Markets don’t seem to agree the UK is heading for dark economic times.
The Bank of England (BoE) announced its biggest rate hike since 1995 on Thursday, raising the Bank Rate from 1.25% to 1.75%—but that wasn’t the day’s biggest news. Paired with that rate hike was the BoE’s August Monetary Policy Report, which included the bank’s updated economic forecasts. That forecast: inflation reaching 13% y/y when the household energy price cap resets higher in October and recession starting that quarter and lasting all of 2023. Looming over all of this is a fierce political debate on the BoE’s mandate and independence, which has featured in this summer’s Conservative Party leadership contest. We see some medium-term risks for UK stocks here, but not the ones you might think. Let us discuss.
When last we left the BoE in May, its top-line forecast was for inflation at 11% y/y and a -0.25% GDP contraction in 2023. Now it thinks the most probable scenario is CPI hitting 13% this autumn and GDP falling -1.25% in 2023. Our May coverage discussed the BoE’s methodology and inputs at length, so we won’t rehash that here, but suffice it to say they mostly extrapolate recent conditions forward, which is a big reason why forecasts often don’t pan out. (Which, in turn, is part of the reason for the political kerfuffle over the BoE’s status, which we will turn to momentarily.)
The BoE could prove correct. Wage growth, while strong in nominal terms, has lagged inflation, and the patchwork quilt of tax credits and rebates hasn’t offset the headwinds of this spring’s tax hikes and spiking household energy costs. We could see a scenario where GDP grows steadily in nominal terms but shows as contraction once the inflation adjustment kicks in. That would represent a fall in living standards and, yes, recession. Plus, the yield curve spent the past two weeks ever-so-slightly inverted, and as we write, it is just barely positive. Couple that with slight falls in broad lending and money supply in June, and there is some indication conditions are tightening.
But tightening doesn’t mean a full-blown credit crunch. As the Monetary Policy Report also documented, banks haven’t passed the recent rate hikes on to depositors. This is a negative for households, as it means inflation erodes their savings’ purchasing power at a swift pace. But it also could keep banks’ net interest margins—the difference between their borrowing costs and loan rates—wider than the yield curve would otherwise imply, especially with mortgage and prime loan rates on the rise. The BoE’s decision to begin selling down its bond portfolio gradually this autumn, while widely viewed as tightening, should also support higher long rates and the yield curve, theoretically helping boost loan availability. That doesn’t argue for a rip-roaring expansion necessarily, but we think it builds a case for things going somewhat better than the BoE and most other forecasters presently expect.
Here is another case: UK stocks don’t seem to agree that dark economic times are in the offing. On a local currency basis, the US, eurozone and many individual eurozone nations have endured bear markets this year. UK stocks, as Exhibit 1 shows, haven’t. Instead, they had two near-corrections (sentiment-fueled declines milder than -10%) and, after a sharp rebound since July 5, are a mere -2.2% below their April high.[i] This July 5 low came after the BoE’s initial recession forecast, which most observers at the time called too optimistic. Plus, on the way down during that April 8 – July 5 pullback, the UK trailed global markets, with its more economically sensitive sectors and industries trailing—both consistent with markets pricing in expectations for an economic decline. Expectations haven’t improved since that trough, yet UK stocks are climbing—and, though we wouldn’t read into it, closed higher still on Thursday. No doubt some will argue stocks are ignoring recession risk, but we think that is nigh-on-impossible after over half a year of economists arguing the cost-of-living crisis would cause a recession. More likely, markets are confirming that the BoE’s credibility is shot and are assessing future conditions on their own—and seeing a reality that goes better than feared.
Exhibit 1: The Resilient UK Stock Market
Source: FactSet, as of 8/4/2022. MSCI United Kingdom IMI total return in GBP, 9/30/2021 – 8/4/2022. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
For now, this is good news. But longer term, it sets up the aforementioned risks. The BoE’s lack of credibility isn’t lost on the general public, the bank itself or—crucially—politicians. Current chief Andrew Bailey went on record this summer with the closest a central banker will ever get to a mea culpa for his institution’s recent history of defying its own forward guidance, not seeing the current inflation spike and generally being behind the 8-ball. That appeared to be aimed at heading off politicians from fiddling with the bank’s remit or revoking its independence, but it doesn’t seem to have worked. Foreign Secretary Liz Truss, widely presumed to have the inside track in the Conservative Party’s leadership contest, has campaigned on “reviewing” the BoE’s mandate. Several op-eds in Conservative-leaning publications have argued in favor of this idea and, in some cases, outright revocation of the bank’s independence. Truss’s statements could be mere posturing, but it wouldn’t be the first time a Conservative government responded to the public’s rock-bottom economic sentiment by undertaking a regulatory review. David Cameron’s government did it after 2007 – 2009’s global financial crisis, resulting in a multiyear inquiry and overhaul that, in our view, extended uncertainty over UK Financials and, given the sector’s outsized presence in the country, UK stocks overall. If Truss were to win and stick to her word in a meaningful way, we could see it ratcheting up uncertainty, which could weigh on returns.
Now, we aren’t saying all has gone perfectly at the bank, nor are we arguing its mandate to target 2% inflation over time is perfect. The enforcement mechanism, which amounts to the BoE Governor occasionally answering to Parliament and having to write a letter to the Chancellor whenever the inflation rate deviates from the target by more than a percentage point, hasn’t exactly borne fruit over the years.
However, simply raising the question of whether and how to change the current system introduces uncertainty. Investors will have to consider whether the BoE will start targeting nominal GDP instead of an inflation rate. Or whether the inflation target will change. Or whether its independence will end, making it an arm of the Treasury and fiscal policy, giving politicians undue influence over interest rates. Or or or! We have seen op-eds arguing for all of these, and we think all are ignoring some potential downstream risks, which is an article for another day, if and when a review zeroes in on a potential change. For now, the mere possibility of rising uncertainty is what matters, and we think it bears watching.
Not that we are picking a horse in the leadership fight, mind you—we aren’t. In our view, either contender has the potential to champion policies that could extend uncertainty and create winners and losers. It is part of the reason why we think intraparty gridlock will prove beneficial and lower legislative uncertainty. But a regulatory review often exists outside of this process and could even extend to a potential Labour government, depending on when the next election occurs and who wins. All of it would probably create a cloudy overhang for UK stocks. We don’t view this as outright bearish, but should the review progress, it would likely be a factor for relative returns and could weigh on British stocks relative to the rest of the world. So keep an eye out and watch this space for more.
[i] Source: FactSet, as of 8/4/2022. MSCI United Kingdom IMI total return in GBP, 4/8/2022 – 8/4/2022. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
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