BearBull Group Research: Better Prospects for British Assets
BearBull Global Investments Group (DIFC)
BearBull Global Investments Group is a leading independent Swiss wealth advisory firm based in the DIFC
Key Points
The United Kingdom has finally entered a recession
For several quarters, the British economy resisted economists' forecasts of a probable recession. After a second quarter revised to stagnation, the third quarter recorded a very slight negative change of -0.1%, which worsened towards the end of the year (-0.3%), ultimately pushing the British economy into recession by the end of 2023. On an annual basis, GDP transitioned from positive growth of +0.3% in September to -0.2% in December. The United Kingdom thus entered a recession in the second half of 2023, surprising observers once again who expected a better performance towards the end of the year. Prime Minister Rishi Sunak, who hoped to revitalize British momentum, will have to acknowledge that a technical recession has occurred instead. For now, it seems very moderate and suggests more of a growth stagnation than the beginning of an economic downturn. This situation could greatly motivate the Bank of England to promptly lower its interest rates, once again becoming the first central bank to make a monetary policy shift. The rise in interest rates in response to the sharp increase in inflation is beginning to erode short-term consumer confidence. The decline in GDP this time is due to an unexpected drop in private consumption (-0.1%), a decrease of -0.3% in public spending, and a plunge of -2.9% in exports. Exports plunged more sharply than imports (-0.8%), while investments in equipment still appeared relatively solid (+1.4%). Domestic demand is beginning to falter more noticeably considering the negative revision of third-quarter data, which already indicated a consumption decline of -0.9%. However, statistics from early 2024 could already suggest a slight improvement.
The beginning of 2024 could already be more positive
The technical recession of the last two quarters remains very moderate and may even turn out to be even milder after the year-end data revision. Nevertheless, we anticipate a less pessimistic scenario for the British economy this time compared to previous recessions. In 1980, the recession was marked by a decline of about -3% in GDP, and those in 1990 (-1.6%) and 2008 (-2%) were also more significant than the decline of the last two quarters. The GDP figures for January show an increase of +0.2%, suggesting indeed that the beginning of the year already seems to be marked by a certain return of overall growth, supported this time by the service sector, retail and wholesale trade, as well as the construction sector.
These positive developments have helped offset the decline in industrial production (-0.2%). The very mild recession of the second half may already be halted by a beginning of an upward trend in GDP. The prospects for the first quarter are now somewhat better, and we expect a +0.2% increase in GDP by the end of March. The economic recovery in the UK will remain somewhat limited at first, but given the rather positive trend in inflation, the chances are now higher for the BoE to act in the coming months by lowering its interest rates. Households are once again benefiting from positive real wage growth, which likely contributed to the +3.4% increase in retail sales in January and supported the service sector. The construction sector has also benefited from this improvement in household purchasing power, growing by +1.1%.
For the year 2024, the expected GDP growth should be around +0.4%, thanks to still positive domestic demand supported by a +0.3% increase in household consumption and a +1.8% rise in government spending.
Slight improvement in leading indicators
As the end of March approaches, published leading indicators confirm the expectations of a slight economic activity recovery. The manufacturing PMI remains the slowest among the PMI indicators, despite a recent increase from 47.1 to 47.5. The services PMI has shown some retracement from expectations, but with a level of 53.8, although lower than January's (54.3), it remains firmly in a growth zone. The improvement in the construction PMI to 49.7, close to the growth threshold, is also a positive development, supporting the rise of the composite PMI to 53 points, back in positive territory for the past four months. Since PMI measures do not include the public sector, we anticipate that the expected increase in public spending in 2024 will further reinforce the more positive trends expected for the private sector.
Decrease in tensions in the labor market
The labor market is beginning to show some signs of weakness, with little effect on the unemployment rate, which stabilized in 2023 and now stands at 3.9%. Official data suggests a significant decrease in wage pressures, consequently lowering the risks of transmission to prices and inflation. The labor market is expected to further relax in the coming months. Annual wage growth has been declining for five months and is now at +6.1%, significantly lower than its peak of +7.9% reached in July 2023. Companies are now more willing to lay off employees, especially in the manufacturing, construction, IT, banking, and finance sectors. Meanwhile, monthly job creation has practically reached its lowest level in the last three years, while new claims for unemployment benefits are now at their highest since February 2021. The potential risks of wage-driven inflation are thus significantly decreasing, but the increase in weekly wages excluding bonuses of +6.1% (3m/GA) remains significant and exceeds inflation. Overall, we believe that this trend should be considered by the BoE as a favorable factor, allowing it to consider a change in monetary policy and a first reduction in the benchmark interest rate in the current quarter.
