UK buckles up for storms ahead

14 November 2022

Henk Potts, London UK, Market Strategist EMEA

  • Political uncertainty, a cost-of-living squeeze and dire business sentiment are all conspiring to plunge the UK economy to the brink of recession
  • Inflation has jumped to multi-decade highs amid soaring food and energy prices, although there are some signs inflationary pressures could be easing – and the worst may now be behind us
  • Despite the raft of gloomy economic data, the labour market remains a bright spot. That said, strong growth in wages exerts more pressure on the Bank of England to lift interest rates
  • Nevertheless, a mild recession may yet be inevitable – although the resilient labour market, smaller exposure than eurozone countries to an energy shock, and a potential housing market downturn (rather than a crash) should all help to limit the downside risks

After an unforgettable year for UK politicians and investors, as the economy dives into recession and the third prime minister of 2022 gets his feet under the desk, the next 12 months could be just as blustery. 

Wilting economic data, political turmoil, and policy confusion encourage us to take a much more pessimistic view on the UK’s growth prospects. 

The post-pandemic recovery is rapidly fading and the cost-of-living squeeze is becoming more pronounced. September’s disastrous mini-budget has led to a tightening of credit conditions and the Bank of England has been forced to ratchet up interest rates to fight the fastest rate of inflation in 40 years. 

After being one of the fastest growing top-ten economies in 2022, the country now looks set to contract next year (see table).

Services and manufacturing being squeezed

The UK economy shrank in August and a raft of indicators has added to the evidence that it is in a recession. 

October’s S&P Global Purchasing Managers Index (PMI) survey revealed that both services and manufacturing are contacting (see chart). The combined composite measure fell to a 21-month low of 47.2 from 49.1 in September, being below the 50 neutral line for three consecutive months1.

The service economy lost ground (47.5) for the first time in 20 months and at the fastest pace since January 2021. While the measure for construction output (52.3) expands, helped by strength in house builders, civil engineering has weakened and orders on builder’s books have fallen to a 2.5-year low. 

Business confidence in the future has diminished at a rapid rate. The slump in the new orders, backlog of work, and export demand has helped to reduce business expectations to its lowest level since the global financial crisis (excluding the COVID-19 lockdown period in 2020). 

Weaker household demand

Rising prices of goods and the squeeze on discretionary incomes have hit household demand. Cautious consumers are starting to save more, reducing the rate of consumption. Retail sales dipped 1.4% in September, following a fall of 1.7% in August. Retail sales remain 1.3% below February 2020’s pre-pandemic level. 

The combination of rising energy, food, and borrowing costs has been a drag on consumer confidence. Over the past couple of months, the GfK consumer confidence survey has been languishing down at its lowest levels in nearly half a century2.

Consumers have become particularly cautious about buying big ticket items, including properties or cars. We expect that shoppers will remain very cautious over the next year with private consumption contracting by 0.4% in 2023 rather than the impressive 5.1% growth registered this year. 

Service sector rebound is over

High demand for travel, leisure, and tourism following the end of COVID-19 lockdowns has helped to propel the services sector over the past year and half. That bounce back has now ground to a halt as households slash their spending. Data from the Office for National Statistics show that output in consumer-facing services fell by 1.8% in August, including a large drop in arts, entertainment, and recreation3

Labour markets a rare bright spot

Despite the weakening economic backdrop, UK labour markets have remained robust. Unemployment fell to 3.5% in the three months to August, the lowest rate since February 19744

The rise in job vacancies to record levels is a further signal of the tight labour markets. That said, both the unemployment rate and vacancy levels are flattered by the higher levels of inactivity plus the reduction in the supply of labour following Brexit.

Rising wages have helped to cushion some of the demand for goods and services. Growth in average total pay increased by 6% year-on-year (y/y) in the three months to August5. However, in real terms (adjusted for inflation) pay fell 2.4%, one of the largest such declines on records that began in 2001. 

The weakening economic backdrop and more cautious employers should exert some downward pressure on labour markets over the next year. We forecast that unemployment will gradually rise through 2023, with UK unemployment finishing next year at 5.2%. 

