On the face of things, the UK’s decision to avoid fully locking down the economy over the Christmas period appears to be paying dividends. The downside risks flagged by the Bank of England in its surprise December decision to hike rates may yet be avoided and the prospect of relatively open international borders has also supported inflows into the UK equity market, which has strong exposure to the sector.
In contrast, the euro area and wider European Union introduced restrictions relatively early (see Figure 1), so markets are starting to price in greater underperformance on growth and policy normalisation.
This is particularly clear in the euro/sterling exchange rate, which has fallen to levels approaching multi-year lows. Current trends run counter to our view on euro area outperformance versus the UK this year, but we don’t expect the situation to last long. Valuation pressures aside, the UK’s growth and policy foundations remain very fragile.
Figure 1. Stringency index: UK, France and Germany
Source: Bloomberg, BNY Mellon
The UK economy may remain open, but rate expectations have not changed much over the past quarter. In our view, one of the key reasons behind the market’s reluctance to add to UK pricing at present is the troubling outlook for the UK household. Fiscal differentials were already expected to widen but, when the path towards consolidation in public finances was set, the UK Treasury likely did not anticipate the growth impact of a new variant and the sustained gains in energy prices.
Despite calls for an additional £20bn in support for household energy bills and the removal of VAT for the same (a potential price advantage following the UK’s departure from the EU), Chancellor Rishi Sunak has warned that there are ‘limits on state help’. There will only be targeted support for UK households, mostly those on lower incomes, and the net fiscal impulse will be very limited.
Meanwhile, the small rise in interest rates would also add to household cashflow burdens before the bigger-ticket items come through mid-year, especially the national insurance hike which will reduce take-home pay outright. Meanwhile, household savings have reverted to pre-pandemic levels, leaving very little room for any form of acceleration in discretionary spending, which resulted in upside growth surprises through much of 2021.
More recently, labour market mismatches and shortages have been exacerbated by staff absences. The latter may resolve itself in the near future but even a short period of increased dislocation represents a productivity drop which would inhibit real income growth.
Figure 2. End-2022 rate expectations, BoE & ECB
Source: Bloomberg, BNY Mellon
Next steps for the BoE will require greater justification on inflation persistence. In aggregate, this means that if the bank meets or exceeds current market pricing in rate hikes, on balance monetary policy is being tightened in line with the ‘product market scenario’ as outlined by the Office of Budget Responsibility in its October outlook. This implies that inflation will be driven by business cost mark-ups over wages and energy.
However, in this scenario the labour market gains are not broad-based, and firms will be unable to ‘fully compensate workers for increased inflation’, leading to real wages that are ‘3.5% lower at the scenario horizon’ and the labour share of the economy at ‘1pp lower than the central forecast’. By the end of 2023 the level of real wages is expected to fall below Q4 2019 levels. This explains why 15 basis points of cuts are expected in 2024 relative to end-2023 pricing – a gap which has shown every sign of increasing.
While it may take longer than anticipated, the market may realise that the BoE might have to opt for a slower pace of tightening rather than simple front-loading to manage inflation expectations alone, lest the economy be forced to opt for nominal growth over real, and at the expense of the household.
This is not to say that all is rosy in the euro area, but on balance the situation has been much better than expected. As Figure 3 shows, even though the services purchasing managers’ index continues to underperform the UK equivalent, December continued to show an expansion which should limit the growth drag witnessed the previous winter.
On the matter of euro area versus UK convergence, on a relative basis we also believe the risk is that the UK stops outperforming. First, despite the lack of headline lockdown measures, the self-isolation requirements led to a voluntary reduction in activity over the holiday period, which ultimately reduced the potential for the UK economy to outperform. This is one of the main reasons behind the UK government’s decision to bring down self-isolation times and testing requirements.
Second, the UK’s vaccination drive in the first half of 2021 led to a sharp rise in expectations – largely realised – for a speedier recovery in domestic demand through 2021. Despite the success of the booster programme, the vaccination lead for the UK is likely to be much reduced for 2022, resulting in fewer marginal gains for reopening-related gains for the UK economy relative to the euro area.
In contrast, as the euro area had a stronger lockdown due to the higher levels of stringency, the recovery process may prove stronger and at least help economic and price expectations stabilise at current levels, rather than face downward pressure ex-post.
Figure 3. UK versus euro area services PMIs
Source: Bloomberg, BNY Mellon
The bottom line for the UK versus euro area trade is that while current divergence in restrictions supports the pressure on the euro/sterling, most of the easy gains for the UK are already in the price. Barring a highly unlikely growth surge driven by productivity or real income gains, all the risks to the UK are now to the downside, and the country is still struggling to make the most of its relative lack of restrictions.
As the BoE’s December hike was largely precautionary in nature and represented the removal of emergency levels, next steps would require greater justification on inflation persistence. In contrast, the European Central Bank’s Governing Council members are becoming increasingly comfortable with talking about 2023 hikes. As these are gradually in the price, convergence in policy differentials with the UK should support a euro/sterling recovery in due course.
Geoffrey Yu is Senior Europe, Middle East and Africa Market Strategist at BNY Mellon.