Prolonged recession risks, strong bias to international companies
Austerity even as recession bites. Having contended with the economic shocks of Brexit, the COVID-19 pandemic, and this year’s energy crisis, the UK is the only G7 economy still languishing below its pre-pandemic output levels. It is now being subjected to sweeping tax increases and spending cuts totaling almost 2% of GDP even as the Bank of England tightens monetary policy and a recession starts.
Newly appointed Prime Minister Rishi Sunak is imposing austerity in an effort to restore credibility after his predecessor’s fiscal recklessness increased UK assets’ risk premium and nearly caused a financial crisis. Sunak aims to get the nation’s debt-to-GDP ratio, roughly 103% as of the end of 2021, falling by a comfortable margin.
This is being done even as economic activity has significantly slowed due to a crippling cost-of-living crisis, with inflation of some 11%. The Bank of England (BoE), the first major central bank to embark on a tightening cycle back in 2021, has lifted interest rates to 3% so far. With a more prudent fiscal policy in place, the BoE will likely be less aggressive going forward, mindful of the impact of higher rates on the housing market. Some 30% of mortgages are fixed for two years and will be coming up for refinancing at much higher rates. A more cautious monetary policy will mean tolerating sticky inflation and a weaker pound, in our view.
UK business investment struggles
UK business investment (Q4 2019 = 100)
The line chart depicts a quarterly index of UK business investment from 2010 to 2022 (Q4 2019 = 100). Business investment grew strongly up until the 2016 vote to leave the EU, when it was just over 100. From then on and until the onset of the COVID-19 pandemic, UK business investment flattened. In early 2020, the index plummeted to less than 80. A fiscal incentive is highlighted, introduced in the second quarter of 2021. The index remains much below the pre-2016 level, at 94.3.
Source - UK Office for National Statistics, RBC Capital Markets, RBC Wealth Management
We believe the Bank Rate will reach 4.0% at the end of the current tightening cycle. This is in contrast with markets, which are discounting a peak interest rate of 4.6% by mid-2023.
Overall, the result of all this will likely be a long, drawn-out recession, which we think could last well into 2024.
Consensus economic forecasts for the UK point to a 0.75% contraction in 2023, but we believe risk may be to the downside as the impact of austerity gets further incorporated into forecasts.
Decisions taken by policymakers (fiscal recklessness, then austerity) and society at large (Brexit) have put the UK economy on a shaky growth path. The economy should ultimately recover, but a change of direction would likely help achieve this sooner.
What could change this cautious thesis? Lower natural gas prices and inflation receding faster than currently envisaged would enable the BoE to end its interest rate hiking cycle earlier. Moreover, a warmer relationship with the UK’s major trading partner, the EU, would go some way towards reducing the Brexit uncertainty which contributes to holding back growth.
Low valuations, high dividends. Following a period of outperforming other major regions, we downgraded UK equities to Underweight in September 2022 as we were worried about the fiscal policies being entertained by then new Prime Minister Liz Truss. With austerity worsening economic conditions, we maintain this rating.
Yet we think attractive opportunities remain for UK equities, which trade at a historically large valuation discount to other markets, even accounting for the different sector composition. For income-seeking investors, UK equities offer interesting opportunities, in our view, given the FTSE All-Share Index has the highest dividend yield among the major equity regional markets, at over 4%.
The FTSE All-Share Index hasn’t been this cheap in 10 years
FTSE All-Share Index 12-month forward price-to-earnings valuation relative to FTSE World Index
The line chart shows the 12-month forward price-to-earnings ratio of the FTSE All-Share Index relative to that of the FTSE World Index from November 16, 2012 through November 14, 2022. A value above 1.0 indicates that the All-Share is relatively expensive, and a value less than zero indicates the All-Share is relatively cheap. The value was near 1.0 in 2015 and 2016, has declined since then, and is currently near 0.65, its lowest value during the time period shown.
Source - Bloomberg
Within UK equities, we maintain our strong bias for internationally oriented companies. Across the market, the valuation multiples of many global leading UK-listed companies are at notable discounts to their peers listed in other markets. The UK market is also well endowed with Energy companies which, despite strong outperformance in 2022, remain attractively valued given the prospect for higher-for-longer oil and gas prices, in our opinion. We would continue to be selective towards domestically focused UK stocks given our cautious stance on household spending due to the cost-of-living crisis. Though still too early, in our view, we believe there will be a point this year to begin allocating towards UK small-caps and midcaps.
