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June was a difficult month for the UK economy.
The core inflation numbers showed no sign of improvement and the Bank of England, which was previously expected to raise official interest rates by 0.25% instead increased them by 0.5% to 5.0%.
This caused another mini panic in the mortgage market (similar to the Truss/Kwarteng Budget) and much criticism of Andrew Bailey the Bank’s Governor. This was to some extent unfair, Bailey had been “playing for time”, UK inflation is likely to fall significantly, but not until August.
This is when July’s 15% electricity and gas price cap fall feeds into the inflation numbers. It is also important to remember that historically UK interest rates are usually just above their US equivalent.
After the last but one Federal Reserve meeting, US interest rates were 5.25%, however, the UK was at 4.5%. The UK was thus out of line with history, which was a brave stance to take.
Thus, they had to act and close the gap. Speaking at a European Central Bank symposium at Sintra in Portugal, Bailey explained the various technical issues surrounding UK inflation and the difficulties they and the other Central Banks have in trying to manage it down. The biggest issue for the UK is the labour market, alone amongst the major economies the size of UK available workforce remains below pre-Covid levels.
Across Europe and the USA labour shortages are not as severe.
Feedback from the Bank of England’s network of agents suggests that companies are currently very unlikely to make employees redundant in a recession. This makes the main inflation busting tool almost irrelevant as no redundancies makes mortgage defaults less likely.
These same agents have also reported that food manufacturers are locked into expensive raw supply agreements taken out following the invasion of Ukraine. These are due to expire soon and food price inflation is starting to flatten off.
Historically though, it doesn’t come down until one supermarket breaks ranks and starts a price war. Globally, inflationary pressures are abating, Copper, Oil and Wheat are 30% to 50% down on their Ukrainian invasion levels, a return to a “normal” is coming, just not yet.
UK Inflation Why Higher Rates Aren’t Working… Yet
May’s core inflation rate in the United Kingdom rose to 7.1 percent in May 2023, the highest level since March 1992 and above market expectations of 6.8 percent.
The biggest drivers of this increase were theatre and concert tickets (allegedly Beyonce’s fault), flight tickets ( a 20% increase in May probably linked to the additional bank holidays) and computer games (new release of The Legend of Zelda).
All are discretionary purchases and might reverse in June. Nevertheless, the Bank of England had to be seen to be acting and thus reduced the unusual gap between UK and US official interest rates.
But there does remain the question why we and the USA aren’t in recession, especially when Germany is? Remember Central Banks and stock markets want a recession.
The answer lies partly in this chart, it is rare to see the UK at the top of any league table but UK households have more savings than the US and the major European countries.
Covid helped but this is a long term trend which is partly explained by the ageing demographic profile of the UK especially compared to the USA.
Also greater home UK ownership than in Europe leads ultimately to a comparatively wealthier retirement for UK citizens.
Despite the ”cost of living crisis” this has not reached the stage in the UK where savings are being eaten into.
This is in marked contrast to the USA where this number is dropping rapidly.
For the US this may mean a return to work for many post Covid early retirees, thus helping the Fed.
For the Bank of England it is another reason why interest rate increases may not work to bring down inflation.
The other major factor is the UK mortgage market. Normally, interest rates and thus mortgage rates rise and consumers consequently see an immediate reduction in disposable income and have to cut expenditure accordingly.
Bank of England data shown in the first chart below indicates that the share of households in England with outstanding mortgages has fallen over the past decade from 32% to a new low of 26%, possibly reflecting the ageing UK demographic.
This makes sense as with more savings there is also less debt.
Furthermore, the second chart shows that the percentage of mortgages on a floating rate has fallen from 71% in 2012 to just 13% in December 2022.
UK households have taken advantage of very low interest rates and increased fixed-term mortgage products to reduce their near-term exposure.
The share of households with a fixed-rate mortgage of two years or more has risen from 16% to 63% over the same period. This means that after combining the sets of data, only about 10% of households will see interest rates impacting their mortgages and thus their disposable income by the end of 2024.
This gives the Bank of England a third problem, food manufactures can’t cut prices, employers won’t sack staff and the majority of mortgage holders, at least for time being, don’t care.
Retirees meanwhile are protected by the “triple lock”, are finally getting some interest on their savings and generally don’t have a mortgage. Not much Andrew Bailey can do but sit and wait for the extraneous (energy prices etc.) elements of the UK inflation calculation to drop out and hope we get some imported deflation.
US Presidential Election
Stock markets like US Presidential Elections, the incumbent, particularly if it their first term of office, like to leave nothing to chance.
Joe Biden has proved to be an astute political operator achieving many things that neither Trump nor Obama could, However, he is deeply unpopular.
His Approval Rating is below both of the previous two Presidents and way below George W. Bush.
What can he do?
He is starting to use the US economy as his major success, indeed the term “Bidenomics” has been promoted by his own campaign team.
With US interest rates just “paused” and the data still showing a strongly growing and thus possibly inflationary US economy, this may appear to be a risky strategy and one that could backfire.
The Fed is of course apolitical, but with a previous Chair (Janet Yellen) as Biden’s Treasury Secretary and the current Chair Jay Powell undoubtedly still bruised from his dealings with Donald Trump, it is reasonable to assume that the Fed Governors might be more pro-Democrat than Republican?
Markets
We are now entering the final stage of this part of the investment cycle.
Tech has picked up, thanks to the new Artificial Intelligence mania but the broad markets have not. A proper Bull market is led by the Mid and Small Cap stocks, all of these indices remain close to their post Ukrainian invasion lows.
The Fed has stopped raising rates but with the caveat that it is data dependent.
However, there is still no hard data, as yet, that the US economy is about to enter the widely forecast recession. The Yield Curve does remain inverted, this means that the big institutional money continues to bet that it is coming.
Nevertheless, the expected downturn in economic growth remains elusive. This increases the risk of the Fed raising rates too much, as they wait to see what the impact of the dramatic and record breaking increases is on the US economy.
The recession should be coming, US savers are eating into their reserves and the collapse in commercial real estate is just beginning.
Nevertheless, markets can take comfort in the fact that the Fed has at least chosen to slow their rate of tightening and inflation remains downward trending.
As the above chart shows, inflation is one of the three keys to the markets, when inflation is declining equity markets have, since 1945, always shown healthy returns.
If interest rates do stop going up then this second key will also stop being a negative for markets.
The window for further tightening of monetary policy will start to close rapidly over the next few months.
Biden will want no further rate increases just before Thanksgiving.
US Inflation projections do have it below 3% by the end of the year, currently it is at 4.5%, so very possible. The global economy is not doing brilliantly, China is struggling to emerge from the Covid lockdowns, but overall it’s doing way better than expected. That for now still means higher interest rates until something else breaks, or the US economy finally nosedives, as is widely predicted.
Will this appear in this month’s quarterly earnings season? Current indications suggest not, inflation is generally good for company profits.
July 2023
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This information is not intended to be personal financial advice and is for general information only. Past performance is not a reliable indicator of future results.
