Reasons to be Cheerful, Part 3

One important pillar of the downbeat consensus view on the UK economy is the broad “falling living standards” narrative often cited by the popular media. Unfortunately, when commentators talk about this metric, they are not always talking about the same thing. Historically, economists have measured living standards by reference to GDP per capita, but more recently, the term has been used in commentary related to real wage growth, average incomes, housing affordability and elements of non-discretionary spending. All are relevant, ultimately, to our general sense of economic well-being, and so I thought I should highlight here a range of important data series that will give a rounded view of how a UK family on average earnings or a family confronting average monthly mortgage payments or average gas and electricity bills, has and is now faring compared to an appropriate history. 

Importantly, this analysis cannot apply to all. These are aggregated data that reflect the average circumstances of median families and individuals, but they also give what I believe is a rounded factual perspective on the current health of the UK economy.

As a reminder, 62% of the UK’s GDP is household expenditure which is the amount of final consumption expenditure made by resident households to meet their everyday needs. Let's start with a look at the household sector balance sheet and savings.

Bank deposits

My favourite UK economist once told me that economics is about winners and losers, and I think this maxim applies very clearly in this situation. Mirroring the public sector’s balance sheet deterioration since the pandemic is something of a transformation in the UK household sector, as is graphically shown in the charts below (for those who guessed correctly in yesterday's quiz, well done!).

Employment & wages

The data clearly shows that the labour market has recovered from the COVID crisis, and employment is now above pre-pandemic levels.

The unemployment rate, which spiked during the pandemic, is now very near a 50-year low. The latest data shows a slight uptick in unemployment to just over 4%, alongside an increase in hours worked of 1.25% in the three months to February.

These labour market data indicate a slight easing in what policymakers have described as a tight market. Although an increase in unemployment is not welcome, it may help to ease the MPC’s concerns about future wage growth.

So far, so good, albeit there are some worrying trends in economic inactivity due to significant growth in long-term sickness post-pandemic and economic inactivity in the 18-24 age cohort.

More people in work is a good thing, but what about wages? Here again, the consensus view is that there has been a prolonged squeeze on real wages. The OBR, for example, forecast that in 2023, real household disposable income would fall by around 2.5%, having also fallen in 2022. Was it right?

In short, the answer is no. Real household disposable income grew by 2.2% in 2023.

Real wages (not real disposable income but normally closely related) grew in 2023 and will grow again in 2024 by about 2%. Importantly, this isn’t a function of an acceleration in the underlying rate of wage growth, something that would worry policymakers. Instead, this is the product of the rapid increase and then fall in inflation and the lagged response of wages to those changes. Ultimately, this is good news for the UK’s household sector after an undoubtedly difficult time in 2022 and the first half of last year.

Mortgages and housing

To get a more complete picture of the outlook for the UK household sector, I felt I should also show what’s happening to the cost of mortgages (just under a third of UK households have a mortgage) and rents.

First, mortgages and housing affordability. The UK mortgage market has been transformed over the last ten years. Most importantly, this huge shift from floating-rate to fixed-rate mortgages in the UK has fundamentally changed the relationship between official interest rates and the mortgage rates people actually pay. This relationship is dampened further by the dominance of 5-year fixes over two years.

Consequently, the impact of the significant increase in official interest rates since early 2022 has and will continue to be spread over a long period of time in the mortgage market. Time in which incomes will grow, providing the means for households to adjust to higher monthly payments. Homeowners who fixed their 5-year deals late in 2021 are particularly fortunate because when they come to refinance in 2025 or 2026, interest rates and five-year fixed rate deals will likely be back down in the 3.5 to 4.0% range, having peaked at nearly 6% in the summer of last year.

This shift in the structure of the mortgage market has consequently had an important impact on mortgage affordability. Despite significant increases in official interest rates over the last two years, mortgage payments as a % of household disposable income remain well below the peaks reached in the financial crisis and will remain well below this level.

Also, housing affordability for first-time buyers is now similar to long-term averages, and as rates start to decline this year, this metric will begin to improve.

This changing structure of the mortgage market, alongside the constrained supply of new houses, has led to the real house price outcomes shown below. In fact, recent data from RICS and other surveys shows that nominal house prices are now increasing, which, as inflation falls to the 2% level in the next few months, should translate into real price rises later in the Spring, higher mortgage approvals, and housing transactions.

To complete the picture, I also wanted to look briefly at rent. As more households choose to rent rather than buy a home, total rents in the UK have grown rapidly over the last quarter of a century. But, when aggregated with mortgage payments, the combined “stress” of these two components of non-discretionary spending is still well below the peak seen in the financial crisis and is predicted to remain so.

I believe this fundamentally changed, but not well-understood, structure of the mortgage market explains why the negative consensual view on the outlook for UK house prices back in 2022 and early 2023, which was carried extensively in financial media, was so wrong. Furthermore, looking at real, long-run average house prices in the chart above, which have not changed significantly from where they were before the financial crisis, it is hard to argue that they are at all extended.  

Energy, food and inflation

Now to a subject that affects every household in the UK: energy and food prices. Unsurprisingly, these are huge components of the inflation indices. A lot of media attention has been focused on these subjects over the last 12 months. 

