Recession: Definite, but Not Definitive

This article appears in our Q3 2022 issue of Finance Transformation Magazine. To download the issue, click here

As the Bank of England declares the UK is entering Recession, Mark Smith, CEO of 4D Contact, looks at how UK policy makers can contain its impact.

The UK economic outlook looks bleak. High level inflation, low-level growth, and interest rate hikes loom on the Christmas horizon like the ghost of future cost-of-living doom. The finance markets "stagflation" is now the Bank of England's Recession. Will Liz Truss's government have better luck flattening the Recession curve than Boris Johnson did with flattening that of COVID-19?

There is a growing acceptance that the UK economy will enter a Recession towards the fourth quarter of this year. Latest estimates from Deloitte suggest that activity will fall by a total of 1.6% over three quarters. Thanks to government interventions, this is a significantly smaller contraction than those seen during the pandemic (21.5%) and the financial crisis (5.9%), and most economists are predicting growth to resume by the second half of 2023.

The Impact of Inflation

UK inflation hit 10.1% in July, a 40-year high. With Kate Bush topping the charts, Top Gun at the cinema, strikes and an energy crisis you could easily think you were back in the 1980s!

At the heart of the current inflation crisis lies the basic economic principle of the effect of supply and demand on price. Whether it is the impact of the COVID-19 pandemic, the fall-out from the Ukraine conflict or the perfect storm of global events that has led to the current energy crisis, the inability of supply to meet demand have driven price inflation.

Deloitte's latest predictions suggest UK inflation will peak at 11% this winter as these underlying inflationary pressures remain strong. Core inflation, which strips out the impact of energy and food prices, is currently 6% - the highest level in 30 years. These price pressures are widely predicted to remain throughout most of 2023 before recovering in 2024.

The impact of inflation on the economy is not to be underestimated. Inflation is affecting consumer spending power at a speed that has not been seen in decades and it is also having a devastating effect on business. Spiralling costs, a tight labour market and weaker demand, post-Brexit difficulties with international shipping, uncertainty in capital markets,
geo-political uncertainty compounded by the end of government Covid support measures make it a tough environment for businesses to thrive or even survive.

In these conditions an economic contraction is unavoidable. In August the number of companies in England and Wales declared insolvent jumped by 43% with 1,933 insolvencies. This was 42% above the level in August 2019, before the COVID-19 pandemic hit.

For the first time since the pandemic there was a month on month increase in the administration and CVA figures (43% for administrations and 160% for CVAs). This suggests that more live businesses are reaching for insolvency and restructuring protection.

Owning the Inevitable

With some form of Recession inevitable, policy makers must now shift their focus from avoidance to containment and prioritise strategies which will shorten and soften the contraction. In the current situation this can only be achieved by dampening demand and curbing inflation.

The UK's energy support package is a massive response to the cost-of-living crisis, expecting to cost the taxpayer nearly twice the COVID furlough scheme. The scale of its cost and reach has staggered supporters and critics alike. Much lower energy prices will help lower the peak in inflation, delivering a shallower downturn as well as reducing the squeeze on household income. But it will not be a magic bullet and consumers will still feel the inflationary pinch on their spending power.

The fact that energy subsidies will bring down inflation, and that the economy is already slowing, has not changed the view in financial markets that interest rates are heading sharply higher as the Bank of England will make its own moves to control inflation. UK interest rates have already risen to 2.25 and are predicted to peak at around 4.5% next summer.

At What Cost?

Without question this will all come at a cost - fiscal interventions rarely come without some form of fallout.

Interest rate hikes and inflation will substantially increase companies' costs. This combined with weaker demand will squeeze corporate margins, driving both corporate cost-cutting and an increase in insolvencies. Cost-cutting equates to further reductions in investment and a rise in unemployment as companies streamline - and thus, the cycle of Recession begins.

The recent sweeping tax cuts announced in Kwasi Kwarteng's mini budget are a bold move by the Government to "turn the vicious cycle of stagnation into a virtuous cycle of growth". The cuts to income tax and National Insurance will put cash back in consumers' pockets in the hope of stimulating spending. But there is considerable scepticism whether this will be enough to offset the impact interest rate hikes have on most people's disposable income.

The cuts to corporation tax and banker's bonuses aim to stimulate enterprise in the UK. However, post announcement the Pound plummeted and there is clear concern in the financial markets about the irreconcilable realities of monetary tightening at the same time as fiscal loosening.

Whether this is bold or foolish, it will be no quick fix and the likelihood is that a Recession is now inevitable. Whilst interventions by both the Bank of England and the Government will hopefully reduce its' impact, it will in the short-term cause significant disruption. We can expect a turbulent 9 months for corporations and consumers alike.

About the author: Mark Smith

Director of outsourced credit management solutions providers Barratt Smith and Brown and 4D Contact, and a major shareholder in fintech company Invevo, Mark has over 30 years of experience providing clients build strategic O2C process solutions to mitigate challenging financial markets.