Is the UK sleepwalking into recession? Evidence is mounting that activity is cooling in many areas of the economy. The latest hike in interest rates by the Bank of England might be a step too far. Finances are rapidly tightening; any businesses that are already struggling may now find borrowing very expensive if indeed loans are available at all. What does this mean for Scotland?
Data from around the world paints the same worrying picture. Voluntary cuts in oil production point to softening global activity and demand for energy. These economic worries extend to China and the US, with recent signals suggesting deteriorating business and consumer confidence. Consumer credit demand is slowing rapidly and some key indicators such as used car prices are registering their biggest drop since the pandemic. In Europe, the warning is in the construction indicators. Even the Bank of England expects inflation to drop “markedly” this year, something that may already have been on course before the latest rate rise.
We can expect problems to surface quickly now, particularly where businesses were already struggling. The biggest challenges will likely be areas where a lending squeeze combines with slowing demand. Highly borrowed sectors such as property and private equity owned businesses may also suffer. The unwinding of years of easy money will involve some business failures as well as higher unemployment. But unlike past recessions, this time the pain of losing jobs and businesses might not actually solve any economic problems. Supply is tight.
Central banks seem confused by the economic data; in the UK and US, employment creation is weak despite strong wage growth. This may explain the policy errors over the past two years and the risk of over-correcting now. Consumer demand in areas like travel and hospitality remains strong - in part funded by excess savings - but interest rate rises may not be the solution. The challenge remains the supply side; even as inflation in energy and food is slowing, labour shortages remain.
Whether the missing labour stems from post-pandemic health issues or lifestyle changes is not clear. Certainly there is a problem in the mature and ageing economies of the West, but the UK fix must involve a step change in productivity. Immigration can never be a sustainable solution for any individual country’s labour shortages. Wage rises combined with unusually higher vacancies mean employers are already becoming more cautious about hiring. We can see the evidence of a choking-off of demand in the form of shorter opening hours in many restaurants, for example.
It is easy to characterise inflation as a wage problem, with public sector wages rising at the fastest rate in 22 years and private sector wages growing even faster. But UK insolvencies are also at 10 year highs and the mortgage squeeze will not be solved solely by bank forbearance of struggling borrowers. The UK has limited options on its spending and borrowing and overall taxes are at a relatively high level. High interest rates have even brought a strong Pound, not helpful for exports or tourism. Scotland would benefit currently from a weaker currency.
Before the recent jump in interest rates, the UK economy was on track for a marginal level of growth this year. But higher rates are a hurdle for a lot of financing activity that drives the economy; property transactions, capital investment and refinancing. The latest International Monetary Fund projections for output growth suggests that UK growth by the end of next year will have lagged the Eurozone by 4% and the US by 7% over five years. Already, the cost of new borrowing by the UK Government on ten year debt is the highest in the G7. That ten year cost matters more for many company investment decisions than short term interest rates. Even the best rated UK corporate debt is now at its highest level since the 2008 financial crisis.
More signs of slowdown could come soon. One sector that stands out as facing more current risk is retailing, particularly in clothing where many operators are running with high inventory levels. They are unprepared for any sudden fall-off in demand. This could quickly become expensive to finance if stock levels represent multiple weeks of sales, extending beyond normal trade credit terms.
Many sectors benefit from a tail wind when the economy is growing. This operational leverage means that as activity expands there are some efficiencies from scale and better profit margins and cash flow. In a recession all that goes into reverse, which can put a financial strain on businesses whose profit margins were already thin. A small slowdown can trigger much bigger problems.
The rise in the Bank of England interest rate may underestimate the real borrowing costs for deteriorating businesses whose credit is poor. It is less of a problem for the biggest stock market listed chain stores with well-integrated high street and online operations, but many smaller and medium sized groups are struggling. Company administrations show the stresses; recently Scottish chain, Wilkies announced the closure of almost half of its units. Retailing is polarising, with widening gap between the winners that are strong enough to invest in efficiency and sustainability, and those left behind.
For all the UK’s current problems, it is not clear that inflation should be the nation’s number one priority, nor that the Bank of England has the solution. Across the political spectrum there are differences in aspiration for the economy. But setting aside different opinions on tax levels and the social aims of growth, there seems broad agreement on the desirability of an innovative entrepreneurial economy. That would be a sound foundation for sustainability and wellbeing.
Yet recent City speeches by the UK government do not suggest that there is currently a clear focus on enterprise, innovation and productivity as priorities. Industries that can be champions in international competition need a period of policy stability rather than constant change. The UK economy has looked resilient over the last year, but a preoccupation with inflation and monetary policy may change that.
A version of this article was published in The Herald on 19.7.2023