Following Russia’s invasion of Ukraine in February 2022, energy prices increased significantly, especially in the European gas market, which had become excessively dependent on gas supplied from Russia. Dramatic increases in wholesale prices quickly translated into much higher retail energy prices (principally gas and electricity). The UK government, recognising that this posed a significant problem for the UK economy, intervened in the retail energy market by effectively limiting what consumers would pay through the energy price guarantee scheme. This, alongside other smaller schemes, insulated UK households and businesses from the worst effects of the crisis but ended up costing the government more than £70bn in 2023.                                        

These energy price impacts were felt across Europe and the world and significantly impacted inflation not just through direct energy costs but also indirectly through food and other goods and service prices. Now that energy prices have fallen almost as rapidly as they rose after February 2022, retail energy prices are effectively back to pre-pandemic levels relative to average post-tax earnings.

These recent falls have also significantly impacted overall inflation here in the UK, a subject I will come to later in this piece.

Alongside the cost of energy, food prices, the largest single weight in the CPI, have also attracted many column inches in the “cost of living crisis” commentary. Food production, processing and distribution are all energy-intensive activities, so naturally, energy costs heavily influence food prices. Not surprisingly, therefore, food prices followed the upward spike in energy costs and have since followed them down in lockstep. Forward indicators of food price inflation point to price increases falling to near zero later in 2024 and possibly then deflating.

With both goods prices and service inflation falling, the good news on UK inflation continues, such that the CPI is set to fall close to its 2% target in April and stay near this level throughout the remainder of this year and into 2025.

With inflation down at the MPC’s target, it will only be a matter of time before the committee starts to cut official interest rates from their 5.25% level. My guess is that the pressure for a cut as early as May could become irresistible for a committee whose credibility is far from riding high. Much will depend on what other leading central banks do (the Swiss have already moved), but it would seem clear that a cut will be fully justified from a domestic perspective. 

Income taxes

Having looked at the household sector’s balance sheet, employment, wage growth, the mortgage market and inflation, the final missing piece is to look at income taxes. This subject always attracts a lot of commentary, especially around budgets, and for political reasons, often much of it is not particularly accurate.

Over time, the burden of income tax has shifted considerably towards higher income cohorts but to get a balanced perspective, I have looked at taxes on average earnings and how these have changed over a 15-year period from 2010/11 through to 2024/25. The data is, I think, quite revealing in that it shows that the % rate of tax on someone with average earnings has fallen over this period from 22.7% to 18.3%, with the absolute level of national insurance reduced from £1,929 to £1,895.

Household cash flow

The latest reduction in national insurance took effect in April, alongside significant increases in pensions and benefits. These are noteworthy because all of these changes, alongside the real wage growth I highlighted earlier, combined with significantly lower energy bills, will contribute to significant growth in household cash flow in 2024. As the chart below shows, at just over 10%, this is the fastest growth in household cash flow (after non-discretionary spending) since 2009, which we believe will naturally lead to strong growth in consumer spending in 2024 and 2025.

Conclusion

As we’ve seen in this three-part series, the current economic circumstances are far from perfect. However, given how challenging the last few years have been for the economy, they are far removed from the rather bleak view that most economic commentators would have us believe.

In the first instance, the UK has performed relatively well against its peers since 2010, but more importantly, it is poised to deliver a period of much better growth with significantly lower inflation and interest rates in the future. UK consumers, in aggregate, have the means (low indebtedness, high savings and real wage growth) to start to grow discretionary spending significantly. As inflation continues to fall and interest rates follow, I believe this is precisely what they will do in the months and years ahead. This growth in consumer spending will drive economic growth towards, and possibly beyond, the 2% level in 2025.

The MPC’s February forecast for Q1 GDP growth was 0.1%, and the OBR’s most recent forecast for the same period was 0.2%. Based on a better-than-expected January and February, my guess is that Q1 growth will be 0.4%, which is not far removed from the consensus view for UK growth in 2024 as a whole. Not surprisingly, I expect that we will see some significant upgrades to these forecasts in the weeks ahead.  

I hope that I may have helped you to develop a more positive perspective not just about the historic performance of the UK economy but, more importantly, on its immediate future. But, apart from just feeling better about the UK’s economic prospects, why is this relevant?

An improving economy that delivers faster growth than the consensus expects will generate more tax revenue that benefits the public finances, higher corporate profits, a stronger labour market that helps those looking for work, and for those in work, if higher growth generates better productivity, higher real wage growth.

So far, so good. But a return to more normal economic growth rates here in the UK might also catalyse long overdue share price appreciation in those parts of the market that have been moribund for years, namely the domestic economy focused sectors. Since before the pandemic, the valuation of companies in these sectors has remained well below “normal” levels for a number of reasons, but arguably, mostly because investors have convinced themselves that the UK economy cannot grow sustainably. Maybe, at last, that myth will be slayed in the months ahead, and that will lead to a recovery in the valuation of these overlooked and fundamentally cheap sectors of the UK equity market. 

More broadly, and despite the differing composition of comparator indices, better UK economic performance may also eventually lead to wider equity market outperformance relative to the UK’s peers.

So, I hope you can see why there are many good reasons to be cheerful about the UK’s economic outlook. If you are feeling a little deflated because you have just read another opinionated piece about how we are all economically doomed, why not have another listen to Ian and his Blockheads and remind yourself that the reality is, in fact, rather different.