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Our views 16 January 2023

JP's Journal: Looks like I am wrong

5 min read

Looks like I am wrong. I had been expecting the fourth quarter of 2022 to confirm that the UK economy had entered recession. But the data out for November shows that the economy grew a bit in the month. It would now take a big decline in December to see negative output in Q4.

So where have been the surprises? Services were stronger than predicted, with admin and support services going well. Consumer services, in particular food and beverages, also beat expectations. Conversely, manufacturing remains weak, with industry taking little comfort from the weakness of sterling. Let’s be clear here: leaving the EU and the botched negotiations have harmed UK trade. The sunny uplands of trade agreements that would come our way in a post Brexit world have not materialised. It is now time for the serious politicians to sort this out.

But the better than expected GDP data does not change my downbeat view on UK growth. There are four ‘horseman’ out there. First, the squeeze of real consumer disposable income. The World Cup may have spurred more consumer spending on food and beverages but, from a January perspective, the Messi magic seems a while ago. Yes, energy and some commodity prices (including food) have declined significantly, but the impact on spending power is still working through. Second, interest rates have gone up and will go up more; negative equity and mortgage defaults will follow. Third, fiscal policy is tightening. Admittedly, the pain has been postponed a bit but the direction of travel is clear: taxes are going up. Finally, the baby-boomers are retiring and will stretch healthcare and social care services.

If we look at what the government spends on our behalf, we see there are three big chunks: welfare, healthcare and education. Add in the rising burden of debt interest payments, courtesy of higher rates and Retail Price Index uplifts, and it is unclear how we easily square the circle of providing acceptable key services whilst maintaining a competitive economy which, fundamentally, will be the source of future prosperity.

Maybe I have become too gloomy. So, let’s look at some upside surprises for 2023 that may derail my pessimism. First, China has the capacity to surprise. A re-invigorated economy, coming to terms with Covid, could provide an engine for growth; if economic patterns are repeated, we could be looking at growth upside here, albeit with a potential downside of higher commodity prices. Second, the US could achieve a soft landing, taking pressure off global interest rates. Third, a resolution in Ukraine may lead to a collapse in energy costs. It is also possible that lower inflation and rising wages reverses the squeeze on disposable income and that better relations with the EU are established, resulting in reduced trade barriers. So, there are no shortages of things that may go right. It’s just that, on balance and at this time, I find the pessimistic case more convincing.

Bond markets were again in upbeat form last week. Sensing a soft landing in the US we saw 10-year yields moving to 3.5%. This trend was mirrored in other major markets. UK 10-year yields ended at 3.35% and Italy saw yields nudging 4%. The soft landing scenario was also reflected in credit markets. At the moment, global markets are pulling off a neat trick. Government yields are lower because inflation is falling and growth is moderating whilst risk assets (equities and credit) are benefitting from lower government yields and no major perceived threat to corporate earnings. Can this be sustained? Perhaps yes, given the right outcomes of lower energy, food and wage costs, combined with a growth pick-up in China. But my view remains that soft landings are more talked about than actually witnessed.

US inflation data did not really provide much insight last week; Consumer Price Index was in line with expectations, falling to 6.5%. There were further big falls in the used cars and trucks prices but the shelter component rose, pushing up service inflation. Where does that leave the Federal Reserve (Fed)? Markets are pricing a peak of Fed Funds at around 5%, which has been the case for some time. What has changed recently is the profile in H2 2023: pricing indicates that rates are cut with about -75bps now expected in the second half. In the UK there is a much flatter profile, with a peak around 4.5% and a -25bps move in H2.

Let’s end on some good news. My nomination for bond manager of Q4 2022 goes to the Bank of England which made a nifty £4bn profit on its well timed intervention in the gilt market post the Liability Driven Investment inspired sell-off. A pity about its three, five and ten year record though.


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