Market Analysis

Britain's Sky-High Inflation Fosters Gloomy Forecasts

But the UK economy has weathered falling real wages before.

The UK notched a dubious milestone in July, becoming the first major country to record double-digit inflation (broadly rising prices across the economy) this year. The Consumer Price Index’s 10.1% y/y rate is the fastest since 1982, and the Office for National Statistics (ONS) estimates it is just the fourth trip over 10% in 70 years.[i] This is obviously not good news, not least because essential goods and services—food, petrol, household energy—fuelled much of the rise.[ii] But even excluding food and energy, core inflation accelerated to 6.2% y/y, driving commentators we follow to warn entrenched price hikes will hit consumer spending hard—and likely give UK stocks a nasty recession to price in.[iii] In our view, a UK recession is possible and could already be underway. But we see reasons to think reality has a higher likelihood of going better than analysts we follow foresee, not worse.

With that said, we think inflation is quite likely to accelerate from here due to the forthcoming rise in the default household energy tariff, which energy regulator Ofgem is due to announce next week and will take effect in October. Some researchers anticipate it will double the current ceiling in order to reduce the risk of more suppliers going bust if power is in short supply this winter. The Bank of England (BoE) projects the cap increase will cause inflation to pass 13% y/y in October—a forecast some commentators we follow warn is too optimistic.[iv] Labour market data released earlier this week showed real (meaning, inflation-adjusted) wages falling at the fastest rate in the dataset’s short history over the three months ending in June (-3.0% y/y), a figure that doesn’t account for either the forthcoming price cap hike or the fact that income tax bands currently aren’t indexed to inflation.[v] So we can understand why observers suggest the consumer spending outlook is bleak.

Yet there is some history of consumer spending growing despite falling real wages. Inflation-adjusted wages fell on a year-over-year basis in every month from November 2009 through September 2014—a long, dismal stretch of seemingly falling living standards. The peak-to-trough drop, using the seasonally adjusted monthly inflection points of April 2009 and June 2014, was a painful -6.0%.[vi] Yet from the end of Q1 2009 through Q2 2014, inflation-adjusted quarterly consumer spending rose 9.1%.[vii] There were some occasional quarterly contractions, but the UK didn’t slide into recession during this stretch. Lest you think spending rose only because people borrowed beyond their means, consumer credit actually fell by over £25 billion over this span.[viii] The much-discussed consumer borrowing boom came later, in the decade’s second half, by which time real wages were rising.[ix] We aren’t saying that period is a perfect analogue for now, but we think it shows falling real wages aren’t assured to sink spending.

As ever, we think the question for stocks isn’t whether things go well or badly in the absolute sense, but whether reality beats anticipated outcomes. The flurry of dreary economic data and dismal forecasts doesn’t appear to have deterred UK stocks, which are up nicely from their 5 July low and sit about 1% below their 8 April high.[x] That suggests to us that stocks see a decent likelihood that things don’t go as badly as commentators we follow warn they will. We can see a case for that. Right now, the dog days of August have soured the national mood. Heat waves, flooding in the South East, energy prices and a series of transit strikes are pulling sentiment down, and the Conservative Party’s leadership transition and Parliament’s summer recess are delaying a government response to cost-of-living pressures. We think this is an understandable sore point, especially with a deluge of subsidies and other assistance measures keeping inflation rates artificially lower across core EU nations.[xi]

But soon a new prime minister and cabinet will be in place, which, based on historical polling data, typically boosts sentiment and helps uncertainty fall.[xii] Based on recent proclamations from both leadership contenders, that new cabinet appears highly likely to introduce some measures aimed at helping households, which will likely create winners and losers. If recent history is a guide it will probably attract criticism for being too small yet, in our view, it is still likely to help sentiment all the same. Meanwhile, regular unleaded petrol prices are down -9.4% since 1 July, and falling crude oil prices will likely continue filtering through.[xiii] And with Ofgem set to begin reviewing the household energy price cap every three months instead of every six, the cap may respond more quickly to potential declines in wholesale power prices.

In our view, things don’t have to go much better than commentators we follow suggest for UK stocks to continue rising. At this point, with forecasts so dim, we think simply muddling through would likely suffice. We know this is probably of little comfort to those struggling with rising living costs in the meantime, but, in our experience, markets are usually cold to such things, making it paramount for investors to conjure up similar objectivity, in our view.

[i] Source: ONS, as of 17/8/2022. A consumer price index is a government-produced index tracking prices of commonly consumed goods and services.

[ii] Ibid.

[iii] Source: ONS, as of 17/8/2022. A recession is a decline in broad economic output.

[iv] “Monetary Policy Report – August 2022,” BoE, 17/8/2022.

[v] Source: ONS, as of 16/8/2022.

[vi] Ibid. Percent change in real regular pay (seasonally adjusted), April 2009 – June 2014.

[vii] Source: FactSet, as of 17/8/2022. Percent change in real quarterly household consumption, Q1 2009 – Q2 2014.

[viii] Source: BoE, as of 17/8/2022.

[ix] Source: BoE and ONS, as of 18/8/2022.

[x] Source: FactSet, as of 17/8/2022. MSCI UK IMI Index return with gross dividends.

[xi] “Factbox – Europe’s Efforts to Shield Households from Soaring Energy Costs,” Bozorgmehr Sharafedin, Reuters, 15/8/2022. Accessed through MSN.

[xii] Source: UKPollingReport, as of 17/8/2022.

[xiii] Source: RAC, as of 17/8/2022.

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