MARCH 2025
There is a whiff of stagflation in the UK economy with inflation trending higher again despite stalling growth.
The chart below shows headline UK CPI (blue line) rising back to 3%y/y in January; comfortably below the pandemic peak of 11%y/y, but above the Bank of England’s (BoE) 2% target (the top horizontal line).
With energy prices rebounding and the recent tax hikes yet to fully filter through, CPI is likely to rise further over the coming months.
Price pressures are building elsewhere in the world, but mostly because aggregate demand is perking up. That isn’t the case in the UK, where GDP growth has all but ground to a halt. It came in at 1.4% y/y in Q4 (red line), but rose by just 0.1% in the final quarter.
With consumer and business activity struggling in the face of fiscal headwinds and continued cost-of-living pressures, UK GDP growth is likely to stall this year.
This puts the BoE in a bind.
The economy desperately needs lower borrowing costs, but the inflation rebound limits the scope for further rate cuts.
The OECD survey of confidence in the UK manufacturing sector (red line) paints a pretty bleak picture for Britain’s industrial sectors.
Sentiment has taken a sharp leg lower since last year’s Autumn budget, extending a downtrend that began in late 2021. Business leaders cite escalating operating costs and a rising tax burden as the main drivers of this multi-year downtrend.
Encouragingly, consumer confidence (blue line) has recovered strongly from its 2022 low despite persistent cost-of-living pressures. A resilient labour market and elevated wage growth have evidently buoyed household activity; average weekly earnings were up 6%y/y in December.
There is a good chance that these trends reverse as the year unfolds.
The health of UK manufacturing is intricately linked to the global cycle, so the expected pick up in US and Chinese growth should spark a rebound in UK industrial activity.
Conversely, consumer confidence may struggle in the face of rising cost pressures and heightened political uncertainty.
The chart below helps to put the current UK inflation episode in context. It shows the average rate of retail price inflation (RPI) for every decade going back to the 1910s.
The RPI is a broad measure of UK goods and services costs. It includes housing-related costs, which tend to amplify the inflation reading compared to the widely-used consumer price index (CPI); RPI typically comes in at least 1% p.a. higher.
The low point for UK RPI came in the 1920s and 1930s as the Great Depression took hold. At the other end of the spectrum, the 1970s saw the RPI average a debilitating 13% p.a..
The horizontal red line shows that UK RPI has averaged 6.1%p.a. during the first half of the 2020s. This is well above the levels of the past 30 years, but well below the 1970s norm, especially if one factors in that much of the recent spike was the temporary surge above 10% in late 2022/early 2023.
The UK economy is clearly facing a number of challenges, but comparisons to the 1970s are misplaced. Whilst UK inflation is trending higher again, a return to sustained double-digit RPI prints is unlikely given the deflationary impact of the prevailing debt burden.
The chart below is a ratio of the FTSE 250 index divided by the FTSE 100, covering the past 10 years.
This is a simplistic metric, but one that neatly captures the significant underperformance of the FTSE 250 stocks since late 2021; a falling line shows the FTSE 100 producing a better return than the FTSE 250.
As a reminder, the FTSE 100 is the UK large-cap index and most of its constituent firms have significant international operations.
Conversely, the FTSE 250 mid-cap index houses companies with more of a domestic focus. It thus tends to be a better barometer of how the UK economy is faring compared to the FTSE 100, which reflects the global conditions.
The significant underperformance of the FTSE 250 thus highlights the UK’s recent struggles relative to the global economy, but this bucks a multi-year trend that generally saw the FTSE 250 outperform its large-cap counterpart.
We may be on the verge of this ratio resuming an upward trend.
Despite Britain’s economic woes, the UK mid and small cap stocks are trading at depressed valuations, so even a minor improvement in news flow could catalyse a decent rally, at least in relative terms.
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