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Economic and Market Commentary

Safety in Numbers: Why the UK Economy No Longer Looks Like an Outlier

Many thought the UK economy was exceptional, but it has now converged – a timely reminder that, for investors, it pays to look under the bonnet.

Rewind a few months and some people feared the UK was a global outlier. Core inflation was running at close to 7% in May, in year-on-year terms – almost two percentage points above that in the euro area and the US at that point. Worse, underlying price pressures appeared to be accelerating, while activity remained depressed, with GDP still below its pre-pandemic level and underperforming the post-pandemic recovery in almost all other developed countries.

At face value, the UK seemed to suffer from structurally higher inflation. Many blamed Brexit or other supply shocks, including a fall in labour participation, while others pointed to a lack of monetary policy credibility. At one stage, in early July, financial markets expected the Bank of England (BOE) to hike its policy rate to around 6.5%, well above that in the US and the rest of Europe. The UK seemed different.

But there were good reasons to dig deeper. Small open economies tend to be more vulnerable to external shocks and experience higher inflation volatility. Indeed, other small open economies, including Sweden, Australia, and Norway, faced similarly high inflation rates. While Brexit might have added to consumer prices, this was likely a one-off level adjustment, rather than ongoing inflation. Most importantly, monetary policy credibility seemed intact, with medium-term inflation expectations anchored around the inflation target. Although the BOE’s communication at times appeared dovish, its actions were conventional and hawkish, responding to higher inflation with repeated hikes in the policy rate.

Fast forward to today, and the UK no longer stands out. Granted, in year-on-year terms, core inflation remains higher than in the US and the euro area. But sequentially, inflation is falling sharply, even more so than elsewhere. Annualise the last three month-on-month prints (in seasonally adjusted terms), and core inflation is now even back to the inflation target. It’s a similar story with wage growth, which remains high at approximately 7-8% year on year, but sequentially has been falling recently. When annualizing the last three month-on-month prints, wage growth in the private sector is closer to 4%.

Meanwhile, the underperformance in activity was – it turns out – misplaced. GDP has been revised sharply higher and is now almost 2% above its pre-pandemic level, on par with France and Spain, even better than in Germany. No doubt, some smaller parts of the UK economy still struggle (manufacturing output is depressed; so too are exports, especially in goods) but the broader picture now resembles that of most other developed countries. But recent market volatility serves as a good example that investors can benefit from a global perspective to fixed income. Up until recently, in our expectation that UK inflation would normalise, we favoured UK Gilts over US Treasuries in our global portfolios, with the former yielding about 60 basis points above the latter. The market has repriced sharply since, with UK Gilts now yielding 20 basis points less than their US equivalent. As such, we have shifted to a more neutral stance from a relative value perspective, although from an absolute point of view, we continue to find both attractive. US duration – a gauge of a bond’s sensitivity to interest rate movements – in itself offers the potential for attractive returns and we also see very good opportunities in other regions such as Australia, Canada, and Europe.

Still, the UK's journey from outlier to convergence reminds us that perhaps it can pay for investors to look under the bonnet.

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