New year, new stories?

2023 still looking like a tough year for the UK economy

Monthly GDP figures for November were unexpectedly in positive territory, leading to a strong possibility that the UK narrowly avoided recession at the end of 2022. However, while such an eventuality may lead to some temporarily positive news headlines, it would only show the UK economy flatlining, and fundamentals arising from the high inflation and rising interest rate environment mean the central case for 2023 remains for the UK to enter into a period of economic contraction, albeit a shallow one.   

UK households have been much less willing to use the excess savings accumulated during the pandemic compared to households in many other developed economies, and there is every reason to suggest that UK consumers will remain cautious over 2023. Over 1.4 million households’ fixed-rate mortgages will end this year, leading to a huge squeeze on the disposable income of those affected, while recent readings for consumer confidence and retail sales by volume have registered well below expectations. Many businesses may start tapping into their savings but this will often be simply to cope with higher interest payments: around three quarters of business loans are floating rate, making it pressing for many corporations to prioritise debt repayment. This, of course, does not bode well for any prospects of a resurgence in business investment in 2023, especially as the composite PMI is already registering below 50 (which indicates contraction). It is notable that both household and business indicators continue to suggest the economic outlook for this year remains very challenging (see Figures 1 and 2) . 

The Bank of England’s (BoE’s) Monetary Policy Committee (MPC) will meet for the first time this year on 2 February. Rate-setters will be pleased to see that y-o-y headline CPI inflation has now fallen in two consecutive months, dropping from its peak of 11.1% in October to 10.5% in December. However, the core inflation print – which remained at 6.3% in December – will maintain pressure on the MPC to act, especially as nominal wages continue to register high readings despite there being tentative signs of labour market loosening. Annual average pay awards for September to November 2022 came in at 6.4%, up 0.2pp from the previous month, with more timely PAYE data suggesting the figure is above 7%. While still representing significant falls in real terms, these levels of nominal pay would not be consistent with the BoE meeting its 2% inflation target. There also remains a major discrepancy between yearly pay increases of the private and public sector, which have risen by 7.2% and 3.3% respectively for September to November. Public sector pay awards are likely to increase further, and continuing strong growth in broader nominal wages means that core inflation, especially the services component of it, will probably remain stubborn over the course of 2023. In light of this backdrop, we maintain our view that the MPC will likely increase interest rates by 50bp to 4% in February in order to address potential domestically-led inflationary pressures.

Source: Macrobond

Daniel Mahoney, UK Economist

With the next major central bank meetings not scheduled until February, the focus as the new year begins remains on incoming data, namely on the labour market and inflation. Markets have started the year optimistically, buoyed by further signs that inflation is on its way down, coupled with the aggressive reopening underway in China and hopes that any global recession this year may not be as bad as originally thought.

From the point of view of the central banks, the above may prove slightly contradictory as the year goes on. Yes there are signs that inflation is falling, annual inflation in Europe dropped more than expected to 9.2% in December mainly off the back of a big fall in energy prices, and output prices from the PMI and ISM surveys are still falling, pointing to a further reversal of the supply side shock seen over the past couple of years – indeed the US ISM Prices Paid index fell to 39.4 in December from a high of 92.1 in June.

China’s reopening may throw a spanner in the works for global inflation, if the reopening leads to a sharp increase in demand for commodities. Many argue that the oil market is not fully discounting this risk, with Brent crude trading at $80 a barrel, and therefore we may see some upward pressure as the year develops – this is indeed the view of Goldman Sachs. Morgan Stanley has also dropped its prediction of a recession in the Eurozone this year, perhaps a brave call, but nonetheless an interesting one. The premise of that may be down to the significant drop in gas prices we have seen over the past month, where prices in Europe and the UK almost halved. Reduced demand and warmer weather have allowed prices to drop to EUR 65 per MwH and 180 pence per therm respectively. This will undoubtedly help the inflation picture, but only with a lag as utility prices are more rigid, and this assumes that prices don’t move higher again which cannot be ruled out. Even if this does materialise and the economic outlook looks much brighter, the improved demand picture could act as another counteracting balance to lower inflation.

This is all very uncertain, so central banks can only focus on the data in front of them, and ultimately tight labour markets and subsequent wage growth still remain the key concerns for officials -evidenced particularly by the European Central Bank which released a paper on significant wage growth ahead. UK wage data from November also surprised to the upside, with 3m/YoY average wage growth including bonuses hitting 6.4%.

The US payroll data for December, released in January, showed a strong gain in payrolls coupled with waning wage growth as monthly hourly-wage growth slowed to 0.3%. US inflation also slowed for a third consecutive month, with the annual core number dropping to 5.7%. The monthly figure is still too high at 0.3% to be in line with inflation coming back to target (ING bank estimates this figure is 0.17%) but is encouraging, as well as the fact services inflation also seems to be slowing.