Households seem more confident
Household living standards are further improving thanks to an increase in real wages due to the significant decline in inflation in recent months and the maintenance of nominal wage growth at +6.1%. The drop in the consumer price index has now lowered inflation from +11.1% in October 2022 to just +4% year-on-year in January 2024. Households view these developments as rather favorable, which is now quite evident in the positive evolution of their confidence level. Indeed, the household confidence indicator (-21) for January (GFK) has been trending positively since the 4th quarter of 2022, although it remains well below pre-pandemic levels (-8). Confidence is undeniably improving against all odds as the economy teeters on the brink of recession. The recent increase in the unemployment rate and the decline in job creation could contribute to deteriorating consumer sentiment and resilience, but the prospect of significantly declining inflation and upcoming interest rate cuts should strengthen the current favorable trend.
Inflation is falling and approaching the Bank of England's targets
Inflation reached a peak of +11.1% in October 2022 in the United Kingdom, making it one of the worst price developments among industrialized countries. Despite the rapid action taken by the BoE and a very intense increase in interest rates, British inflation struggled to show the expected signs of easing. In June 2023, it was still at +7.9% before the increase in interest rates to 5.25% could finally trigger the expected downward acceleration. The decline remained disappointing for a quarter before the end of 2023 finally witnessed a more pronounced drop in the CPI. The sharp decline in food, housing, and energy components allowed the price index to quickly slide to +4%, fueling hopes for further declines. In January, the monthly drop of -0.6% significantly supported positive expectations of continued price declines and a favorable response from the central bank. In this somewhat more optimistic context, the producer price index also contributed by showing persistent stability (-0.6%) for over six months, after recording a +20% increase over twelve months in June 2022. It is now increasingly conceivable, in our view, for the BoE to consider these factors as sufficiently positive to contemplate a future monetary policy adjustment, despite still high inflation in the services segment (+6.5%).
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The Bank of England is soon able to lower its rates
The technical recession in the second half was widely expected by the BoE to contribute to reducing inflationary pressures in the country. Indeed, during this period, inflation fell sharply from +8.3% to +4% while its monetary policy remained unchanged. Since August 2023, interest rates have remained stable at 5.25% in anticipation of the hoped-for cyclical easing. After fourteen consecutive interest rate hikes and one of the quickest implementations of restrictive monetary policy, starting as early as December 2021, the BoE now faces a somewhat more comfortable situation, just days before deciding whether to proceed with its first interest rate cut. We believe the Monetary Policy Committee will probably not immediately change its interest rates on March 21, but action at the next meeting now seems more likely. In recent weeks, inflation has slightly outperformed the MPC's forecasts, and the next figure released just before March 21 may show a further decline in inflation to only +3.4%. The decrease in wage growth has also been a key factor in recent weeks, especially if it falls as expected to only +5.4% by the end of March. We estimate that the BoE will still hesitate to act in March, but given a positive flow of data and economic statistics pointing to a continued decline in inflation in the coming months, it will lower its rates in May or June. By that time, it is now possible to anticipate annual overall inflation of +1.6%, 3.2% for the index excluding food and energy, and +5.1% for services. The consensus suggests that the first rate cut will only come in August. However, we believe that current and upcoming conditions in the short term are already sufficient to allow for a change in monetary policy implementation before summer, especially if the Federal Reserve in the United States also decides to ease its policy.
