Is the party over for post-Jubilee Britain?

It appears that the UK’s post-pandemic bounce back is now decisively behind us.

While it may be true that national GDP has recovered to it pre-pandemic levels, the momentum of the recovery has waned in the face of the global energy price shock, inflation reaching 40-year highs, and Britain’s exposure to worldwide supply chain issues.

The UK’s GDP grew by 0.5% in May[1], which may appear a cause for celebration – but month-by-month figures can obscure longer-term trends and become distorted by events.

For example, May’s figures were propped up by including an extra working day thanks to the pushing of the spring bank holiday to June to synchronise with the Queen’s Platinum Jubilee. June’s two bank holidays, while enjoyable for all who celebrated them, are all but certain to significantly depress the data.

As a result, it’s now very likely the second quarter of 2022’s readout will be negative, but we anticipate a return to positive territory in the third quarter as the country returns to ‘normality’.

Gathering clouds

Regardless of the month-by-month fluctuations, it’s clear that UK is facing multiple structural issues that, in our view, threaten to slow growth.

Against an overall inflationary picture, the energy regulator’s cap on consumer prices is set to again rise in October, triggering a rise in utility bills that will eat into consumers’ wallets at a time when wages are failing to keep pace with prices.

At the same time, the Bank of England’s recent rate hikes are starting to bite, with its credit conditions survey for the second quarter indicating signs of modest tightening, most notably in the availability of mortgage credit[2].

Meanwhile, the labour market has shown signs of significant strength, with strong employment gains. However, it looks as though job vacancies have peaked; indeed, the weekly data we track shows a marked downturn, as we can see below:

Furthermore, business confidence has weakened.

Investment is currently languishing at levels substantially lower than those seen just before COVID, contributing to a gloomy picture for growth in the short- to medium-term. At the same time, the UK’s post-COVID levels of investment lag substantially behind both the US and its European peers:

Looking to the future, fiscal policy remains one of the greatest wild cards.

While we won’t get much clarity in this regard until the Conservative Party’s leadership contest is over, many of the current candidates are pledging tax cuts that run the risk of adding to the British economy’s already brutal inflationary dynamic, and in turn prompting even more interest rate hikes from the Bank of England.

A recession, then – but when, and how bad?

When thinking about how deep a recession we will see, it is important not to allow our perceptions to be anchored by our most recent experiences, especially as the pandemic-induced recession of 2020 was both exceptionally severe and in highly unusual circumstances.

Typical UK recessions in the post-war era tend to see a peak-to-trough fall of around 2-6% , as we can see below:

Our base case at LGIM is that, like the rest of Europe, the UK faces a recession at the turn of the year.

Given the huge amount of uncertainty surrounding energy prices, inflation and fiscal policy, it is hard to precisely anticipate the severity of this recession. However, we expect it to be relatively mild compared to others in recent history as interest rates are rising from low levels and consumers still retain a substantial quantity of COVID-era savings.

This outlook means the Bank of England is faced with a tricky balancing act but getting inflation – and inflation expectations – lower will all but inevitably mean more rate increases in the coming months, which are, in our view, likely to continue into early next year.

Then, as the recession becomes more visible in the data and peak inflation passes, the Bank will likely be forced to stop hiking for fear of triggering a deeper recession than would otherwise take place. This scenario would lead to a retrenchment in demand that would then reduce the medium-term inflation outlook to below its ‘normal’ target of 2%.

So, the overall picture suggests that while the UK faces a difficult winter, this recession will most likely be milder than those we have seen in recent years. Whether policy measures can be taken to help the UK's poor investment and trade performance remain to be seen.

[1]https://www.ons.gov.uk/economy/grossdomesticproductgdp/bulletins/gdpmonthlyestimateuk/may2022

[2] https://www.bankofengland.co.uk/credit-conditions-survey/2022/2022-q2#:~:text=Lenders%20reported%20that%20the%20availability,Q3)%20(Chart%201).