This time last year, things were looking good for the UK. Inflation was rising, but was still deemed “transitory” by a complacent Bank of England, growth was recovering, the labour market was strong, and the pandemic (with hindsight) was already past its peak.
A year on, and while the labour market remains strong and Covid-19 is firmly in the rear-view mirror, inflation has surged relentlessly higher, only made worse by Russia’s invasion of Ukraine.
The Bank of England has been very clear that things are no longer as rosy on the economy front – perhaps rather too clear, some might argue. Bank governor Andrew Bailey agreed when asked by MPs last month that he feels “helpless” in the fight against inflation and also warned of the “very real income shock” facing consumers as higher food and energy prices eat into disposable incomes. Suddenly all the talk is of “stagflation” – the toxic combination of rising prices and slowing growth most closely associated with one of the most painful decades ever for investors, the 1970s.
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While Bailey’s slightly hopeless tone is hardly helpful (after all, difficult or not, tackling inflation is his job), there’s no doubt that consumers’ incomes are under serious pressure. Energy regulator Ofgem added insult to injury by warning that the energy price cap looks set to shoot up again to £2,800 in October, meaning that energy bills for the average household will have more than doubled in a year. The UK is a consumerdriven economy.
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If consumers feel the squeeze and stop spending, the economy slows down. That in turn would mean fewer new jobs being available, followed by higher unemployment, leading to a further squeeze on spending, and perhaps even a recession.
The government splashes out
That’s bad news for a government already beleaguered by scandalous house parties, so it’s little wonder that the chancellor, Rishi Sunak, suddenly felt the need to drop his stern tone on the public finances and rush back to stick his arm down the back of the Number 11 sofa to see what he could find there. As it turns out, what he found there was pretty significant. The chancellor has handed money to every household to help cope with rising energy bills, with the poorest households getting the most – quite possibly enough to offset the energy bill hike at least, if not the entire rise in living costs. Meanwhile, he argued that this would be funded with a windfall tax on the profits of North Sea oil and gas producers.
As is usually the case with these things, the cost of the spending is a good bit clearer than the amount that will actually be raised from the taxing (everyone will accept the former, while companies will take steps to mitigate the latter). But in all, says Paul Dales of Capital Economics, the chancellor has pumped the equivalent of about £10.3bn into the UK economy. That is made up of £15.3bn being given to households, and £5bn being taxed away from oil and gas producers. In turn, that means “real” (after-inflation) household disposable incomes will fall by 1% rather than 2% this year; GDP growth will come in at 1.5% rather than 1.2% next year; and inflation – as measured by the consumer price index (CPI) – will average 4.8% rather than 4.3% in 2023. You can, of course, ignore the specific numbers here – they’re estimates and as such are likely to be wrong. But the point is that consumers won’t be as squeezed, and so growth will be a little higher than it otherwise would have been – as will inflation.
A recession is less likely
So what does this mean in practice? For a start, it makes a consumption-driven recession less likely, which is good news. As for the impact on the nation’s balance sheet, economist Julian Jessop of the Institute of Economic Affairs think tank points out on Reaction that the decision is affordable (in relative terms at least) and probably even makes fiscal sense. The public finances are currently in better shape than had been expected, because employment and thus taxes have remained strong. “This ‘windfall’ from higher cash incomes and prices has given the chancellor some extra wiggle room.” Given that “a recession would have been an even worse outcome for the public finances”, this is probably money well spent. Secondly, this makes it easier for the Bank of England to narrow its focus to inflation (rather than flailing about in a panic, worrying about triggering a recession).
“Most economists agree that fiscal policy has been tightened prematurely, but also that monetary policy is still too loose. Sunak’s announcements may help to correct that imbalance,” says Jessop. There’s also an intriguing technical question. As Jessop notes, if official statisticians decide to treat the £400 energy bill discount as a price cut – rather than a transfer payment – then that would mean the headline measure of inflation might actually be lower than expected in October.
It’s also worth noting that a recession was not a foregone conclusion in any case. As James Lowen of the JOHCM UK Equity Fund points out, there were already two offsetting factors at play.
