Slump in PMI raises recession risk

There are signs that the economy contracted in May. The S&P/CIPS Composite PMI has slumped 6.4 points to a 15-month low of 51.8. Indeed, the drop was the index’s fourth largest on record and was almost entirely driven by a dive in the output index.

This is a clear indication that the economy looks set to worsen after contracting by 0.1% m/m in March. We have already pencilled in growth of -0.1% q/q in the second quarter, but this reading increases the chances of a bigger fall in Q2 and of a recession this year.

What’s more, the jump in the input prices balance to a new record of 85.7 suggests that inflation has further to run after hitting 9% in April. This highlights the trade-off facing the Monetary Policy Committee (MPC). On balance, we think the MPC will raise interest rates again in June – but worries about recession may cause the committee to take a brief pause over the rest of the summer.

Services activity slumps but inflation soaring

The fall in the composite index was driven by a decline in the services PMI, which tumbled from 58.9 to a 15-month low of 51.8. Given the PMI survey does not cover the retail sector (which showed signs of resilience in April), this suggests services activity elsewhere in the economy may be suffering more from the cost of living crisis.

Despite signs of weakening economic activity, the input price balance of the composite PMI rose further in May to a new all-time high. The press release noted that ‘survey respondents overwhelmingly cited higher wage bills, energy costs and fuel prices’. That suggests high global commodity prices and a tight domestic labour market are continuing to add to inflationary pressures. Although the output price balance edged down slightly, it is still very close to a record high. It is consistent with our forecast for CPI inflation to rise even further, from a 40-year high of 9% in April to 10% in the coming months.

Supply chains holding up for now

Admittedly, the manufacturing sector seems to be holding up well. The manufacturing PMI fell only from 55.8 to 54.6 and the input prices balance eased a little, suggesting that the war in Ukraine and coronavirus-related shutdowns in China aren’t affecting supply chains yet.

However, this is unlikely to be maintained over the rest of the year. As the impact of the war in Ukraine on supply chains and coronavirus-related shutdowns in China starts to filter through, UK supply chains pressures are likely to significantly worsen again.

Despite the sharp drop in the output index, the employment balance barely moved, suggesting that firms are still hiring. Indeed, the tight labour market, along with very strong household balance sheets and the likelihood of more government support, will support consumer spending; all are key reasons why we still think the economy will narrowly avoid a recession this year.