Despite news that the UK economy is set to slow due to uncertainty around US trade policy, our analysts Andrew Sheets and Bruna Skarica explain why they have a more optimistic outlook.
Read more insights from Morgan Stanley.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley.
Bruna Skarica: And I'm Bruna Skarica, Chief UK Economist at Morgan Stanley.
Andrew Sheets: Today we're going to talk about the United Kingdom and why, despite a downbeat outlook by many in the market, we remain more optimistic.
It's Friday, May 2nd at 2pm in London.
Bruna, it's great to talk to you again about the UK and not just because this is an unusual day in London where it's sunny and warm, and at the moment warmer than Los Angeles. You know, when discussing the UK, I do think you kind of need to take a step back. This is a country and an economy that's had a tough number of years where growth has been sub-trend, inflation's been higher, and a lot of assets have traded at a discount.
So maybe just to give some context, talk to us a little bit about the last couple of years in the UK and the challenges the economy has faced.
Bruna Skarica: Indeed, Andrew, I do think it's important to take a step back to appreciate just the amount of supply side shocks the UK has seen in recent years. First, between 2016 and 2020, of course, the country had to navigate Brexit negotiations. The elevated uncertainty kept a lid on business CapEx. In 2020, of course, as the rest of the world, we saw the lockdown and the pandemic. What followed were supply chain disruptions, and then, the European energy shock in 2022. I do want to zoom in on this final point because in its scale, the natural gas price surge in the UK was twice more of a hit to growth compared to the 1970s oil price shock.
We've also seen a fair share of volatile market moves, most notably around the mini budget in the autumn of 2022. On top of all of this, the Bank of England into these supply side shocks had to hike interest rates to cap the inflation surge. And they went to above 5 per cent and have recently been relatively slower in reducing policy restrictiveness than most of its peers.
So, when you tally all these factors up, it's really no surprise that the UK has seen an exceptionally weak post COVID recovery.
Andrew Sheets: And that's continued right into this year. You know, I remember a lot of conversations with global investors heading into 2025, and again, the sentiment around the UK was kind of downbeat. Growth was pretty soft. Inflation was still high. Because inflation was high, interest rates here were still quite high. And so, you really had this, you know, unattractive mix of weak growth, high inflation, tight monetary policy. And then you could throw onto that, this uncertainty around the U.S. and trade. And you had a Trump administration that was adopting a more adversarial policy towards trade and towards Europe, which the UK was getting caught up in.
So, you know – again, did I miss any of the challenges that the UK was facing, entering this year?
Bruna Skarica: No, I think that's a great summary. First, at the end of last year, of course, the government faced some pretty tough decisions in the October budget, and they hiked a tax – a payroll tax really – in order to balance the books, which created somewhat subdued sentiment around the labor market this year.
Now the labor market has been soft in the UK at the start of this year, but it did hold up a little bit better perhaps than the expectations from the end of last year. At the start of the year, we also saw the energy inflation forecast rise. So, that led to a more cautious tone by the Bank of England in February and March, as you mentioned. And now on the trade front, although we have a small manufacturing sector, we are a small open economy, we're a big beta to global growth dynamics.
I would just like to mention here that one of the real bright spots of the UK economy in recent years have been services exports to the U.S., the kind of high-value-added white-collar services exports, which rose between 2019 and 2023 by 50 per cent. Now with the growth in the U.S. slowing and obviously the Euro area as well, UK growth will be affected too this year. We actually took our growth forecast down by around 30 basis points in our latest GDP revisions.
Andrew Sheets: But Bruna, we're here to talk about the future and you know, I do think it's fair to say that going forward we think this picture is starting to look better. So, let's jump right into that. Across a number of specific points. Why do we think the UK story could look better as you look ahead?
Bruna Skarica: Absolutely. I mean, the last point that I mentioned, I do think I want to put it in context. The trade related revisions in the UK are still less than what our colleagues in the euro area and the U.S. had undertaken in recent months on the back of the U.S. trade policy shifts. So, the UK does look a little bit like a relative winner there.
Second, we now think that inflation can come down faster than both the Bank of England and the market expected at the beginning of the year. Commodities prices will do a fair bit of heavy lifting this year, but we do think that next year in particular, domestically generated inflation could slow fairly sharply as wage growth sticks around 3 to 3.5 per cent, which we think is fairly inflation target consistent.
This all means the Bank of England should be able to cut more than the markets expect. We anticipate 125 basis point worth of cuts between May and November, and we think the terminal rate could fall to as low as 2 ¾. So, we think the neutral rate in the UK is between 2.5 to 3.5 per cent, and we do think the market still has a bit of adjustment to do in the sense of the pricing of the terminal rate one and two years ahead.
The third point around fiscal policy I think is quite interesting. Fiscal policy has been in great focus in the UK in recent years. We had a big fiscal event in October. We had another fiscal event just now in March. The borrowing increase was less than what the market expected. Deficit projections are such that we are expecting deficit to fall from around 4.8 per cent this year to 3 per cent over the course of the next three years, and for debt to GDP ratio to remain at around 100 per cent of GDP. I would perhaps contrast that with France where our economist is expecting the deficit to remain north of 5 per cent over the course of the next two years.
Finally, an important point to make is that the UK government amid trade shifts in the U.S. is looking for a closer relationship with the EU, or rather a trade reset with the EU. EU remains our closest trading partner and in the aftermath of Brexit, the current government has an ambition to improve trading in food and goods; and also to ensure that the UK is part of the European Defense Program, which would allow UK defense companies to partake in the defense and security path that the European Union presented in recent weeks. There is a summit being held on May 19th, and obviously the trade and corporation agreement is coming up for revision in 2026.
So, we do think those relations between UK and the EU could become somewhat closer over the course of this year and next.
But now a question from me, which is, what does all this mean on the strategy side? UK assets have obviously been quite unloved in recent years. Do you think that's about to change?
Andrew Sheets: So again, I think it's pretty interesting that markets are anticipatory, and I think markets are pretty smart here. So, you've already seen the British pound, the currency do quite well. This year it's up against the dollar. You've seen the UK stock market do quite well. It's up about 5 per cent this year, despite the S&P 500 being down quite significantly.
So, you're already seeing, I think, some signs that investors are warming up to the UK and you know, I do think that if our expectations play out, that could continue. You know, UK stocks do tend to be concentrated and slower growing, less exciting sectors. But their valuations are also less demanding. You know, the U.S. Stock Index trades at about 21 times next year's earnings. The UK stock market trades a little bit under 13 times next year's earnings.
And I also think it's really important that if the Bank of England does cut interest rates more than the market expects, which again, as you discussed, is one of our expectations here at Morgan Stanley, that could be pretty supportive for the UK bond market, which continues to offer pretty high yields.
Bruna, thanks for joining me for this conversation. It's always great to catch up with you.
Bruna Skarica: My pleasure, Andrew. Thank you for the invite.
Andrew Sheets: And thanks for listening. If you enjoyed the show, leave us a review wherever you listen and share Thoughts on the Market with a friend or colleague today.