United Kingdom: Trapped by policy choices

The Bank of England seems caught between a rock and a hard place as the UK faces both elevated inflation — likely to last until Q4 2022 — and upcoming fiscal consolidation. However, by not acting, it risks creating even more inflation. At its monetary policy meeting on 04 November, we expect the Bank of England to significantly cut its growth forecasts as the UK’s economic slowdown intensifies amid supply-chain disruptions driven by global trends and exacerbated by Brexit. We expect +0.6% q/q in Q4 2021 and +1.0% q/q on average in 2022. In theory, this should buy more time before the first rate hike, initially expected in early 2022. However, recent communications from Governor Andrew Bailey have pushed the BoE into a corner: his unexpected hawkish twist triggered an immediate market repositioning, with participants now anticipating a much earlier start of the hiking cycle.

However, embarking on an earlier monetary policy tightening cycle is premature and could raise the risks of a 'technical' recession, especially as the UK will be the first major economy to start fiscal consolidation in 2022. The UK’s labor market is far from full employment and two thirds of the ongoing surge in inflation is driven by temporary factors such as supply-chain disruptions, Covid-19 base effects, the sharp rise in energy prices, the rise in taxes and the rise in wages, given the mismatch between available jobs and workers. In our view, inflation should reach 2.4% y/y in Q4 2021 from a peak of above 4.0% in Q4 2021 and H1 2022. And even as other G7 countries are implementing significant amounts of fiscal stimulus, 2022 will bring about the freeze of personal tax allowances and thresholds for households  in the UK. This will be followed by an increase in the headline tax rate from 19% to 25% for corporates with profits of GBP250,000 or greater (around 10% of firms) in 2023, bringing the headline corporate tax rate slightly above the advanced economy average. Overall, the tax rises announced in the 2021 Budget increase the tax burden from 34% to 35% of GDP in 2025-26, its highest level since the late 1960s.

Given the current market expectations, if the BoE decides to remain in wait-and-see mode the probable sterling depreciation of up to -8% could eventually create even more inflation, entering into a self-fulfilling feedback loop. Several reports show that the FX pass-through to import prices is one of the highest in the UK, given its dependency on foreign inputs (around 55% of UK import prices are estimated to reflect changes in FX, compared to 10% in Germany and 5% in France). The import share is highest for manufacturing goods, notably food, clothing and transport. Overall, 29% of UK consumer expenditure is dependent on imports. Research shows that between June 2016 and June 2018, the impact of the -10% depreciation in the sterling boosted inflation by +2.9pp .

Watch out for wider corporate credit spreads in an environment where business insolvencies are already on the rise. Corporate credit spreads have started to price in the current changing economic environment and some further spread-widening periods are to be expected as they are extremely tight. Digging deeper into the drivers of UK corporate spreads reveals that the latest spread compression, especially within the investment grade universe, has been led by a combination of declining equity volatility, an improving macroeconomic outlook (proxied by consumer confidence) and expanding policy support (proxied by the M3 money growth in this model). Taking these market drivers into account, a worse-than-expected economic outlook paired with retracting policy support is the perfect mix for a substantial widening of corporate spreads, which could at the same time trigger a spike in equity volatility. Because of this unstable equilibrium and market fragility, a mild widening of credit spreads is to be expected in the short run, especially within high-yield space.

On the equity side, the UK remains the big 2021 underperformer compared to the rest of the world. As in the case of corporate spreads, the combination of high inflation, policy support and a mildly stronger currency are keeping equities afloat. In this context; we expect UK equity to close the year at ~10% returns. In addition, 2022 will be the year of consolidation, with returns going back to long-term averages (~5%). Nonetheless, a bigger-than-expected economic disappointment paired with a too aggressive policy response could easily derail equity markets, leading to a correction, albeit likely to be milder (~-10%) due to the already low starting conditions.



Ana Boata
Allianz Trade
Jordi Basco Carrera
Allianz SE