UK health check - positive fundamentals, temporary headwinds

Almost back to normal?

Better not say it too loudly, but with less than a month to go before the year is over, we can tentatively say that 2024 is the first year since 2019 in which the major story for the UK economy and financial markets is not a huge disturbance caused by large and unusual external shocks. The result? Things have started to look a bit more, well, normal. In 2020 and 2021, the UK suffered huge gyrations in output as the world struggled through the COVID-19 pandemic and periodic lockdowns. Then, in early 2022, before the pandemic shock had fully faded, Russia’s invasion of Ukraine triggered the biggest energy crisis since the 1970s. A dramatic tightening of monetary policy at home and abroad to curb surging inflation caused momentum in open economies like the UK to slump through 2022 and 2023. But this year has been different.

Whereas real GDP grew just 1.7% in the four years between 4Q19 and 4Q23 – the period encompassing the COVID-19 and war shocks – economic activity has already risen 1.3% in first three quarters of this year as part of a broader improvement in economic vitals. Confidence is up – even including the wobble over the 30 October Budget, real incomes are rising solidly, investment growth is strong, and credit conditions are normalising as the Bank of England (BoE) step-by-step turns its monetary policy from tight to neutral. Although 2024 has been far from a blockbuster year, if we lean back and consider the big picture, it will likely mark an important transitional period in which the situation in the UK economy started to shift back towards almost normal.

Mind the budget effect

Without question, and despite the government's pro-growth investment stimulus, some of the tax and regulatory measures announced in the budget are anti-growth. And although the overall confidence shock is not extreme judging by surveys, anecdotal evidence suggests pockets of serious pessimism - especially among some small and medium-sized firms which will be hit hard by the rise in employer national insurance. Having inherited an economy on the up, and with a tailwind of rising consumer and business confidence, Labour have partly squandered a good hand. The near-term risk to watch now is that the dip in confidence starts to feed on itself and become self-fulfilling. But that is not our base case. In my experience, positive fundamentals tend to reassert themselves after a while following policy-related slips in sentiment. Still, Labour has some work to do to bring business back onside.

Health check – in our chart pack we show that:

• The recent weakness in UK PMIs is part of a wider trend that is visible across other open advanced economies (except the US which remains ultra-strong) and is likely due to still-soggy global demand and growing uncertainty over US trade policy.
• Rising domestic policy uncertainty following the Budget has knocked back consumer expectations for the year ahead, but businesses remain positive in their outlook.
• Despite the negative headlines, UK equity and bond markets have largely moved sideways since the Budget – suggesting no major surprise in the overall policy thrust.
• Sterling has risen against the euro since the budget mainly due to Eurozone economic weakness and rising political risks in France and Germany. Meanwhile, sterling has softened versus the dollar as part of a broad-based dollar strengthening linked to the election of President Donald Trump.
• UK equity markets look cheap relative to history and versus the US on a price-to-earnings basis, and based on the value of the UK stock market as a ratio of GDP (which stands at c.0.95 for the UK but +c.2.0 for the US).
• Bloomberg consensus expectations for UK real GDP in 2024 and 2025 have risen over the course of the year while a two-quarter lead of the FTSE 250 versus real GDP signals more near-term growth to come.
• Business investment is rising solidly in line with its long-run trend, employment is at an all-time high and real incomes are growing nicely after the big negative shock in 2022 and 2023.
• Inflation has moderated to close to the BoE’s 2% target – the UK is no longer a high-inflation outlier. Underlying cost pressures remain consistent with sustained moderate inflation.
• From a weak starting point, housing market activity is rebounding. Rising real incomes and easing mortgage conditions are lifting housing demand and prices.
• Although consumers enjoy strong balance sheets – low consumer credit and falling mortgage debt as a % of incomes – a lingering nervousness continues to underpin precautionary saving. The gap between income growth and consumption growth can narrow as the upswing gains momentum and the BoE further reduces interest rates.
• Businesses have low levels of debt and high cash balances. Banks are well capitalised. During the bad times, this balance sheet strength offered defence against shocks and financial volatility. As conditions normalise, it should provide a springboard for economic recovery.

Lower for longer is over - across the curve, bond market rates have returned to roughly their pre-2008 levels and show no signs of returning to their post-2008 to 2021 lows.

Kallum Pickering

Chief Economist