This is positive, but the Federal Reserve will want still further evidence, even if it can reduce the pace of hikes. On this note, we can’t ignore that some of this continued ‘hawkishness’ might be tactical, in order to stop financial conditions loosening more than central banks deem necessary, but given the extent of the inflation shock, you can understand the cautiousness.

The same themes all matter for the Bank of England too, but the BoE now sit as one of the most dovish, especially with the split seen in the December meeting. We have heard familiar comments from chief economist Huw Pill and Catherine Mann so far this year and the soundbites remained of a hawkish tone, reciting previous stances such as the need to act “forcefully” if necessary – but this has been ignored by the market. One positive though is that the BoE’s active selling of bonds from its portfolio is going rather well, with strong demand in early Jan for longer-dated bonds it purchased during September’s turmoil. 

Where and when do markets expect the peak in rates?

In the case of the BoE and Fed, we are approaching the end of the cycle. What is interesting is that we have opposing scenarios: the market expects the BoE to hike by more than the central bank itself suggests, whereas markets expect the Fed Funds rate to peak at a lower level than what the Federal Reserve is forecasting.

For bank rate, the market still sees the peak at around 4.5% (buoyed by stubborn wage growth), suggesting that we will see bank rate rise by another 1% between February and June. The market  sees a 50 basis point rise at the next meeting, and a cumulative 75bp rise over the next two, before a final hike in the summer. For the Federal Reserve, the market is pricing in two 25bp hikes in February and March, with a risk of no hike at all in March – indicating the Fed Funds rate upper band will settle at either 4.75% or 5%.

The desk view here for the pathway of the Federal Reserve is broadly similar to market pricing, especially after recent poor data from the US (retail sales, industrial production). For bank rate however we lean more towards the view of our economists in that we will see the peak at 4%. Again there is some debate about whether we will see two consecutive 25bp moves or one last 50bp and hold, which is the economists’ view. Either way we see the peak in rates earlier and lower than the market.

The doubling down of the ECB’s hawkish stance in December saw a significant readjustment in implied rates, and we look set for at least two more 50bp hikes with the potential for one more 25bp hike taking the Deposit Rate to 3.25% in April, although market pricing suggests the peak may come in June/July. Some reports, citing ECB sources have indicated the ECB could pivot lower in March, but officials have played this down on the news wires.

Chance of cuts this year?

This is without doubt the key topic heading into 2023, especially with some aggressive market calls for the latter part of this year and next. More action is expected on the other side of the Atlantic with 50bp of cuts priced in for the latter half of 2023, effectively counteracting the 50bp worth of hikes expected in Q1. However in 2024 the Overnight Index Swap market is pointing to a near further 150bp worth of cuts, taking the Fed Funds rate to between 3% and 3.25%.

The market expects rather little change from the Bank of England, seeing only a 50/50 chance of a 25bp cut late in 2023. From our perspective, given that we do not see rates reaching the levels implied by the market, we do not expect any rate cuts from the Monetary Policy Committee in 2023. In fact, we do not see any cut to interest rates until early 2025, on the basis that inflation will fall but only gradually, warranting rates remaining on hold during 2024 too – this contrasts with the market view that we will see a cumulative 75 basis point fall from the peak by the end of 2024. 

Looking beyond that, we do agree with the market that rates will remain above what is said to be neutral, around 2.5%. The market sees bank rate at between 3 and 3.25% at the end of 2027. Looking at swaps, put simply a rough average of where bank rate over a given timeframe, the 5-year and 10-year swap rates are trading at 3.75% and 3.45% respectively, implying rates will be above neutral for a long period of time – but we know this can change quickly!

What could surprise us?

The above mentioned developments in China and commodity markets form part of this answer, as well as the obvious positive or negative escalations in the Russia-Ukraine war. Other areas to watch include how far central banks who are playing catch up are willing to go - this refers not only to the European Central Bank but perhaps more importantly the Bank of Japan. We noted in the last Rate Wrap that there was shift in policy in December, where the BoJ increased the tolerance band for 10 year bond yields moves to plus-or-minus 50 basis points, from 25 previously. More is expected to come in April when the term of current governor Kuroda ends, and is likely to be replaced by someone with more hawkish views. The tilt in the makeup of the BoJ may also be coupled with a change of the mandate, which is expected to be reviewed around a similar time. A significant shift in BoJ policy, at a time when the Federal Reserve is flat-lining (or even loosening policy) may make things complicated, especially as Japanese investors are significant holders of foreign bonds. If Japanese bonds start to look more attractive relative to elsewhere, Japanese investors may further switch to buying domestic bonds (they are already to a degree), leading to falls in the value of foreign bonds and therefore increasing the yield. The ECB and BoJ will have a tough decision to make if they find themselves at odds with the Fed.

This ties into another risk which is just general policy errors. Whether it be forecasting, managing the balance sheet, communication – all have the potential to spook markets at some point. Let’s see what 2023 brings!

Cameron Willard, Capital Markets

All data in this article, unless otherwise stated, is sourced from Bloomberg