UK housing market

Elevated prices and rising mortgage rates have begun to take their toll on the housing market. Lenders have been withdrawing products, particularly on high loan-to-value mortgages. The average rate for a two-year fixed mortgage has risen above 6%, the highest since November 2008 . 

UK house price fell month-on-month for the first time since the pandemic in October. The 0.9% decline was the first since July 2021 and the biggest decrease since June 2020, although the annual pace of growth still remained a relatively robust 7.2%, according to data from the Nationwide6. A cooling of conditions is also evidenced by the decline in mortgage approvals and reduction in new buyer enquires. 

Whilst we would expect house price growth to ease over the next year, we do not anticipate an aggressive correction in home values. The impact of rising mortgage rates will take time to filter through to higher payments. 

Since 2018, 90% of property purchases have been through fixed rate mortgages. From 2014, a more stringent affordability regime has been in place to ensure borrowers are tested against a higher interest rate environment. 

The UK housing market should continue to be underpinned by the structural supply and demand imbalance. Meanwhile, the weaker pound should encourage international investors.

Sustainable finances

The government’s mini-budget in September, that was structured around a series of un-funded tax cuts, sent a shockwave through UK assets, as investors questioned the sustainability of the nation’s finances. 

In his first week in office, Chancellor Jeremy Hunt reversed all the permanent tax cuts except for those that were mid-legislation (the reversal of the 1.25 pence in the pound National Insurance Contribution rate increase and changes to Stamp Duty Land Tax). He also cancelled the 1p reduction in the basic rate of income tax. These measures have clawed back around £32 billion of the £45 billion giveaway. 

Alongside the hole in the public finances made by the mini-budget, additional pressure on the UK’s fiscal position have been created by the deteriorating growth profile, rapid rise in interest rates, and higher cost of servicing inflation-linked debt. 

In order for the government to restore fiscal sustainability and bring the deficit back down to 1–2% of gross domestic product, we estimate that additional tax increases or public spending cuts worth around £30 billion will be needed. 


September’s UK inflation report showed consumer prices rose to 10.1% y/y. The acceleration back into double digits, matched the 40-year high in July and was slightly ahead of consensus, as was the core reading at 6.5%. The contributing factors were broad-based and were led by food (14.8%) and hospitality (specifically accommodation). 

Services inflation continues to strengthen with few signs that weaker activity over the summer is deterring companies from raising prices. Short-term inflation will continue to be driven by food and to a lesser extent housing and miscellaneous goods and services. 

The key to understanding the medium-term inflation profile will be the trajectory of energy prices and the development of the Energy Price Guarantee Policy. Chancellor Hunt pledged that the policy will be reviewed in April 2023 and become more targeted.

If energy prices do revert to the historical Ofgem formula, we would expect inflation to be back above 10% in April and stay above 7% through 2023. 

Under this scenario, inflation would be, on average, 3.6 percentage points higher next year than if the price guarantee was maintained at current levels through 2023. Any extension of support to mitigate energy bills would help to ease price pressures, but could simultaneously result in an increase in demand expectations. 

Path of policy

The Bank of England has had a particularly difficult task in assessing the appropriate level for rates. Beyond the obvious challenge of double-digit inflation, the Monetary Policy Committee (MPC) has also had to digest the turmoil in UK financial markets and wild gyrations in government policy. 

With a struggling economy, tighter fiscal stance, and taking into consideration that base rates are already in restrictive territory, we believe that policymakers will conclude the hiking cycle at December’s meeting. 

After delivering a bumper 75 basis point (bp) increase in November, we expect a final 50bp increase at the end of the year, leaving the terminal rate at 3.5%. However, given the vast amount of economic and fiscal uncertainty, we should acknowledge that risks to rates still remain skewed to the upside. 

Prolonged recession beckons

Given the multitude of pressures on the UK economy, we think that a deeper and more prolonged recession is inevitable. We expect that the economy will register five consecutive quarters of negative growth, starting in the third quarter of 2022. 

We forecast that the recession will generate a peak to trough decline of -1.6%. For calendar year 2023, we predict that real GDP will contract by 1%, followed by only a sluggish recovery (0.7%) in 2024.

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