Britain’s Sky-High Inflation Fosters Low Expectations

The UK notched a dubious milestone in July, becoming the first major country to record double-digit inflation this year. The Consumer Price Index’s 10.1% y/y rate is the fastest since 1982, and the Office for National Statistics 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, gasoline, household energy—fueled much of the rise. But even excluding food and energy, “core” inflation accelerated to 6.2% y/y, driving worries of entrenched price hikes hitting consumer spending hard—and giving UK stocks a nasty recession to price in.^[ii] 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 feared, not worse.

With that said, inflation is quite likely to accelerate from here due to the way household energy costs factor in. Millions of households are on what is known as the default tariff, which is not a barrier to international trade in this case, but rather the official term for the standard electricity pricing for households that don’t secure a fixed-term rate by switching providers. Parliament capped this rate in 2019, but it isn’t a hard, permanent ceiling. Every six months, regulators announce a new maximum for the default tariff, typically based on how wholesale prices have evolved over the prior half year. When wholesale prices rise, power suppliers tend to treat the price cap as a target to mitigate the likelihood of future losses. Hence, Brits endured huge stair-step increases to household energy costs last October and this April. Yet dozens of suppliers have failed anyway after being forced to take steep losses when wholesale power prices spiked, limiting competition and probably pushing prices even higher.

Later this month, the UK’s energy regulator will announce the new price cap that 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 projects the cap increase will cause inflation to pass 13% y/y in October—a forecast some warn is too optimistic. Labor market data released earlier this week showed real 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 tax brackets aren’t indexed to inflation. So we can understand why people think 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%.^[iii] Yet from the end of Q1 2009 through Q2 2014, inflation-adjusted quarterly consumer spending rose 9.1%.^[iv] 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.^[v] The much-discussed consumer borrowing boom came later, in the decade’s second half, by which time real wages were rising. We aren’t saying that period is a perfect analogue for now, but it shows falling real wages aren’t assured to sink spending.

As ever, the question for stocks isn’t whether things go well or badly in the absolute sense, but whether reality beats expectations. The flurry of dreary economic data and dismal forecasts hasn’t deterred UK stocks, which are up nicely from their July 5 low in pounds and sit about 1% below their April 8 high.^[vi] That suggests to us that stocks see a decent likelihood that things don’t go as badly as headlines warn they will. We can see a case for that. Right now, the dog days of August have soured the national mood. Heat waves (and now flooding in London), 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. That is a sore point with many, especially with a deluge of subsidies and other assistance measures keeping inflation rates artificially lower across core EU nations.

But soon a new prime minister and cabinet will be in place, which typically boosts sentiment and helps uncertainty fall. That new cabinet is highly likely to introduce some measures aimed at helping households, which will likely create winners and losers. It will probably attract criticism for being too small yet should still help sentiment all the same. Meanwhile, regular unleaded gasoline prices are down -9.4% since July 1, and falling crude oil prices should continue filtering through.^[vii] And with energy regulators set to begin reviewing the household energy price cap every three months instead of every six, there is some potential for the cap to respond more quickly to potential declines in wholesale power prices.

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