By William H. Witherell, Ph.D.
The contraction in consumer and government spending led to a slight decline of 0.1% q/q in UK GDP in the second quarter. Consumers were facing increasing pressure on their real incomes due to inflation. Government health spending has been reduced by the end of the coronavirus testing and tracing programme. With this decline following a 0.8% q/q gain in the first quarter, economic momentum is clearly weakening. Opinions differ on whether a small positive gain can be achieved in the third quarter, with the boom in travel services being a positive development. In the longer term, the outlook is both bleaker and highly uncertain. The Bank of England forecasts that the UK economy will experience negative growth and enter a recession which will begin in the fourth quarter of this year and continue until the end of 2023. This implies a decline of 1.4% in 2023 The economic policy outlook, with a new Prime Minister to be chosen on September 5, is an important unknown. Fiscal policy measures could lead to a recovery of the economy in 2023. Other sources of uncertainty are future developments of the Russian-Ukrainian war, the Covid pandemic, Brexit and the external economy.
The main headwinds in the future are caused by the sharp increase in energy bills driven by soaring gas prices. Since Britain imported only a small part of its gas from Russia, one would think that it would not be greatly affected by gas supply restrictions from Russia. However, Britain is linked by a gas pipeline to Europe, and the prices paid by Britain are closely linked to European gas prices. In addition, a greater proportion of homes in England than in Europe are heated by gas or electricity generated from gas. Britain has an energy price cap that regulates the maximum that suppliers can charge most households in the country. The cap was designed to limit suppliers’ excess profit margins, but not to prevent prices from rising. The ceiling is now recalculated every three months. Wholesale gasoline prices last week were 40% higher than a month ago and almost double January’s level. The cap could be increased by almost 60% to £3,135 in October, and a further increase in January is very likely. A higher cap will intensify the cost of living crisis, especially for the most vulnerable households. A political response will be needed.
At the same time, the Bank of England (BOE) gives priority to the fight against inflation. This choice is understandable. Consumer price inflation in the UK hit a 40-year high of 9.4% in June and could top 10% by October. Real disposable income is falling this year and is expected to decline further in 2023, when inflation could remain at a still high 6%. The BOE surprised the market with a 50 basis point hike in August and accelerated the expected pace of further rate hikes. It also plans to start quantitative tightening through sales of government bonds (gilts) in September. Don’t expect the BOE to let up on the brakes anytime soon.
Polls predict that Foreign Secretary Liz Truss will win the Conservative Party leadership on September 5 and become the next Prime Minister, replacing Boris Johnson. Its biggest immediate challenge will be the growing cost of living crisis as real incomes fall. She promised an emergency budget in September. She says she will seek to reduce the tax burden, not distribute “handouts”. She also says she will do “everything I can” to help the most vulnerable. She is surely aware that tax cuts can do little to offset soaring energy bills for lower-income households. She proposed a reversal of the 1.25 percentage point increase in National Insurance contribution rates instituted in April and a reversal of the rise in corporation tax from 19% to 25% scheduled for April. next, which together would amount to some £30bn of unfunded tax cuts. These changes could somewhat reduce the severity and duration of the projected recession.
Another challenge the new Prime Minister will face will be the continued fallout from Brexit, England’s decision in 2016 to leave the European Union and its subsequent departure from the European single market in December 2020. Truss indicated that she supported the enactment of the Northern Ireland Protocol Bill, which would unilaterally tear up part of the Brexit deal between the UK and the EU. The EU has indicated it will retaliate for such unilateral action by eliminating all UK scientists from the massive Horizon research programme. The streak could trigger a trade war that would damage the economies of the UK and EU at a time when both will struggle to recover from a period of weakness. Truss, who once voted to Remain but now says she is seeking to make Britain a low-tax, low-regulation ‘Singapore-on-Thames’, may be able to return to bargaining of a solution to the intractable problems in Northern Ireland that have plagued Brexit from the start.
The UK stock market outperformed European stocks earlier in the year, with the FTSE 100 up 1.58% since the start of the year on August 12, against a 9.62% drop in the STOXX Europe 600 over this period. However, recently, as the outlook for the UK economy has started to weaken, the UK market has underperformed that of Europe somewhat. Over the past four weeks, the FTSE 100 has gained 4.04% while the STOXX Europe 600 has gained 5.71%. At Cumberland Advisors, we have maintained relatively small UK positions in our international and global equity ETF portfolios and will monitor developments closely.
Sources: Financial Times, The Economist, Oxford Economics, The week, CNBC.com, Barclays Research
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.