18 April 2023
‘Slowcession’ more likely than recession
The UK economy has proved remarkably resilient over the last year, in the face of a record-breaking cost-of-living crisis and the biggest rise in interest rates in a generation. Indeed, the economy managed to avoid falling into a recession at the end of last year and the latest data suggests the economy will avoid a recession this year as well, although it will be a close-run thing.
What’s more, the real economy, has faired even better. UK GDP has been depressed over the last year by weak output in the public sector. Part of this is due to an unwinding of pandemic era effects, for example healthcare output has dropped due to fewer coronavirus vaccinations. And part of it is due to widespread strike action by doctors, teachers and other civil servants. The ONS estimates that almost 2.5 million working days were lost to strike action in the second half of last year.
While fewer students in classes and a reduction in GP appointments will weigh on GDP, it’s difficult to argue that this is something the business community or households should be concerned about. Output in the real economy is running at about 1.5% above its pre-pandemic level compared to the whole economy, which is only fractionally above it.
It stands to reason, then, that 76% of middle market businesses are feeling prepared for a recession now.
Most cost pressures set to ease
As well as general economic resilience, the huge surge in cost pressures is set to ease rapidly over the rest of this year.
The massive drop in wholesale energy prices since December should soon start to feed through into lower bills for businesses and consumers. That makes the 10-percentage point drop in the number of middle market businesses saying energy prices were a concern understandable. However, given energy prices are likely to remain at double or triple their pre-crisis levels, it’s not surprising that energy costs remain the biggest concern and that almost half of firms said they are investing to improve their energy efficiency. Whilst the drop in energy prices is very welcome news, they are volatile and a very hot summer or cold winter could cause prices to jump again.
We expect inflation to fall rapidly this year, from over 10% in Q1 to around 3% by the end of the year as the huge rises in goods prices, including energy, fall out of the annual comparison and even move into negative territory in some cases.
And even though the Bank of England (BoE) has continued to raise interest rates over the last six months, the rate that is being priced into financial markets has fallen considerably and rates are expected to be cut more quickly than previously. This probably explains why fewer businesses cited increasing cost of finance as a major concern, despite the increase in interest rates.
In theory, a more resilient economy might tilt the scales for the Monetary Policy Committee (MPC) in favour of another 25-basis points (bps) interest rate rise in May. In reality, the labour market and inflation data will be much more influential. With interest rates already at 4.25%, the BoE has linked any future hikes to signs of inflation persistence — particularly to positive surprises in the CPI and jobs market data. We don’t expect these to materialise by the May meeting, which is why we may see no further rate increases this cycle, but it is an exceptionally close call. The risk further down the line is that the labour market remains tight, services inflation proves sticky and the MPC is forced to resume rates hikes in the summer.
Higher interest rates are typically a drag on business investment. Indeed, less than 40% of middle market businesses are planning to make significant capital investments over the next year. And the priority for most middle market businesses is restructuring supply chains. While that makes sense given recent geopolitical events, it will do little to boost productivity across the broader UK economy. More positively, of those firms planning to make capital investments, energy efficiency and productivity enhancing training and equipment rated highly. Those businesses which continue to invest in training and equipment now will be in a much better position to take advantage of an upturn in growth next year.
The upshot is that the economic outlook is much stronger than it was at the end of last year. But, bear in mind that even though the economy is outperforming expectations, those expectations were for a significant recession. Even if the UK avoids a technical recession, which is far from guaranteed, growth is likely to be bumpy and extremely slow. We have probably only seen about half the impact from the 400-bps in interest rates over the last year, which will act as a big drag on growth over the rest of this year. The big picture is that the UK economy is unlikely to be any bigger in 2024 than it was in 2019.