily to inflation staying stronger. As a result, we’re sticking with our forecast of a 25-basis points rate hike in March, making 4.25% the peak. The stickiness of core inflation and the strength of the labour market means rate cuts aren’t likely to come until 2024.