UK Inflation Cools More Than Expected … Raising Fears?

Supposedly, the only holiday gift the UK wanted this year was slower inflation … and they got it! Headline Consumer Price Index (CPI) defied expectations for an uptick by slowing from 3.6% y/y to 3.2% in November, with core CPI easing from 3.4% to 3.2%.^[i] With the Bank of England meeting Thursday, you might expect slower inflation to spark a chorus of huzzahs for the cost of living and prospects of a rate cut. But sentiment in the UK remains especially skeptical, so the groans and sighs outweighed the cheers as analysts warned slow inflation is another signal of an economy slipping into recession. Yet recession fears have been a brick in the UK’s bull market wall of worry all year. Even if the economy is slipping, the surprise power seems spent.

In a vacuum, it might seem odd for pundits to cast slower inflation as a recession harbinger. Just two years ago, most of the developed world was crying for prices to stop galloping! And Brits have spent all year dealing with one of the developed world’s highest inflation rates, due largely to the household energy price cap’s failure to live up to its name. A slowdown as food and apparel prices eased should be a relief.

But in the UK, inflation isn’t slowing in a vacuum. Last week, the Office for National Statistics announced monthly GDP contracted for the second straight month in October, slipping -0.1% m/m.^[ii] Then this week’s jobs data showed the unemployment rate rising to 5.1% in the three months to October, extending its climb from 4.1% in mid-2024 as both payrolls and the number of people reporting employment in the Labour Force Survey fell.^[iii] Against that backdrop, many headlines interpreted slowing inflation as a sign of weak demand and an economy losing what little steam it appeared to have.

We agree the UK economy has some soft spots, much as any national economy will have pockets of weakness as well as strength. The UK’s are getting a lot of attention this year for political reasons primarily, as economic data feed into the forecasts that determine how much “austerity” the government must enact. When modest employer tax hikes took effect in April, headlines warned it would hit growth, putting everyone on alert for hints of confirmation. That kept the UK economy under a microscope in the run up to the Autumn 2025 Budget, unveiled late last month, which included more modest tax hikes. Even though most of these take effect two or three years out, it adds to the specter of fiscal policy crushing a weak economy. If Friday’s retail sales report isn’t pretty, expect another round.

Yet this gloom is the backdrop for UK stocks rising 30.0% in US dollars year to date.^[iv] There is some currency skew here, but even in pounds, the MSCI UK Investible Market Index is up 21.4%, well ahead of the MSCI World Index.^[v] Tax hike dread, weak economy fears, dreary data, they aren’t new. They were the norm for UK stocks all year. And UK stocks smashed expectations.

Markets are efficient, rapidly pricing in all widely known information. UK stocks aren’t blind to any of this year’s economic discourse or data. They have been pricing it all year long. If the UK were on the cusp of a nasty recession, we would expect stocks to start signaling it well in advance. They aren’t, which strongly suggests the UK economy has some silver linings that aren’t getting much attention. That perhaps monthly GDP contractions aren’t unusual, slower inflation isn’t telling and maybe things aren’t really so bad.

Take, for instance, S&P Global’s flash UK purchasing managers’ indexes for December, which came out Tuesday. They showed across-the-board improvement. Manufacturing rose from 50.2 to 51.2 (readings over 50 indicate expansion), while services improved from 51.3 to 52.1.^[vi] Together, these lifted the composite reading from 51.2 to 52.1.^[vii] It looks to us like activity has started picking up nicely now that Budget uncertainty is gone. Meanwhile, business lending has accelerated this year, hitting a high of 6.3% y/y in August.^[viii] While it slowed since, October’s 5.6% y/y is nothing to sneeze at.^[ix] The UK economy is quietly getting more fuel, enabled by the steeper yield curve. If the BoE does cut Thursday, that curve gets even steeper. Fear abounds, but fundamentals look far better.

So we suggest everyone take a deep breath. We don’t dismiss the UK’s challenges. Small businesses have had a tough time. Households have had to manage years of stealth tax hikes, as tax rate thresholds haven’t risen with inflation for years now. Power and water bills are up due to the aforementioned faulty price cap and a severe crisis at a large water utility, respectively. But stocks don’t deal in absolute good or bad. They weigh reality relative to expectations, and all year, the UK has shown stocks simply need things to be not so bad as feared.