UK fixed income
Higher government debt issuance, quantitative tightening create Gilt supply glut
A downbeat outlook. We expect the Bank of England (BoE) to continue raising rates, albeit at a slower pace going forward, to reach a 4% terminal rate in 2023, below the 4.6% market expectation. Price pressures are widely expected to peak in 2022. Furthermore, the recent austerity measures and the upcoming recession will reduce the likelihood for the BoE to hike aggressively from here, in our view.
Has inflation peaked in the UK?
UK Consumer Price Index inflation and Bank Rate
The line chart shows the Bank of England’s Bank Rate and the UK consumer price inflation rate monthly for the period of November 2021 through November 2022, and future projections. Inflation and the Bank Rate have risen throughout the period; the last data point for inflation is 11.1% in October and the last data point for the Bank Rate is 3.00% in November. The Bank of England’s estimates for future inflation are 11% in Q4 2022, 10% in Q1 2023, 5.2% in Q4 2023, and 1.4% in Q4 2024. Market expectations for the Bank Rate reach 3.53% at the end of 2022 and 4.48% in 2023.
Source - Bloomberg, Bank of England; data as of 11/16/22, 09:35 GMT
The BoE’s economic expectations for the UK are downbeat. It forecast a two-year recession resulting in a cumulative 2.9% loss of output, leaving GDP running 10% below pre pandemic levels. In addition, the BoE stated, “CPI inflation is projected to fall sharply to some way below the 2% target” over the forecast two-year period. The very bearish BoE forecasts from the November Monetary Policy Report (MPR) came with a significant caveat—they were based on a market-implied terminal Bank rate of 5.25%, a level the BoE deemed excessive. Nevertheless, such cautious predictions for the UK’s GDP further support our view that current market pricing, even at 4.6%, still seems excessive.
Labour market dynamics present a risk to our view that the terminal rate will reach 4%, as the BoE will be particularly concerned about wage growth running around 6% and above consensus. This raises the risk of a wage-price spiral that further stokes inflation, which could warrant further policy tightening policy above our 4% forecast.
Oversupply darkens Gilt outlook. The Chancellor of the Exchequer’s recent spending cuts and tax increases, totalling £55 billion by the end of tax year 2027–2028, significantly reduce the government’s debt issuance requirement, which the UK Debt Management Office has reduced by £24.4 billion to £169.5 billion for the current tax year. Still, the net supply of Gilts for the current and subsequent tax years is forecast by RBC Capital Markets to be above record highs—a clear negative for Gilt yields.
Not only will the government issue record amounts of debt, but the supply of Gilts will also increase as the BoE proceeds with the selling of its Gilts portfolio at the same time—in a process known as quantitative tightening (QT). According to RBC Capital Markets’ forecasts, the supply glut will continue into the 2023–2024 tax year with a net issuance of nearly £255 billion, close to double the previous record in 2010–2011. The challenge will be whether demand for Gilts can meet the supply deluge. We have a negative outlook for Gilts in H2 2023.
Barbell approach to credit. As for credit markets, we would proceed with caution given high inflation and recession. Yet, the return potential for credit has improved after a challenging 2022, and we think there are pockets of opportunity. Corporate default rates remain low and credit spreads tend to peak at the beginning of recessions. However, we remain cautious in adding meaningful duration, UK-centric issuers, or lower-quality credit indiscriminately as there are bound to be periods of volatility as risk assets continue repricing.
UK credit spreads are above their 5-year averages
Credit spreads by credit rating
The shows corporate credit spreads in basis points by credit rating for the UK market, based on the Bloomberg Sterling Aggregate Corporate Index. Five-year range bars show the difference between the maximum and the minimum spread from November 2017 through November 2022. The chart also shows that the current spreads are above their 5-year averages and closer to the maximum level for all credit ratings except high-yield, which are now above their 5-year average. Data by rating (average spread, current spread): Aaa (67, 105); Aa (80, 125); A (117, 174); Baa (172, 257); high-yield (493, 743).
Source - Bloomberg, data as of 11/17/22, 17:35 GMT
We prefer bonds that are trading at attractive spreads relative to company fundamentals and peers. To take advantage of compelling yields and spreads in short-dated, lower-quality investment-grade credit, a barbelled approach looks interesting to us where we balance risks in lower-quality credit with higher-quality credit.
The Financials sector is poised for outperformance, in our view, as it is not held within the BoE’s £18.56 billion corporate bond portfolio. Therefore, as the central bank winds down its holdings through QT, sector supply will be unaffected. Moreover, sector fundamentals remain favourable, in our view, as it benefits from higher interest rates.