Firstly, wage growth in the private sector has been strong and the labour market remains tight. Secondly, households built up “around £200bn to £250bn of excess savings” during the pandemic. That in turn “will act as a buffer for certain households” over the coming 12 months, which should help to offset the impact of rising costs elsewhere. Given that Sunak has now stepped in to help the most vulnerable households, then as long as energy costs stop rising next year, it might be enough to help most consumers weather the storm.
The spender of last resort
Perhaps the most important point here is that “austerity” is no longer an option. Voters are not in the mood to tighten their belts and it’s hard to blame them. Companies may have to plug that hole with rising wages as long as the labour market remains strong, but the government is also setting a precedent whereby it will step in to relieve consumers’ pain where necessary. Put more simply, in recent decades markets grew (overly) used to the Bank of England being the “lender of last resort”, intervening to put a floor under markets any time they fell. That’s changed.
Today, the government is the “spender of last resort”, insulating consumers from painful price changes, while the Bank’s role will be to leaven the impact of that spending by tightening monetary policy accordingly.
This implies that we’re likely to remain in a very different investment environment from that which prevailed right up until last year. Inflation will remain a force to be reckoned with, which means that investors cannot rely on interest rates remaining low. For example, Capital Economics reckons that the Bank of England will raise interest rates to 3% next year, and that it might even raise by half a percentage point at the next meeting on 16 June.
Central banks will still step in as and when something in financial markets threatens to “break”, or if declines in markets become “disorderly”. But investors can no longer assume that the Federal Reserve (which usually leads the charge on these things) will step in once the S&P 500 drops below a certain level. Nor can homeowners take it for granted that the Bank of England will act to suppress mortgage rates (although I suspect that government intervention in case of severe mortgage pain cannot be ruled out).
What this means for your money
What does all of this imply for the investment outlook? For a start, it suggests that “value” (which can survive and even thrive in a rising interest-rate environment) will continue to outperform “growth” (which struggles in the face of a rising discount rate). Put more simply, buying stuff that is cheap should continue to be better than buying stuff that is expensive.
The FTSE 100 is something of a classic value index and despite its recent outperformance remains cheap relative to its global peers, so a simple tracker fund could work well. This won’t give you much exposure to the domestic UK economy, but you might as well take advantage of global fund managers remaining slow on the uptake. That said, if you’re looking for individual stocks, particularly those exposed to the UK economy, then JOHCM’s Lowen and his colleague Clive Beagles point out that the recent rising concern about recession in the UK has “led to a material derating of financials and domestic cyclicals” in particular.
As a result, many valuations “are absurdly low”. Big “defensive” stocks now account for “nearly a quarter of the UK market”, with the market cap of drug giant AstraZeneca alone almost as big as “the entire UK quoted banking sector”.
Instead, they say, “this is the time to be selling defensives and buying high-quality franchises in the rest of the market”. Some of JOHCM’s suggestions for companies that warrant further investigation include house builder Vistry (LSE: VTY), with a dividend yield of more than 6%, Barclays (LSE: BARC), trading on less than half its tangible book value, furniture group DFS (LSE: DFS) on a price/earnings ratio of below six, and broadcaster ITV (LSE: ITV), which has just enjoyed a record year for advertising. On the investment trust front, Aurora (LSE: ARR) focuses on UK value stocks and currently trades on a discount of just under 7%. Major holdings include easyJet and Lloyds Bank.
Another value-tilted trust offering exposure to smaller UK companies is Aberforth Smaller Companies (LSE: ASL) on a discount of around 14%. The trust is heavily invested in industrials and financial stocks – the top-ten holdings include wealth manager Brewin Dolphin, transport operator FirstGroup, and recruiter Robert Walters.
Politics remains a potential tripwire
In short, the UK was already looking cheap. Now that the worst-case scenarios of recession alongside stubbornly high inflation may be avoided, it looks an even better bet.
However, all of that said, the chancellor is making the tax system even more complicated, which is hardly good news, particularly for the longer run.
