UK: Stagflation nation? – RBC Wealth Management

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