A struggling economy
Observers breathed a sigh of relief when it was revealed that UK GDP was flat quarter over quarter in Q3, against consensus expectations of a contraction. However, any celebrations were short-lived; as for 2023 overall, the economy has hardly grown.
In fact, we think economic data is likely to slip further as the full impact of much higher interest rates increasingly filters through to the economy. This could be partly offset by an improvement in real wages as inflation declines. Much will depend on the labour market. The risk is that it could weaken should the impact of higher rates put pressure on corporate margins. For now, the Office for National Statistics estimates that the unemployment rate stabilised at 4.2 percent over the three months to September, having been as low as 3.6 percent a year ago. Consensus expects GDP growth of a mere 0.4 percent in 2024, on par with what it projects for 2023.
Despite this economic weakness, we believe the Bank of England (BoE) will likely maintain the Bank Rate, currently at 5.25 percent, elevated for much of 2024. Inflation excluding food and energy prices has waned but remains elevated, at 5.7 percent. Over the next couple of months, a more flattering year-over-year comparison could result in lower inflation. But RBC BlueBay Asset Management Chief Investment Officer Mark Dowding points out that the BoE will be alert to long-term inflation expectations remaining elevated or “de-anchoring.” The government has been very vocal in its promise to “halve inflation” by next month. Given the starting point was double-digit inflation, it seems to have directed the public to expect inflation of some five percent at year end. High inflation expectations increase the risk of inflation becoming entrenched.
Dowding also surmises that inflationary pressures could be increased if the UK government announces additional tax cuts at the upcoming Autumn Statement. The UK finances are in poor shape, but the Conservative government is in a precarious position, having trailed the opposition Labour Party in the polls for close to two years. It may be tempted to shore up its fortunes with feel-good measures ahead of what will likely be an election year. Though it is not our base case, the risk is that the BoE may well need to hike again in 2024 to bring inflation lower.
RBC BlueBay thinks the UK is facing a high risk of stagflation, a state characterized by low economic growth, high inflation, and rising unemployment.
Will there be a changing of the guard?
Given that the traditionally left wing Labour Party has held a consistently large lead in the polls for more than a year, we think it is worth considering how it could govern once in power.
Under Sir Keir Starmer’s leadership, Labour has changed its spots. The policies of its radical left wing faction, from imposing higher taxes on high earners to nationalizing utilities, have been abandoned. The party seems to have moved successfully to the centre, and it has markedly improved ties with the corporate sector. Overall, we do not think a Labour win would incite strong negative reaction in financial markets.
Labour has outperformed the Conservatives for two years
Westminster voting intention tracker
Line chart showing the voting intentions in the UK for the two main parties, the ruling Conservatives and Labour, for the period of January 26, 2020, through November 8, 2023. Since November 2021, Labour has gained an advantage. The gap has markedly widened since September 2022 and Labour now commands 47% of the vote intentions compared to 23% for the Conservatives.
Source - YouGov; data as of 11/8/23
At its recently held Labour Party conference, Starmer stated that the party aims for a closer relationship with the EU including regulatory alignment of “certain sectors” and accepting some oversight of the European Court of Justice. It is also looking to deregulate the planning process for new homes, to strengthen employment rights, and to forge ahead with the transition to a low-carbon economy.
Some of these goals may be difficult to achieve. The EU is unlikely to accept this cherry-picking approach, and planning deregulation may continue to meet fierce opposition as it threatens to change the landscape. Importantly, Labour would inherit a country with deep scars—not only from Brexit, but also from the BoE’s fastest monetary policy tightening spree in three decades—and heavily indebted with gross debt to GDP approaching 100 percent. This may limit a new government’s ability to reboot the economy.
Opportunities in an unloved market
We acknowledge the challenging domestic economic prospects but recommend a Market Weight exposure to UK equities. We believe the market’s defensive qualities should hold it in good stead given the more volatile backdrop we are expecting for the global economy and global equities in 2024. The UK’s blue-chip equity index, the FTSE 100, has a relatively large exposure to defensive sectors (e.g., Health Care and Consumer Staples). Moreover, it has a bias to “old economy” industries, including Energy (approximately 14 percent of the FTSE 100), a sector where the risk-reward is favourable at present, in our view, given the tight supply-side dynamics, inexpensive valuations, and improving earnings momentum. Importantly, UK equity valuations are undemanding, with almost every sector trading on an abnormally high discount relative to history.
Given the challenging domestic economic prospects, we remain cautious on domestic stocks. We continue to recommend maintaining a bias for globally diverse, high-quality businesses. Across the market, the valuation multiples of many leading UK-listed global companies remain at a notable discount versus their international peers listed in other markets. We view this unwarranted “UK market discount” on these global companies as an opportunity for long-term investors in these stocks.
UK fixed income is an interesting asset class with yields elevated and the BoE close to the peak of its hiking cycle. We are somewhat concerned about the heavy Treasury issuance schedule however, so for non-UK-based investors, we suggest a Market Weight in Gilts with a bias to shift to Overweight in the near term.
For UK-based investors, the tax treatment of Gilts makes them an attractive investment. Gilts are exempt from capital gains tax, so no tax is paid on any profit realized when the Gilt matures—only income tax on the coupon is paid. This is particularly useful for higher-rate taxpayers, who would otherwise pay capital gains tax at 20 percent.
With contributions from Thomas McGarrity, CFA