The Bank of England’s attempt at reigning-in a sustained period of uncomfortably high inflation has prompted commentators to predict that the UK will fall into recession by the end of this year.
A recession is a significant decline in economic activity that can last for months, or even years. More specifically, the technical definition is when a nation’s economy experiences two back-to-back quarters of negative gross domestic product, or GDP, growth.
Despite a prolonged period of monetary tightening by the Bank, consumer prices continued to rise by 8.7% in the year to May 2023, the same level as April.
In addition, core inflation – which strips out the effects of rising prices from energy, food, tobacco, and alcohol – hit 7.1% in May according to official figures. This was up from 6.8% a month earlier and it is now at its highest level for more than 30 years.
Having risen from 4.5% to 5% last week, markets now expect the Bank Rate to peak around 6% early next year. Set against the backdrop of an extended cost-of-living crisis, this would pile extra pain on borrowers in general and hundreds of thousands of fixed-rate mortgage customers in particular as they attempt to re-finance loans set up on more favourable terms.
In recent months, the UK has managed, albeit narrowly, to avoid entering a technical recession. But a downturn in the UK economy is now being viewed as a likely sacrifice to be paid in the battle against stubbornly elevated prices.
Ernst Knacke, head of research at Shard Capital, said: “A recession in the UK appears to be all but set in stone. Inflation has proven to be more persistent than expected, leading the Bank of England to continue raising interest rates.
“While this ‘higher for longer’ approach may have initially benefited the pound, it will ultimately slow economic growth and put pressure on the currency by tightening credit and increasing the cost of capital. A weaker pound will further worsen inflation risks, potentially resulting in a deeper and more prolonged recession.”
John Wyn-Evans, head of investment strategy at Investec Wealth & Investment, agreed: “A UK recession is now more probable than not, to a great degree because the Bank of England might have to create one to rein in inflation and inflation expectations. Interest rates are set to rise further even as the lagged effects of past rate increases are yet to be fully felt, especially by mortgage holders.
“The global economy is also slowing down as higher rates bite elsewhere, and China’s recovery is proving to be lacklustre. Much as we expect benefits from the development of generative artificial intelligence, they are unlikely to appear soon enough to provide the productivity boost required to avoid a current recession.”
Giles Coghlan, chief market analyst, consulting, at HYCM, said: “Whether or not the UK falls into a recession comes down to which direction core inflation goes. If the next official inflation announcement shows it has increased again, for instance, disposable income will fall and UK companies will struggle, elevating the chances of recession.”
Nicolo Bragazza, associate portfolio manager at Morningstar Investment Management, said: “Higher interest rates make financial conditions more challenging for both households and companies and this might slow down the overall economy in the coming months.
“In addition, the high indebtedness of the UK government, coupled with rising financing costs, could decrease the ability to increase public spending to support the economy. Therefore, this increases the chances of an economic slowdown.
“However, when we talk about recession risk, we should always remember that uncertainty is key, and no one can say with 100% certainty that the UK will be in a recession over the next 12 months. Forecasting the path of the economy is extremely difficult and, therefore, it is more important to focus on portfolio construction and the selection of asset classes that may help in different economic environments.”
Gloomy outlook
A gloomy economic outlook can take its toll on the performance of stocks and shares. In order not to suffer long-term damage to their portfolios, investors need to be alert to the looming danger signs and, if necessary, take action against recession by readjusting the weighting of their holdings.
HYCM’s Giles Coghlan said: “For investors, the current outlook for interest rates presents some opportunities, particularly if inflation doesn’t rise higher. With the terminal rate hopefully close to peaking, buying bonds now is a potentially attractive option for yields and potential capital appreciation as we head towards year end.”
Investec’s John Wyn-Evans is also a fan of bonds and adds that more adventurous investors could consider looking further afield: “Short-dated UK gilts offer attractive income potential with minimal risk. Those looking for longer-term asset-backed income and growth potential with a decent element of inflation protection might consider the quoted infrastructure sector, where share prices have been hit badly by rising bond yields. Too badly, in our opinion.
“More adventurous souls can explore emerging market equities, which offer good long-term value and should receive a boost from a weaker dollar once the US interest rate cycle peaks, as we expect it to this year.”
Morningstar’s Nicolo Bragazza is also enthusiastic about fixed-income securities: “Historically, during recessions, UK government bonds have proven to be a good hedge to protect portfolios and offset the losses of equities. On the equities side, UK smaller companies tend to suffer more during recessions as they are more closely linked to the strength of the British economy.
“In terms of currencies, sterling often depreciates against the other major currencies, such as the US dollar and the Japanese yen, as investors may achieve superior diversification by investing in high quality foreign currencies during phases of economic weakness.”
Although a reasonably strong case is being made for the UK falling into recession, not all commentators believe the outcome is inevitable.
For example, Alexandra Jackson, fund manager at the Rathbone UK Opportunities fund, says: “The UK is under-owned, under-priced, and underestimated.
“I believe it’s facing neither recession, nor a regional banking crisis, nor another populist election campaign. What happened to the baked-in recession for the UK that everyone from the International Monetary Fund to the Bank of England had originally forecast?
“Having front-loaded a fair amount of economic and interest rate pain last autumn thanks to the infamous ‘mini-Budget’ from Liz Truss and Kwasi Kwarteng, the then Prime Minister and Chancellor of the Exchequer, we’re now in the unusual and, frankly, surprising position where the US is expected to slide into recession while the UK avoids it.
“Yet the UK stock market is still pricing in a recession, which cannot be said for the US. The FTSE All-Share index is trading below 11 times earnings, while the US is trading on an elevated figure of 18. The UK is starting to look like the grown-up in the room again. The clearer that becomes, the harder it will be to justify a 30% discount for British businesses, which we believe represents a very attractive opportunity.”