Attractive yields and capital gain prospects for sterling-denominated bonds
The increasingly visible cyclical slowdown, along with the more pronounced easing of inflation, now gives hope for a somewhat different evolution than envisaged just a few months ago for interest rates. In October, UK ten-year government bond yields once again reached the 4.7% threshold, which was touched in September 2022, July, and August 2023. Following the recent acceleration in the decline of inflation and a series of more favorable economic statistics, including the technical recession in the second half, the appreciation of monetary tightening risks and the perception of the appropriate level of long-term rates have evolved significantly. After an initial reaction to the decline in long-term rates from 4.7% to only 3.4% at the end of December, the rebound in the first two months of the year to 4.2% has put long-term rates back above annual inflation. Given the developments mentioned above in terms of inflation and monetary policy, we believe the BoE will begin to lower its interest rates in May and will continue this policy to reduce rates from 5.25% to 4% by the end of 2024. The currently inverted yield curve of nearly 100 basis points should also flatten further on longer maturities, with yields potentially slipping back to 3% if expectations of a drop in overall inflation are realized. Prospects are normalizing for sterling-denominated bonds, which can now expect to record significant capital gains in this context of a 100 basis point drop in ten-year yields.
Stability of the GBP/USD exchange rate
The recent evolution of monetary policies and interest rates has highlighted a rather clear correlation between the strategies of the American and British central banks, which is expected to continue in the coming months. The restrictive monetary policies pursued by both institutions have indeed pushed short-term rates to similar levels before pausing during the summer of 2023, which has persisted to date. While inflation developments have been more favorable in the United States, the recent acceleration in the decline of prices in the United Kingdom also strengthens the prospects for rate cuts in the country. In the context of simultaneous rate cuts, the interest rate differentials between the dollar and the pound could remain similar as their respective central banks implement looser policies by lowering their rates by similar increments at roughly the same time. The GBP/USD exchange rate is expected to stabilize between 1.25 and 1.30. As for the pound/Swiss franc exchange rate, the situation is different, particularly due to the significant differential that would persist even during a phase of rate cuts in both Britain and Switzerland. The weakness of the franc will likely also be evident against the pound sterling, which we believe will continue its appreciation towards the 1.15 level.
It's time to bet on securitized real estate
The annual evolution of property prices continues to slow down. After reaching +14.3% year-on-year in July 2022, the year-on-year property price movement has been mostly negative for six months now. According to UK Rightmove data, in February 2024, the twelve-month change is finally at +0.1%. According to figures published by the Nationwide Building Society, the average house price also declined by -5% by the end of September and has been gradually recovering since then. At the end of February, this indicator suggests a rise of +1.2% over twelve months. Most indicators of the UK property market now seem to point towards a recovery. The more favorable outlook for future financing costs and wage growth contributes to a revival in demand. Regarding price movements, household affordability relative to potential acquisition prices remains historically low, and the still significant supply will certainly limit upward pressure. After eighteen months of price consolidation, direct real estate seems rather resilient in the face of difficulties in securing the necessary financing for an acquisition. The ongoing cyclical slowdown does not seem sufficient to cause a more notable decline in real estate. However, risks are not completely eliminated by the prospect of future cost reductions. Approximately 1.5 million households will see an increase in their carrying costs in 2024. We estimate that the real estate market will remain in a phase of consolidation and stabilization in 2024 without significant short-term price increases. As for securitized real estate, its short-term evolution remains more correlated with inflation and interest rate movements than with the physical market. After the downturn of -34% in 2022 and -17% in 2023 due to negative expectations related to the prospect of rising financing costs, leading to an overall correction of listed property prices of nearly -50%, British securitized real estate seems particularly attractive again. The recent evolution of interest rates has motivated both the +20% rebound between October and December and the decline of the past two months. We expect the next phase of rate adjustments to occur in the coming months, allowing for a 100 basis point reduction in financing costs. In this again positive context for securitized real estate, a positive trend is expected to emerge soon.
Discounts still attractive for stocks
The FTSE100 index has been significantly underperforming other European and international indices for several quarters. It continues to face negative expectations due to a sluggish economic environment, persistent inflation, and competition from the domestic bond market. The level of the FTSE100 is currently barely higher than its peak in February 2022. The composition of the index, with very little exposure to growth and technology stocks, explains its underperformance in 2023 and early this year. The current level of the stock market offers some opportunities due to relatively attractive valuation measures both in absolute and relative terms. All companies in the FTSE100 still benefit from a relative advantage with an average PE ratio (11x) significantly lower than those of American stocks in the S&P500 (201.3x), the SX5E in Europe (13.8x), and the SMI (18x). With FTSE100 profit growth expected to be +7% in 2024, the British market is not particularly attractive, but it should nonetheless be supported by expected interest rate cuts in 2024.