Is 'stagnation nation' a thing of the past for the UK economy?

Joint With Hywel Ball , EY UK Chair and UK&I Managing Partner, Ernst & Young LLP.

The ups and downs for the UK economy continue, as the much-anticipated recession finally hit in the second half of 2023 – with data released a few weeks ago in March confirming that GDP contracted in both Q3 and Q4 2023. This met the technical definition of a recession, two quarters of negative growth. However, it looks like a recession very much in technical terms only; the fall in output was marginal (0.4% across both quarters), and so could well be revised away in subsequent releases. As other commentators have pointed out – with the labour market remaining robust, unemployment barely shifting and consumer and business sentiment improving in parallel – the term ‘recession’ may not be that appropriate. In reality, it was a continuation of the stagnation the UK economy has experienced since early 2022.

The dip in activity is also likely to have been short-lived. Monthly GDP grew in both January and February this year, and the forward indicators for March are consistent with positive growth across the whole of Q1 2024, likely bringing any recession to a rapid end.

The EY ITEM Club now expects the economy to grow by 0.7% in 2024 – a slight downward revision from the winter forecast (reflecting a weaker starting point). Otherwise, not much has changed – inflation is still expected to fall steadily and will perhaps dip below 2% in April (reflecting another fall in household energy bills). This should open the way for interest rate cuts by the Bank of England (BoE) – but again, the EY ITEM Club is a little more cautious than in its winter forecast, now expecting three rate cuts this year starting in June, reflecting ongoing stickiness in services and wage inflation.

A combination of lower inflation and lower interest rates should allow for a recovery in consumer spending this year, boosted by some chunky tax cuts (particularly to National Insurance) from the Autumn Statement and March Budget, and a labour market that continues to cool gently preventing any significant rise in unemployment. A stronger demand outlook and a lower cost of capital should allow for continued growth in business investment.

This should be enough to allow the economy to recover properly into 2025 and 2026, with the EY ITEM Club forecasting growth of 1.9% and 2.0% respectively.

However, as has been the case for the last four years, any optimism should be conditioned by several prevailing risks. Whilst the base rate is expected to fall, higher interest rates will continue to act as a drag to spending – 1.5 million households are due to refinance their mortgages this year and most will end up paying more than on their current fix. In the labour market, economic inactivity remains a problem. There are an extra 700,000 people classified as long-term sick compared to prior to the COVID-19 pandemic and addressing this should be the number one priority of the (new?) government.

More broadly, the geo-political environment is clearly challenging. Tensions in the Middle East continue to build, with recent events raising the spectre of further escalation. Markets are spooked, but perhaps more worryingly from a central banker’s perspective, is the impact on the oil price and what that may mean for inflation. The BoE will also look closely at the US experience, where inflation is proving remarkably sticky, and be concerned that the UK faces a similar situation. The EY ITEM Club believes that the first interest rate cut will come in June – but if wage and services inflation remain stubbornly high, the BoE may wait and see till the autumn.

Bringing this all together – the outlook remains uncertain! Although we perhaps shouldn’t discount too heavily some of the positives – for example, a brighter outlook for consumers should start helping consumer-facing sectors such as retail – particularly those that sell ‘non-essentials’, services activity remains strong and a sporting summer (with the Men’s Euros and Olympics ahead of us) combined with better weather, could provide a lift to the leisure and hospitality sectors. Businesses should remain agile to take advantage of opportunities as they arise.

Read the full report: www.ey.com/uk/ITEM .