JP’s Journal: Disappearing recessions

Those who have read my weekly Journal over the last few years will know that I am pessimistic on the UK growth outlook. I thought we would be in recession by now: a combination of tighter monetary policy and an energy shock. But we are not.

The latest GDP data shows that the economy grew by 0.1% in Q1. Consumer spending was broadly flat but business investment came in stronger, offsetting the drag from lower government spending. The March monthly figure was a bit lower than expected, with service activity under pressure. Overall, the UK economy has barely grown since late 2021, but this is better outcome than expected by the Bank of England (BoE) only six months ago.

Turning to the BoE, they have become more positive on the UK growth outlook. They are no longer expecting a recession and have raised their growth projection for next year by 1%, although this only implies 0.75% growth. In essence, the labour market has proved to be more resilient than expected which has kept demand above forecast levels. Maybe the more upbeat assessment sugars the pill of higher interest rates.

The BoE duly delivered the expected 0.25% Base Rate increase, taking it to 4.5%. The accompanying message was that inflation will take longer to get to target (consumer price inflation at 2%) although they still see inflation well below this level on a two-year horizon. My take is that the tone was more hawkish than expected with an emphasis that the risks around the inflation were skewed to the upside, reflecting the possibility that wage inflation and food prices may take longer to unwind than these did to emerge. The Governor also took the opportunity to admonish the BoE’s Chief Economist for his choice of words about the need for pay restraint – whilst endorsing the sentiment. Cakeism is still alive and kicking it seems.

Consensus interest rate expectations

If we look at rate expectations a pattern is clear. In the US, market pricing implies that rates have peaked. The first to start the rate hiking cycle is the one most likely to be at a turning point. With Federal Funds now in the 5-5.25% range, markets imply a 1% reduction by March 2024. In the euro zone, the message is that rates have further to go up. Somewhere between 3.5% and 3.75% is being priced, implying one or two more 25bps hikes. In the UK, a similar picture emerges, one or two more rate increases are expected. But in both the eurozone and the UK, pricing indicates that in March 2024, rates will be back to where they are now.

A look at markets

It was a mixed week for bond markets. In the US 10-year yields ended below 3.5%, about 0.5% lower than the level seen in early March. The trend in US real yields is a bit different. Although yields fell last week, the 30-year yield is similar to the level prevailing in March. Looked at another way, implied inflation has fallen in recent week with the present level around 2.2%. In the Euro area nominal yields were broadly unchanged whilst in the UK rates edged up – continuing the trend of UK government bonds underperformance. Inflation is the key here – either investors are less convinced about the prospect of UK inflation coming down than the BoE or there is some thought that higher inflation will be tolerated in the medium term.

In credit markets investment grade markets continued to be well behaved. There was little change in credit spreads despite signs of renewed weakness in the most subordinated bank debt. My bellwether indicator – the recently issued Barclays 9.25% AT1 – ended the week at around 12% yield. High yield markets remained subdued, with spreads wider.

Across markets the message is that rates are nearing a peak, the damage of higher energy costs has been well contained and consumers have shown resilience. On the corporate front, banking problems have been managed and earnings have come in better than expected.

Am I reversing my recession call? Not yet, as I still think that the tightening of monetary policy has not fully been felt. Trouble in the US banking sector has worsened financial conditions and I am unconvinced that business confidence will continue to rebound. We will see. From my perspective it is too early to celebrate a near escape.

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