Since the start of 2022, the UK economy has been steadily faltering in the face of persistent inflation woes, household real income squeeze and a turbulent geo-political climate. The latest BoE forecasts for the UK economy make for bleak reading with GDP contracting q-o-q by -0.2% in Q3 2022 and the economy projected to enter a technical recession in Q4 2022 which would likely last for five calendar quarters (as per BoE Monetary Policy Report Nov’22). UK has been the worst performer in the G7 with the UK GDP 0.7% lower in Q3 2022 versus the pre-pandemic level (as per the Nov’22 OECD Economic Outlook).
Economic struggles have been compounded by double-digit inflation due to high energy prices and continuing labour and good supply shortages. To counter sustained inflation, the BoE has responded with series of aggressive hikes to the UK base rate, raising it to 3.0% earlier this month from 0.1% this time last year. BoE rate expectations have been exceptionally volatile. Maximum terminal rates for next year peaked at nearly 6.30% at one point before returning to around 5.20% but with a considerably longer tail of higher rates being maintained compared to rate expectations in the previous month.
Against the backdrop of the cost-of-living crisis, Truss’ mini-budget, despite its ostensible growth focus, further exacerbated the market sentiments and intensified economic turmoil. Post new leadership and u-turn on tax cuts in the preceding mini-budget, the UK markets have shown tenuous recovery, but look likely to remain volatile for the foreseeable with further ‘known unknowns’ similar to the UK LDI/pensions crisis looming as potential tail events. Secondary market prices, albeit on thin liquidity at attractive prices, have put further pressure on demand for a new paper on both sides of the Atlantic. In contrast, market sentiment stays bearish even though credit fundamentals remain relatively firm. Notwithstanding the challenging conditions, debt still remains widely available for smaller and mid-market transactions (even though the availability of bank credit has contracted marginally), while pricing is resilient for now despite the uplift in borrowing costs.
At present, the markets are not pointing to a major financial crisis along the lines of post-2008 GFC, even though overnight funding gaps in the repo markets have shown occasional unexpected stresses. Europe is likely to face a considerably more troubled winter with possible energy supply disruptions despite recent slackening in gas prices; while the US and UK unemployment remain very low (and has in part been the driver behind the drumbeat of raising rates aggressively) with ISM surveys still holding in positive territory and are not at levels typically associated with a recession. Consequently, it remains difficult to reconcile a severe slowdown with current economic numbers. For the moment, without a further, much sharper external shock, a market move broadly comparable to the European debt crisis would seem to be the more likely downside scenario (i.e. risk premium rises sharply increase with periodic bouts of high market volatility for an extended period, but markets remain functioning and the overall situation remains highly likely to be salvageable), notwithstanding the fact that the available central bank firepower is likely to be more constrained now than a decade ago.
Khalid Khan – Managing Director
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