Will the UK economy go into recession in 2023?
U.K. economic growth is projected to be flat for the rest of the year as tighter monetary policy slows expansion, according to the Asset & Wealth Management Investment Strategy Group (ISG) at Goldman Sachs.
The U.K. exceeded expectations during the first quarter amid lower-than expected natural gas prices, labor market resilience, strength in the services sector, and better-than-expected global expansion, ISG writes in a report. And while consumption is expected to be supported by improving consumer confidence and real labor income turning positive in the second half of the year, as well as excess savings, Britain’s economy will also have to contend with tighter monetary policy that’s projected to stall expansion.
That’s in part because the U.K. economy is more sensitive to rising interest rates than some other regions. Most of the country’s mortgages are tied to fixed-rate contracts with two- to five-year maturities. When those loans mature, buyers must refinance at the current — higher — rates. ISG finds that the average U.K. mortgage holder will pay an additional £250 ($320) a month, or £3,000 annually, in interest payments by the end of 2024.
While inflation is higher in the U.K. than in the U.S. and euro area, it has started to moderate in energy and food categories, and there are early signs that core goods prices are cooling too. Even so, services inflation remains persistent due to the resilience of the labor market and high wage growth. ISG expects this category to remain sticky until the end of the year, preventing a sharp fall in underlying inflation.
Amid sticky inflation, ISG forecasts the Bank of England to make three additional rate hikes of 25 basis points, one at each of the bank’s meetings in August, September, and November, with its policy rate topping out at 5.75%. The central bank has already raised rates by 490 basis points since December 2021. “We attach a high degree of uncertainty to the path and magnitude of hikes, which will ultimately depend on upcoming economic data,” ISG writes.
The bond market, meanwhile, suggests fixed-income investors don’t expect higher inflation to become entrenched. The U.K. yield curve continues to flatten, with shorter-term interest rates converging toward longer-term rates, in response to upside surprises in economic and inflation data. Inflation break-evens and inflation-linked swaps have settled at low levels over the past few months. Adjusted for differences across various inflation-linked derivative markets, ISG finds that longer-term market-based measures of inflation expectations for the U.K. remain anchored and at very similar levels compared to the U.S. and euro area. ISG expects 10-year gilt yields to end the year at around 3.75%, in a potential range of 3.5% to 4%. That’s up from an earlier target of 3 to 3.5%, following better-than-expected economic data and expectations for higher policy rates from the BOE.
As for the pound, ISG notes that the U.K. currency has performed better than most of its developed-market peers this year and policy rates continue to favor British sterling. That said, the team points out that the currency faces headwinds going forward from tepid U.K. growth, weak capital flows, and market positioning. The U.K. current account deficit has declined to 3.8% of GDP against the backdrop of a deterioration in the terms of trade, revealing a source of currency weakness. “We remain tactically neutral on the pound, with risk tilted to the downside,” ISG writes.
The U.K.’s economic challenges are expected to be only a modest issue for the country’s stock market. The FTSE 100 generates 77% of its revenue overseas compared to the Euro Stoxx 50 and S&P 500 which derive 64% and 30%, respectively, of their sales from outside Europe and the U.S.
While U.K. equity valuations remain below average — forward price-to-earnings are trading at an 18% discount to the historical median — ISG predicts valuations will expand in the second half of the year, driven in particular by the energy sector. “The impact of slower U.K. growth on FTSE 100 earnings should be limited,” ISG writes.
Disclaimer: The Investment Strategy Group, part of the Asset & Wealth Management business (“AWM”) of GS, focuses on asset allocation strategy formation and market analysis for GS Wealth Management. Any information that references ISG, including their model portfolios, represents the views of ISG, is not financial research and is not a product of GS Global Investment Research and may vary significantly from views expressed by individual portfolio management teams within AWM, or other groups at GS.
Forecasts are based on assumptions and are subject to significant revision and may change materially as economic and market conditions change. Past performance is not indicative of future results, which may vary.
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