UK's economic challenges continue to grow, but recession isn't baked in yet

Joint article with Peter Arnold, EY UK Chief Economist, Ernst & Young LLP

The list of challenges facing the UK economy continues to grow. Inflation continues to rise, topping 9% in April and is expected to climb above 11% come October. It’s part of a global story that has seen central banks moving quickly and sharply on interest rates, which in turn will squeeze consumers. Meanwhile, businesses face continuing supply chain disruptions, labour shortages and general uncertainty, which, in the UK at least, is dampening down investment.

In that context, there are real concerns about the possibility of a global and UK recession, particularly around the turn of 2022 and into 2023. As a consequence, the EY ITEM Club has cut its GDP growth forecast for 2022 and 2023 for the fourth time in a row. According to the latest EY ITEM Club Summer Forecast, GDP is now expected to grow by 3.7% this year, down from 4.1% predicted in the spring, followed by 1% in 2023, a more significant downgrade from 1.9%. Although, as inflation falls back, the economy is expected to expand 2.4% in 2024, a little faster than previously penciled in.

However, things may not be as negative as they appear, and there are still some grounds for optimism. As of Q1 22, only the US and Canada have outperformed the UK in the recovery from the COVID-19 crisis. Further, whilst headline GDP stagnated between January and April, underlying growth (adjusted for the end of Test & Trace) was positive, and indeed the economy returned to growth in May (0.5%), beating expectations and suggesting that despite the squeeze on consumer incomes, the economy is proving resilient.

Other positives could support activity over the next 12 to 18 months. Firstly, consumers have still yet to tap into the £180bn or so of unplanned savings built up during the pandemic. These savings could support spending in the face of higher inflation, particularly from those on higher incomes, who are responsible for an outsized share of consumer spending and are best able to deal with cost-of-living pressures. Secondly, unemployment is at a near-50-year low, with many industries desperately short of workers; this again should support households for as long as the labour market remains buoyant. Finally, the extra fiscal support announced by the Government in May will go some way to ease the impact of surging energy bills, particularly for those on lower incomes. Regardless of who gains the keys to Number 10, we will likely see further support ahead of the October price cap increase.

However, this slightly more positive narrative relies on major assumptions around the path of energy prices and global economic activity. A gas or oil embargo on Russian energy supplies would see a further surge in energy prices; tightening monetary policy, particularly in the US, risks the creation of a global downturn, and continued and ongoing COVID-19-driven disruptions to supply chains all represent potential downside risks to the latest forecast.

From a UK perspective, the hopes that business investment would bounce back following the relaxation of COVID-19 restrictions are beginning to fade. Business investment continues to lag both pre-pandemic levels and performance in other countries. Greater political certainty would help, but a turnaround looks unlikely in the short term, given subdued growth prospects, rising costs and substantial increases in debt taken on by services sector firms, in particular. The EY ITEM Club forecast is that it will take to early 2025 before business investment returns to its pre-pandemic level. This has longer-term implications for UK growth and productivity. Addressing this shortfall and the UK’s wider productivity challenge will be another job on a substantial ‘to do’ list for whoever walks into Number 10 come September.