Recession Risks Spark U.K. Market Jitters Ahead of BOE Decision

(Bloomberg) -- U.K. markets are sounding the alarm over a potential recession, piling pressure on the Bank of England to balance curbing surging inflation with protecting growth.

An index of discretionary retail stocks has tumbled 26% this year as consumer confidence slumps to the lowest since 2008, while nearly 2,000 businesses are in critical financial distress. The pound is trading at levels not seen since the early days of the pandemic, and money markets bet central bankers will have to cut rates in coming years after sharp hikes in 2022.

It’s a “pretty ugly backdrop” to set the scene for the BOE’s meeting next week, according to BlueBay Asset Management’s Mark Dowding. Policy makers will have to take in a rash of bad news, with retail sales weaker than anticipated and inflation at a three-decade high.

The central bank is widely expected to lift interest rates again Thursday and money markets expect more hikes at each meeting this year, piling further pain on borrowers. BOE Governor Andrew Bailey has already noted the difficult path bankers need to tread to avoid potentially triggering a recession.

“The market is definitely of the view that the U.K. is more vulnerable here,” said James Lindley, a portfolio manager at BMO Global Asset Management. “If we didn’t have inflation, we would be thinking about cutting not raising interest rates.”

Britain’s inflationary shock will be harder to address than in any other leading industrialized nation, the International Monetary Fund has warned. Here are charts showing how markets are dealing with the risks. 

Out of Stock

Stocks most exposed to Britain’s domestic economy have underperformed year-to-date. The midcap FTSE 250 benchmark’s 12% drop compares with a 2% rise for the FTSE 100, whose firms earn three-quarters of their revenue abroad with high exposure to buoyant commodities prices.

An index tracking discretionary retail stocks, including companies such as Marks & Spencer Group Plc and JD Sports Fashion Plc, is faring even worse, as price rises hit demand for non-essential goods. British consumers are being squeezed even harder than elsewhere due to a recent hike in the National Insurance tax and the removal of a cap on household energy prices, just as gas costs spike during the war in Ukraine.

“We think that the U.K. is more vulnerable to an income shock,” said Frederique Carrier, head of investment strategy at RBC Wealth Management, adding that declining consumer confidence will likely feed into corporate results.

Meanwhile, investors betting on the more global companies in the FTSE 100 -- such as Shell Plc and AstraZeneca Plc -- as a hedge against U.K. economic worries may be left disappointed.

Price targets for the year ahead suggest the blue-chip index has among the lowest return potential of major international peers, according to data compiled by Bloomberg. The 12-month implied upside of 19% compares with 29% for the Euro Stoxx 50. 

Bears in Control

The negative mood has led investors to flee the pound, down more than 4% to about $1.25 in April in its worst month since the aftermath of the Brexit referendum in 2016. Traders are favoring the dollar as a haven to global growth risks stemming from Covid-19 lockdowns in China as well as the energy standoff brewing between Europe and Russia.

The slump may not be over yet, with analysts starting to talk of $1.20 and options traders lifting bets on further declines in coming months. The fear-greed indicator -- a gauge of momentum that compares buying to selling strength -- implies that bears haven’t controlled price action this much since the early days of the pandemic shock.

For State Street Global Advisors portfolio manager Aaron Hurd, the long-term fair value for the pound comes in north of $1.50. But even he is reluctant to buy despite these cheaper levels, citing an absence of heavy short positioning in the currency that could pre-empt a reversal. 

“Now you have the recession risk and a more dovish Bank of England relative to more hawkish central banks outside of the U.K -- that’s a really toxic combination,” he said. These factors are also boosting bets on currency volatility, making it much more expensive to hedge.

Rate Cuts 

The growth risks mean money markets have not only trimmed bets on the extent of the BOE’s hiking cycle, but are pricing in interest-rate cuts as early as 2024.

“Do you prioritize growth? Or do you prioritize headline inflation? In our mind, the Bank of England is going to be the first central bank to have to face that trade off,” said Fredrik Repton, a portfolio manager at Neuberger Berman.

No Red Alert

Still, not all the warning signals are firing just yet. Gilt market curves are not inverted -- a widely-watched historical signal for recession -- though they are not far off.

In the corporate debt market, signs of a U.K. recession would show up first in the sterling high-yield bond sector, which is dominated by domestic issuers. Spreads have widened nearly 100 basis points to 474 basis points year-to-date, but remain below peaks seen in early 2016 and late 2018. That suggests the sector “is not signaling an elevated risk of a U.K. recession,” said Song Jin Lee, a credit strategist at HSBC Holdings Plc.

Some sectors are being hit worse than others. The construction industry saw a 51% jump in firms in critical financial distress, according to research by insolvency practitioners Begbies Traynor. Overall U.K. insolvencies are already on the rise and there may be a new wave coming as pandemic-era support for companies is no longer available.

“It’s just a case of when the dam holding it back finally bursts,” said Julie Palmer, a partner at Begbies Traynor. 

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