Is there any silver lining? Some. Financial market volatility has retreated thanks to the fiscal U-turn. Markets have scaled back their expectation of peak Bank Rate to 5.00% by Spring next year, compared with 6.25% priced into assets in the aftermath of the ‘mini-budget’ introduced by then-Chancellor Kwasi Kwarteng.

A recession is becoming more and more apparent in the UK. Gross Domestic Product (GDP) fell 0.3% on a quarterly basis in August, driven by a downturn in industrial production and a pullback in consumers’ discretionary expenditure amid the real income squeeze. 

High frequency indicators point towards a weakening UK economy through September and October. Consumer confidence fell to a record low in September, followed by only a marginal recovery in October. Retail sales, including fuel, plunged by 1.4% month-on-month in September as consumers tightened their belts, on top of a revised drop of 1.7% in August. 

That said, timelier indicators on consumer spend are mixed. Card spend data continue to hold up and UK flight uptake reached 88% of their equivalent pre-covid level in mid-October, the highest since the start of the pandemic. 

Activity amongst firms is cooling, with confidence falling in response to domestic events and weaker global demand. The UK Purchasing Manager’s Index (PMI), a closely watched survey reflecting business confidence, continues to contract; in October, it slipped to its lowest level since March 2009 (excluding months of lockdown). 

Some of this should be taken with a pinch of salt. Falling PMI could reflect worsening sentiment linked to the financial market turmoil seen in recent week; it might rebound in response to the greater market stability. But notably weaker new orders, including from overseas, point to the adverse effect of an uncertain outlook and the cost of living crisis. 

Still, the 2023 outlook remains challenging for businesses and households. Despite the cap on energy prices, they are still twice as high compared to last year, which drags on disposable income. Moreover, tighter financial conditions, and looming spending cuts and tax hikes, will also weigh on consumer demand and business investment. Household spending will remain under pressure from the surge in mortgage rates and rising rents. Healthy finances among higher income groups will be an important source of support in the coming months. And while the labour market is cooling, it’s in decent shape as of right now.   

UK PMI signals further decline in business activity

Core price inflation rose to 10.1% in September, up from 9.9% in August, led by higher food costs. Rising energy costs and the end of the temporary sales cuts in the hospitality sector explains some of this. However, we’re still waiting for signs that inflationary pressures are beginning to subside. Looking ahead, inflation is expected to rise further, peaking in October – driven by c.30% rise in consumer energy prices. 

Prices are then likely to retreat a bit over Q1 2023, helped by falling commodity prices, lower shipping costs, and inventory overhang in the manufacturing sector. Further, the combination of weakening consumer demand and emerging slack in the labour market will likely slow price rises for discretionary services. 

Beyond that, the outlook becomes somewhat uncertain given the new Chancellor’s decision to scale back the universal energy support in April. Energy prices could jump by as much as 74% in April, pushing up the headline inflation by around 5%. 

But there is a flip side to this. As the government tightens its belt to fill the fiscal hole, consumer demand is likely to fall materially. Further, the unemployment rate is likely to move higher next year as firms face the double whammy of higher taxes and weaker demand. Together, this will take the pressure off domestically generated inflation, thereby, in theory, limiting the pace of future tightening to lower than market implied trajectory. 

Wholesale gas prices dropped sharply in September and October

UK labour market conditions have been relatively stable despite the economic slowdown. But that masks some shifting dynamics underneath. While the unemployment rate eased to 3.5% in the three months to August, from 3.8% in May, it was primarily driven by a contraction in the workforce amid a rise in long-term sickness and a higher number of students.  

This means the current tightness in the labour market owes more to labour supply contraction than demand growth. In fact, labour demand is coming off the boil amid a softer growth outlook. Future employment growth indicators such as online job vacancies are on the decline, inching closer to pre-pandemic levels. Business surveys also point to weaker hiring intentions. That said, there are no indications of active labour shedding or initiating redundancies among firms. 

Labour demand is easing, reflected in lower job openings

Separately, labour supply is likely to pick up further ahead as both immigration and domestic participation picks up amid the waning effect of the pandemic. Moreover, the challenges posed by rising costs could push some of those who have departed the labour force to return. Put together, the unemployment rate is likely to rise gently and steadily.

Meanwhile, wage growth retained its momentum. Regular wage growth rose to 5.4% in the 3-months to August, up from 5.2% in July. Wages including bonuses also rose 6.0% in August, from 5.5% the previous month, and twice the pace that prevailed in the three years before the pandemic. 

However, if a rising degree of labour market slack does come to pass, it should slow future wage growth. Further, a slowdown in hiring also will lead to less churn in the job market, easing the pressure on businesses to pay more to retain staff.

The Bank of England raised the Bank Rate by 50 basis points in its September meeting, taking it to 2.25%. Substantial market volatility followed the announcement of the ‘mini-budget’ by the Truss government. Market expectations of the trajectory for interest rates also steepened notably, with a Bank Rate of over 6% priced in. 

However, a semblance of stability has returned. And with it, the UK’s risk premium – as reflected in the price of financial assets – has retreated. The 10-year gilt yield has fallen back to 3.5%, after peaking at around 4.6% in recent weeks. Markets now expect Bank Rate to peak at 5%. 

At the margin, the government’s relatively tighter fiscal stance implies a little less monetary tightening is needed to bring inflation back to target. Forecasters (NatWest included) continue to anticipate a lower peak of around 4.25%. But even at that level there is an impact on economic activity and asset prices, particularly the housing market. 

Another possibility is monetary policy can be loosened later through 2023, should inflationary pressures quickly dissipate amid weaker demand. But the path for inflation is hugely uncertain, with the scaling back of the energy price guarantee bringing a new dose of uncertainty to its path through next year. Sterling’s fall will also apply some upward pressure. Navigating a path through that – for policymakers, businesses, and households – won’t be easy. 

UK Bank Rate forecasts have risen since August but are lower compared to September (Overnight Index Swap Curve Index, %)

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