Spring hope sees UK evading recession

Key takeaways

• The UK is narrowly expected to avoid recession in 2023, and inflation is expected to fall sharply by year end
• The Spring Budget contained some growth-friendly measures, but more work is needed to fix labour market issues, low productivity and investment, and falling living standards
• For now, we see the Bank of England’s rate-hiking cycle peaking at 4.5% in May
• We see downside risks for sterling this year. We are keeping a balanced exposure to equities – including UK stocks – in client portfolios.

Despite the recent strength of inflation, UK interest rates look close to peaking and the economy should avoid recession this year. Politicians face tough challenges on raising living standards, boosting productivity and getting people back to work, but the outlook has brightened in recent months.

The UK’s economic prospects are looking up. On 22 March, Bank of England (BoE) Governor Andrew Bailey said he felt ‘more optimistic’ on the outlook, even after the Bank raised interest rates to a 14-year high of 4.25%. In mid-March, updated forecasts from the independent Office for Budget Responsibility (OBR) showed UK growth contracting just -0.2% this year (we estimate 0%), up from the -1.4% it expected in November. That would mean no ‘technical’ recession, defined as growth falling over two consecutive quarters. The OBR now sees inflation falling to 2.9% by year-end. It also expects Chancellor Jeremy Hunt to meet his own fiscal ‘rule’ of reducing net debt as a percentage of GDP over five years, although only just.

The September 2022 ‘mini-Budget’ proved disastrous both politically and for market confidence in the UK, with a rout in sterling and sovereign bond prices. In contrast, the Chancellor’s 15 March 2023 budget, the annual outline of economic strategy, was received calmly. Much of the good news on growth and inflation was due to factors beyond the UK’s control, chief among them a sharp fall in energy prices. Lower gas and oil prices reduce the cost of the government’s extended support for household energy bills, while falling bond yields in recent months have cut the Treasury’s bill from interest payments. Meanwhile, the rise in the OBR’s long-term growth forecasts (1.8% in 2024, 2.5% in 2025) are a result of improving labour supply, mostly from higher net immigration.

Growth-friendly measures

An improving growth and inflation picture gave the Chancellor room to announce tax cuts and spending increases, which are largely being targeted in a growth-friendly way. Plans to boost labour market participation include extending a scheme of 30 hours a week’s government-funded childcare for three-year olds to younger children. The OBR believes this could bring 75,000 more people into paid work. More emphasis was also placed on encouraging retirees and those on universal credit back into employment.

Meanwhile, plans to raise investment include new allowances for large companies to offset capital spending against their tax bill. Tax-free annual allowances for payments into pensions were raised, and a lifetime cap on the amount that can be contributed before having to pay extra tax abolished. The government hopes this will help keep older workers, mostly in healthcare, practicing for longer. More defence spending and support for artificial intelligence technologies should also help growth.

Stability or stagnation?

However, many of the Budget measures are only temporary or partial solutions to some very pressing problems. A lack of childcare alone does not account for the UK’s large numbers of ‘economically inactive’ people. Around 600,000 workers have been ‘lost’ since the pandemic, and 2.5 million people are out of work due to long-term sickness. But the Budget had few new measures to help the healthcare system, where long waiting times for treatment and cuts to mental health services could be thwarting efforts to get people back to health and employment.

While tackling chronic public and private sector underinvestment is also much needed, new investment allowances are only planned to last three years. Companies are thus likely to simply shift investment plans forward, rather than increase them permanently. Plans to boost economic productivity require long-term commitments, such as those laid out in the US Inflation Reduction Act or the EU Green Deal. A February report by an influential group of academics, policy advisors and former politicians had suggested bolder investments in science and technology, and reforms to pension schemes that would raise their very low investments in UK listed and private companies.

A limited recovery forecast post-2023 shows the UK economy continues to lack dynamism, while the cost of living crisis – also the source of many of the UK’s ongoing pay disputes – continues to bite. Household incomes, adjusted for inflation, are forecast to fall 6% this year and next, and living standards will not recover to pre-pandemic levels until 2027, the OBR forecasts. Meanwhile, the tax burden as a share of GDP is set to rise to a post-World War II high.