UK economic resilience offers mixed outlook

Key takeaways

• We expect the UK to report slightly positive economic growth and avoid recession in 2023. However, inflation remains high and core prices continue to rise, justifying further interest rate hikes
• The BoE’s monetary tightening has not yet fully reached the economy. For now, we see rates rising from 4.5% to peak at around 5.5%, with no easing before mid-2024
• Many UK mortgages do not yet reflect higher borrowing costs and are poised to switch to higher variable rates in the coming months
• We maintain a neutral view on UK equities and sterling: over the next three months, we expect EURGBP to trade in the 0.8450 - 0.8650 range and GBPUSD around 1.25 to 1.30.

The UK economy is proving resilient, and its growth prospects have improved thanks to lower energy costs, more predictable fiscal policy, and better relations with its European Union trading partners. Nevertheless, the country faces stubborn inflation levels that continue to drive wage increases, making it unlikely that the Bank of England (BoE) has finished raising rates, nor will begin easing before mid-2024.

Expectations for the UK’s growth prospects have rebounded in recent months. As recently as January 2023, the International Monetary Fund (IMF) forecast that the economy would contract by -0.6% this year, the worst Gross Domestic Product performance among advanced economies. Instead, we expect that the country will avoid recession entirely to post slightly positive annualised GDP growth (in May, the IMF revised its growth outlook for the year to 0.4%). That still remains the weakest reading of any major economy, but is a remarkable turnaround.

Nevertheless, core inflation that excludes energy and food continued to rise, from 6.2% in March to 6.8% in April, underlining that the BoE has not yet finished its job in stabilising prices. Over the same period, headline inflation slowed to 8.7%, from 10.1%, including an 80% fall in energy costs since 1 December 2022. Food prices rose more than 19% in the year through March 2023, their fastest pace in more than four decades, according to the Office for National Statistics (ONS). On 13 June, responding to April’s data, BoE governor Andrew Bailey warned that inflation is “taking a lot longer than we expected” to decline. Mr Bailey said in May that the effects of rising interest rates “it still working their way through the economy.”

Given this, we see the BoE continuing to raise rates when policymakers next meet on 22 June. Further, we now expect the central bank’s benchmark rate to rise from today’s 4.5%, to peak perhaps as high as 5.5% later this year, with few prospects for any easing until mid-2024.

Rising mortgage costs, falling real wages

The effects of tighter monetary policy are also feeding into the UK’s mortgage market. The share of fixed-rate mortgages rose significantly in the aftermath of the 2007-2008 financial crisis. This has so far cushioned the impact of rising interest rates. However, in the UK and unlike markets such as the US, many mortgages are poised to revert to a variable interest rate (see charts 1 and 2), especially in the third quarter of 2023. By one measure, average new two-year fixed-rate loans are now at 5.9%. House prices fell by 1% in May compared with a year earlier, their first year-over-year decline since 2012, according to a report this month by Halifax, and reported by Bloomberg.

UK wages have been rising strongly as workers aim to maintain their purchasing power amid high inflation, higher mortgage costs, and a tight labour market. However, adjusted for inflation, real wages are still declining. While there is little sign of wage-price spiral, an overheated labour market is a key concern for the BoE, as it risks creating more persistent price pressures. Some signs of loosening have started to appear in the job market, as the number of unfilled vacancies has now fallen for eight months in a row; moderating wage growth is likely a necessary condition for a pause in monetary tightening.

Net arrivals

Labour market imbalances are likely to be alleviated by strong net migration into the UK. A record number of almost 606,000 immigrants arrived in 2022, more than double its average in the three years before the 2016 Brexit vote. Before the UK fully left the European Union in January 2021, almost half of immigrants were from the bloc. Since then, 80% of migrants have come from countries outside the EU. Arrivals from Ukraine explain around one-sixth of the net increase, while another 90,000 people arrived from Hong Kong, the ONS reports.

At the political level, the government of Rishi Sunak has worked to restore confidence after his short-lived predecessor’s September 2022 ‘mini budget’ that triggered a collapse in sterling and sovereign bonds. The prime minister has also sought to improve relations with the EU, through the ‘Windsor Framework’ agreed in February 2023, which attempts to clarify Northern Ireland’s trading position between the UK and European single market.