The UK economy is going to shrink in 2023, according to the Office of Budget Responsibility, the Bank of England and most economic forecasters. Despite Government support for households on paying energy bills, the ‘cost of living crisis’ – with pay rates rising by less than inflation, means consumers – particularly those on lower incomes – are going to feel the squeeze.
Higher interest rates, and higher mortgage rates for those rolling off low-cost fixed rate deals born of the zero-interest rate era, will place further pressure on household finances. Housing transactions will be fewer – a traditional driver of major ticket item sales – and house prices are likely to drift lower from recent peaks by around ten percent.
But this recession is going to be different from previous ones, likely to be shallow but lengthy rather than deep. The labour market remains strong, with many small businesses struggling to fill vacancies. Large companies have been giving employees semi-annual pay rises not annual, together with loyalty bonuses and spending vouchers. They are not going to flip overnight to firing workers they have been desperate to retain, meaning employment should remain high.
Consumer balance sheets are in good shape – with the usual sad caveat about the extreme difference between the ‘haves’ and the ‘have nots’ – as enforced savings and debt repayments during the pandemic mean in aggregate, we enter a downturn without a worrying debt overhang.
Corporate balance sheets are equally reassuring, as companies raised equity capital where needed during the pandemic, so corporate failings through excessive debt are unlikely to be a feature of this downturn – unlike in the 1990-92 recession, coming after the Lawson boom of the late 1980s.
The excess debt this time lies with the Government’s balance sheet, the result of support schemes during the pandemic and now for energy bills, the seemingly inexhaustible funding needs of the NHS and, increasingly, debt service costs on Government debt as interest rates rise or as a consequence of inflation-linked interest payments.
Government debt is a reason why the headwinds to the UK economy are likely to be prolonged. Frozen or reduced tax allowances on incomes, dividends and capital gains at a time of inflation-driven pay increases will push more people into paying higher rates of tax than ever before. Moreover, this effect will build cumulatively over time if the freeze is maintained as the Government intends over the next five years.
Even if there is a change of Government in two years’ time, an incoming Labour Government would face the same fiscal challenges and may well stick with the existing plans to address them, as they did on electoral victory in 1997 through continuing with Chancellor Ken Clarke’s spending plans. No doubt they would place even greater tax burdens on ‘those with the broadest shoulders’, but there is no scope for a spending bonanza irrespective of who is in power.
As a result, the UK economy in 2023 will experience a curious mix of Government support for pensioners and energy users, skewed to the less well-off next winter, rising interest and mortgage rates but a limited rise in unemployment – that traditional source of intense hardship during a recession – modest falls in house prices and some continued growth in wages, albeit with increased taxes on them.
Inflation will determine how high interest rates rise, as well as wages and Government debt interest costs. Without further strength in energy prices – might 2023 see a negotiated end to the conflict in Ukraine? – inflation will be falling during 2023. Given the fiscal tightening the Government has outlined, the Bank of England will do its utmost to raise interest rates slowly. It will seize on falls in inflation to temper its increases and will stop even if inflation is still considerably higher than its 2% target, not wishing to add to the headwinds to activity unduly. Monitoring the evolution of economic data in a measured way will be its watchword.
Bond and equity markets have suffered together in almost unprecedented simultaneous losses in 2022. This the necessary unwind of a bubble induced by maintaining zero-interest rates for too long, alongside expansion of the money supply through Quantitative Easing and Government support schemes through the pandemic. The US Federal Reserve’s belated move to restore a positive interest rate – although less so in real terms – has unwound excessive valuations of both bonds and equities.
The good news is that the unwind has been substantial, with US ten-year Treasury bonds moving from a low in yield terms of 0.5% to around 4%. (Bond prices move inversely to yields.) It is unlikely to rise another 3% from here, so the bulk of the valuation adjustment should be behind us.
Further positive news is that the UK equity market has so materially underperformed other equity markets in recent years – a result of Brexit, a value bias to unpopular sectors and persistent net selling – that it sits on valuation levels from which further material declines are unlikely, in my view. In historical context, UK equities look very attractively valued.
The less good news is that the same cannot be said for Wall Street, which remains highly valued by historic standards despite the scale of falls in highly-rated growth stocks so puffed up in the bubble period. Further derating on Wall Street looks inevitable, even though animal spirits are keen to revive on any ‘pivot’ by the Federal Reserve to stop raising interest rates.
UK equities are unlikely to be immune to any further falls on Wall Street, even if our valuation suggests you are pushing down on a spring likely to bounce back fairly rapidly. Investors will be scrutinising how well their companies navigate the hard yards ahead, but having come through the pandemic, management teams are experienced in overcoming headwinds both of demand and the cost of supply.
After a tough year for investors in 2022, there is much to be constructive about for 2023, irrespective of those very visible headwinds.
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