UK Economic Outlook 2023

The UK is in a challenging position going into 2023. In the short term, it needs to tame inflation near 40-year highs while also reducing its large fiscal and current account deficits, 7.2% and 5.5% of GDP, respectively. In the long term, it needs to deal with chronically low productivity growth, which is lagging behind that of its peers, and stabilise its trading relationships with the rest of the world.

Issues facing the UK

The energy price shock triggered by the Russian invasion of Ukraine was the immediate cause of the UK’s current economic challenges. This price shock is particularly bad for the UK as it is a net energy importer and currently runs a significant current account deficit. The price shock will, directly and indirectly, exacerbate the already large current account deficit. Directly, it means the amount spent on net imports of energy will increase. Indirectly, it will work to make UK firms less competitive against other countries that are not affected to the same extent by this particular energy price increase.

The price shock has also sent inflation in the UK over 10% YoY. Initially, this was driven by volatile components, specifically energy and food. However, it has since spread to wages, housing, and services. This is worrying as wage inflation can be self-propelling as higher wages for workers drives inflation across a wide range of goods and services.

Examining previous periods of economic distress in the UK, we found that three key things happen before the crisis subsides:

  1. Interest rates move up substantially;
  2. The country falls into a recession; and
  3. The current account deficit compresses.
Interest Rates

To grapple with inflation and to maintain funding its current account deficit, the UK needs the Bank of England to raise interest rates. The current market expectations are for a UK base rate of c. 4.75% by the middle of 2023. This rise is in line with previous tightening cycles in crisis periods. Markets expect the rate to fall well below 4% in 3 years’ time.

However, during times when the UK is running a large current account deficit, as it is now, it is often required to hold real rates above those in the US. This attracts investors to fund its deficit. Currently, markets are predicting that the UK will have a real terminal rate roughly 2% below that of the US. Much of this depends on CPI forecasts, which are higher for the UK than the US.

The increase in rates will also make the servicing and issuance of government debt more costly. The fiscal deficit is expected to be c. 7% of GDP this year, and the debt-to-GDP ratio is currently 101.9%. Higher rates will also slow consumer spending by dramatically increasing the amount that the average household pays on their mortgage. This will hit particularly hard as consumer confidence is already near an all-time low, with inflation having eaten into purchasing power.

Real GDP

Most economists now expect the UK to fall into recession in 2023 driven by this reduction in consumer spending. Bloomberg consensus estimates forecast a decline of 1.0% of GDP, and the Office for Budget Responsibility (OBR) predicts a more substantial decline of 1.2%. Observing previous comparable episodes in the UK, we found that the average GDP decline is much higher than predicted at -4%. Similarly, the Bloomberg consensus forecast rise in unemployment to 2024 is only half that of previous crisis periods.

Current account & GBP

There are several reasons why the current account should compress. The deficit is becoming increasingly expensive to fund as rates increase. The UK runs a substantial goods trade deficit with the rest of the world (c. -10% of GDP). Firms and households are strong consumers of imports. However, with average real wages falling, the ability to purchase imports is declining. This is compounded by a falling currency.

In the previous periods, sterling shows an average decline against the dollar of over 20%. The pound fell more than 20% against the dollar from the start of 2022 to mid-September before retracing much of the lost ground to have now (December 2022), only showing a YTD decline of c. 9%.

Conclusion

The UK faces large current and fiscal account deficits, inflation near 40-year highs, and a certain recession in 2023. This is a tough economic outlook that could worsen as 2023 progresses. One upside to this outlook is that the UK has often emerged from crisis periods with strong growth, a healthier current account balance, and lower unemployment.

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