Better UK Data Belie Economic Pessimism

After making new highs in February, UK stocks hit an air pocket after persistent inflation (economy-wide price increases) drove commentators we follow to warn far more rate hikes would spur a deep economic downturn.^[i] In price terms, the MSCI UK Investable Market Index (IMI) slipped briefly below -10%, hitting correction territory (a correction is a sharp, sentiment-driven decline of -10% to -20%).^[ii] More volatility could come, and it seems clear the UK economy isn’t firing on all cylinders, as we will discuss. Yet we think the latest data lend little support to calls for a nasty recession (prolonged economic contraction), as inflation decelerated in June with prices rising only a smidge from the prior month—much less than expected.^[iii] Meanwhile, June’s inflation-adjusted retail sales jumped and July’s flash composite purchasing managers’ index (PMI) showed ongoing growth.^[iv] Who knows how the Bank of England will interpret this, but to us, the data show the UK economy continues defying rock-bottom expectations.

Most coverage we read focussed on the Consumer Price Index (CPI), which rose just 0.1% m/m in June, below consensus estimates for 0.3% and decelerating rapidly from May’s 0.7%.^[v] Month-over-month figures aren’t seasonally adjusted, so we wouldn’t draw big conclusions about the trends, but we think it is a noteworthy slowdown all the same. Core CPI (excluding food, energy, tobacco & alcohol) rose 0.2% m/m—half expectations—after a 0.8% increase previously.^[vi] This brought the year-over-year inflation rate down sharply. CPI fell to 7.9% y/y from May’s 8.7%—and a peak of 11.1% in October.^[vii]

Whilst these figures grabbed headlines we followed, CPI isn’t the Office for National Statistics’ (ONS) headline measure. That honour goes to another measure called CPIH—which includes owner occupiers’ housing costs. This metric follows CPI directionally but has been lower during this inflationary stretch, and it also dropped quickly to 7.3% y/y from 7.9% (and 9.6% in October).^[viii] Meanwhile, core CPIH decelerated more moderately to 6.4% y/y from May’s 6.5% peak.^[ix]

Exhibit 1: UK Inflation Is Seemingly Turning the Corner

Source: ONS, 19/7/2023. CPIH and its services and goods components, January 1989 – June 2023.

Although still historically high, CPIH’s -2.3 percentage point decline from its high shows price pressures continue to ease, following America’s disinflationary lead, in our view.^[x] Like in the US, we think goods prices are leading the way down, particularly as motor fuel costs fall, which to us is fittingly putting a book end on the UK’s 2021 petrol shortages that helped kick off the global inflation scare. Core inflation remains stubbornly high, which we have observed commentators’ attention switching to, but that looks to be moderating, too, in our view—at least with services’ latest tick sideways—which again resembles the American experience to us.^[xi] Our research shows US inflation trends led the UK and Europe on the way up and the way down. US goods inflation peaked in March 2022.^[xii] It took almost a year before US services inflation began to ease in February.^[xiii]

In the meantime, it looks to us like UK consumers are starting to get a grip on higher prices. June retail sales volumes’ 0.7% m/m rise easily cleared 0.2% expectations.^[xiv] Food rebounded big, but non-food did a bit better.^[xv] Non-food stores sales volumes rose 1.0% m/m after falling -0.5% in May, whilst food stores’ bounced 0.7% from -0.4%.^[xvi] Sales volumes in the other main category, non-store (online) retailing, continued rising, up 0.2% m/m following May’s 2.4% surge.^[xvii] More generally, whilst just below pre-pandemic levels, overall retail sales have trended up slightly since December.^[xviii]

Exhibit 2: UK Retail Sales Volumes Trending Modestly Higher

Source: FactSet, 25/7/2023. Retail sales volume and its major components, June 2019 – June 2023.

UK shoppers apparently have some petrol left in the tank, in our view—especially since automotive fuel stores sales have trended down with energy prices.^[xix] The base effect from King Charles’s May coronation holiday also appeared to help June sales rebound, but it seems to us accelerating wage growth is providing a more sustainable fillip.^[xx] The rolling three-month average of weekly earnings excluding bonuses (to smooth out monthly volatility) rose 7.3% y/y in May, matching April’s rate and the highest in two years.^[xxi] Wage growth has also caught up to the inflation rate, which we think likely provides some relief.^[xxii] Retail sales don’t reflect most services spending—the UK economy’s main driver—but they suggest to us reality is less dire than anticipated.^[xxiii]

The bigger and more recent picture from UK PMIs, including its mighty services sector, shows growth slowing but continuing in July, if barely.^[xxiv] Now, we don’t think PMIs give a very detailed portrait. They indicate only how many firms surveyed report business activity expanding or contracting.^[xxv] With the dividing line at 50, PMIs above 50 suggest the majority see growth.^[xxvi] But they don’t aggregate how much activity grew by, like actual sales data can.^[xxvii] We find this means that even if a minority of firms saw output shrink, if they shrank more than the majority of firms’ combined growth, then (lagging) output data would conflict with (timelier) PMI surveys. So whilst PMI reads come sooner, they are blurrier, in our view—particularly near 50.

With that said, July’s flash composite PMI reading, an early count of 80 – 90% of firms’ responses for the month, was 50.7.^[xxviii] Its underlying services and manufacturing components split between expansion and contraction.^[xxix] The services PMI—heavily weighted in the composite—was a bit above it at 51.5, whilst the manufacturing PMI fell to 45.0.^[xxx] Not exactly robust services growth, in our view, and manufacturing is weak. But manufacturing’s downturn isn’t new, and we think services’ plodding expansion thus far seems enough to pull the overall UK economy along.

Exhibit 3: UK PMIs Split, but Still Expansionary Overall

Source: FactSet and S&P Global, 25/7/2023. UK composite, services and manufacturing PMI, July 2020 – July 2023. Latest data are preliminary estimates.

Since February, UK stocks have bucked global stocks’ upward trend.^[xxxi] We think this reflects lingering inflation alarm that has plagued Britain longer than in the rest of the developed world, sending long-term Gilt yields higher.^[xxxii] This also bumped up mortgage rates, feeding into warnings we have observed about higher payments denting consumer spending.^[xxxiii] Although the UK faces some unique headwinds causing inflation relief others are seeing to lag, price deceleration is still coming through, whilst mortgage headwinds appear overstated, based on our analysis. As inflation comes down, rates are likely to as well, in our view. But it isn’t as if they are an economy killer now, either—rates were higher in the 1990s and the UK grew fine then.^[xxxiv]

We think this is likely to help UK stocks as the economy muddles through and pessimism fades, if it isn’t already. Whilst we don’t put much stock in short-term moves, since the MSCI UK IMI’s 7 July year-to-date low, it has risen 6.2%, outpacing the MSCI World’s 3.9%.^[xxxv] Notably, 10-year Gilt yields appear to be spying the shift in inflation winds, too. After rising all year and hitting a 15-year high of 4.67% on 6 July, they have since retreated somewhat to 4.28%.^[xxxvi] Again, a two-week move is hardly anything to go by, in our view, but alongside stocks’ upswing, it suggests to us uncertainty may be starting to clear, lifting moods—and markets with them. According to our research, it would be unusual for the divergence between the UK and the rest of the world to last for long.