UK Outlook: Stronger near-term prospects but challenges remain

Key points:

• The global economy has begun 2023 on a stronger footing than we had expected. Rates markets now price a higher peak for longer.
• UK growth is likely to slow further in 2023, driven by high inflation and slowing demand – but the downturn is likely to be shallower than initially expected and business surveys have been somewhat more positive.  
• Price pressures have begun to ease meaningfully, but fears of persistence will remain as the labour market remains tight.

We expect the BoE to conclude its hiking cycle with a 25bp rise at its March meeting – but see risks of the BoE going further dependent on labour market developments.

The global economy started 2023 in a stronger macro position than expected. China’s rapid reopening has seen consumption begin to rebound. Europe appears to have skirted the worst fears of a sharp downturn driven by the gas crisis aided by a mild winter and the US economy has remained solid, underpinned by a more resilient labour market. Amidst this stronger growth momentum, markets have repriced expectations for rates, now expecting them to remain higher for longer.

UK growth has also been better than expected – though expectations were not high. The economy narrowly avoided recession in 2022, with growth remaining flat in Q4 2022. A more recent improvement has been driven by a substantial drop in wholesale gas prices and a reduction in political uncertainty following the failure of the Truss premiership. The rebound in business surveys suggests that it may even be plausible for the UK to avoid a technical recession this year. Either way growth momentum is likely to be lacklustre and, on balance, we still expect the UK to enter a shallow recession this year. We expect growth to average -0.3% this year and 0.6% in 2024 (consensus -0.8% and 0.8%).

Price pressures have continued to ease but remain uncomfortably high with CPI inflation at 10.1% in January. Importantly, core and services inflation also fell; and services inflation declined to 6% from 6.8% – a development the Bank of England (BoE) will welcome. Lower gas prices could see inflation fall more rapidly in the second half of this year if they persist, with household energy prices likely to fall below the government’s cap if gas prices remain low. However, the labour market remains tight. Demand has shown signs of moderating, with vacancies falling for the seventh consecutive month. Yet labour supply remains constrained, despite a small rebound in recent quarters, with older workers and those suffering from chronic health conditions still withdrawn from the labour market, contributing to its tightness.

The Monetary Policy Committee next meets on 23 March. Additional labour market and inflation reports will be released before this time. We continue to expect one more 25-basis-point hike, bringing the Bank Rate to 4.25%, despite the BoE hinting at an earlier pause. We suspect it will remain cautious in the face of only nascent signs of easing price pressures and a still-tight labour market and on balance the risk of further tightening from the BoE is higher in our view than an early pause. At present, we expect the BoE to stop at 4.25% but to begin to unwind at the end of 2023 as the labour market loosens. We pencil in Bank Rate easing to 4.00% by year-end and 3.00% by end 2024.  

This year has also seen a step change in the UK-EU relationship with an important breakthrough in discussions on the Northern Ireland Protocol. Prime Minster Rishi Sunak and European Commission President Ursula von der Leyen announced the ‘Windsor Framework’ last week. Whilst the direct economic effects of the agreement are likely to be limited, we see the potential for considerable indirect effects because of the agreement and a more constructive relationship between the UK and EU. Of course, political hurdles to implementation remain, but we think it is unlikely to face considerable opposition in Parliament amidst a weakened ‘hard-Brexit’ lobby; the key challenge will be whether the agreement can unlock the Stormont deadlock and bring the Democratic Unionist Party back to the Northern Ireland executive.