Why the UK May Be Poised for a Surprising Rebound

Summary

Podcast Summary: "Why the UK May Be Poised for a Surprising Rebound"
Hosted by Morgan Stanley
Release Date: May 2, 2025

In the May 2, 2025 episode of Morgan Stanley's "Thoughts on the Market," hosts Andrew Sheats, Head of Corporate Credit Research, and Bruno Skaraka, Chief UK Economist, delve into an in-depth analysis of the United Kingdom's economic landscape. Contrary to prevailing market pessimism, the discussion sheds light on reasons why the UK might be on the brink of an unexpected economic resurgence. This summary encapsulates the key points, discussions, insights, and conclusions presented during the episode.

---

1. Context: Recent Challenges in the UK Economy

Bruno Skaraka opens the conversation by outlining the multifaceted challenges that have beleaguered the UK economy over the past several years.

• Brexit Negotiations (2016-2020): The protracted and uncertain Brexit process significantly dampened business confidence, leading to restrained capital expenditures.

  "[...] elevated uncertainty kept the lid on business CapEx in 2020." [00:54]

• COVID-19 Pandemic: The onset of the pandemic in 2020 introduced lockdowns and global disruptions, further straining economic recovery efforts.

• Supply Chain Disruptions & Energy Shock (2022): Post-pandemic supply chain issues were compounded by a European energy crisis in 2022. Notably, the surge in natural gas prices in the UK was twice as impactful on growth compared to the 1970s oil price shock.

  "[...] the natural gas price surge in the UK was twice more of a growth compared to the 1970s oil price shock." [00:54]

• Monetary Policy Responses: In response to soaring inflation, the Bank of England aggressively raised interest rates above 5% and has been slower than its international counterparts to reduce policy restrictiveness.

  "the bank of England had to hike interest rates to cap the inflation surge and they went to above 5%..." [00:54]

These cumulative factors have culminated in a notably weak post-COVID recovery for the UK economy, marked by subdued growth and persistent inflation.

2. Current State: Weak Recovery and Economic Indicators

Andrew Sheats and Bruno Skaraka further dissect the current economic indicators that have painted a bleak picture for the UK:

• Growth and Inflation:

  "Growth was pretty soft, inflation was still high because inflation was high." [02:10]
  The UK has grappled with low growth rates and high inflation, exacerbated by tight monetary policies and external uncertainties, such as adversarial US trade policies under the Trump administration.

• Labor Market and Fiscal Policy:
  The UK government's decision to hike payroll taxes in the October budget aimed at balancing the books has led to subdued sentiments in the labor market. Despite these measures, the labor market has fared slightly better than anticipated. Additionally, energy inflation forecasts have surged, prompting the Bank of England to adopt a more cautious stance in early 2025.

  "the government faced some pretty tough decision in the October budget and they hiked a tax, a payrolls tax really..." [02:41]

• Trade Dynamics:
  As a small open economy, the UK is highly sensitive to global growth dynamics. Services exports, particularly high-value white-collar services to the US, have been a bright spot, growing by 50% between 2019 and 2023. However, slowing growth in the US and Eurozone has necessitated downward revisions to the UK's GDP forecasts by approximately 30 basis points.

  "services exports to the us, the kind of value added white collar services exports which rose between 2019 and 2023 by 50%." [03:20]

3. Morgan Stanley's Future Outlook: Reasons for Optimism

Despite the current challenges, Morgan Stanley maintains a cautiously optimistic outlook on the UK's economic future, attributing this stance to several key factors:

• Relative Trade Resilience: Compared to the Eurozone and the US, the UK's trade-related GDP revisions remain less severe, positioning the UK as a potential relative winner amid shifting global trade policies.

  "the trade related revisions in the UK are still less than what our colleagues in the euro area and the U.S. had undertaken..." [04:02]

• Inflation Prospects: Morgan Stanley anticipates that inflation in the UK will decline more rapidly than initially expected by both the Bank of England and the markets. Enhanced commodities prices are expected to drive this decline, with domestically generated inflation projected to slow sharply next year as wage growth stabilizes between 3% to 3.5%, aligning with inflation targets.

  "inflation can come down faster than both the bank of England and the market expected..." [04:02]

• Monetary Policy Adjustments: The Bank of England is projected to implement significant interest rate cuts, totaling approximately 125 basis points between May and November 2025. The terminal rate is expected to decrease to between 2.5% and 3.75%.

  "the bank of England should be able to cut more than the markets expect... terminal rate could fall to as low as 2 and 3/4." [04:02]

• Fiscal Policy Improvements:
  Recent fiscal measures have exceeded market expectations, with borrowing increases lower than anticipated. Deficit projections indicate a reduction from around 4.8% of GDP this year to 3% over the next three years, with the debt-to-GDP ratio stabilizing around 100%.

  "deficit projections... to fall from around 4.8% this year to 3% over the course of the next three years." [04:02]

• Enhanced UK-EU Relations:
  In response to evolving US trade policies, the UK government is pursuing a closer trade relationship with the EU, aiming for a "trade reset." Initiatives include improving trade in food and goods and integrating UK defense companies into the European Defence Program. The upcoming summit on May 19 and the 2026 revision of the Trade and Cooperation Agreement are pivotal in this strategy.

  "the UK government... is looking for a closer relationship with the eu, or rather a trade reset with the eu." [04:02]

4. Investment Implications: Shifting Perceptions and Opportunities

The discussion transitions to the strategic implications of the UK's improved economic outlook for investors:

• Currency and Stock Market Performance:
  The British pound has appreciated against the dollar, and the UK stock market has risen by approximately 5% in 2025, outperforming the declining S&P 500.

  "markets are anticipatory... you've already seen the British pound... do quite well this year." [06:44]

• Stock Valuations:
  UK stocks, though concentrated in traditionally slower-growing sectors, present attractive valuations. Compared to the US stock index trading at around 21 times next year's earnings, the UK market trades at under 13 times, offering a less demanding entry point for investors.

  "the US stock index trades at about 21 times next year's earnings... the UK stock market trades a little bit under 13 times next year's earnings." [06:44]

• Bond Market Potential:
  Should the Bank of England enact more substantial rate cuts than the market anticipates, the UK bond market could become increasingly attractive, offering high yields in a favorable monetary environment.

  "if the bank of england does cut interest rates more than the market expects... that could be pretty supportive for the UK bond market." [06:44]

5. Conclusion: A Rebalanced Perspective

The episode concludes with a reaffirmation of Morgan Stanley's optimistic stance on the UK's economic prospects. Bruno Skaraka emphasizes the foundational strengths and strategic adjustments that could catalyze a rebound, while Andrew Sheats highlights the already positive market signals and potential investment opportunities. The hosts encourage listeners to reassess the UK's economic narrative beyond recent adversities, suggesting that the country's trajectory may be turning towards stability and growth.

---

Notable Quotes:

• "the natural gas price surge in the UK was twice more of a growth compared to the 1970s oil price shock." – Bruno Skaraka [00:54]

• "inflation can come down faster than both the bank of england and the market expected..." – Bruno Skaraka [04:02]

• "the US stock index trades at about 21 times next year's earnings... the UK stock market trades a little bit under 13 times next year's earnings." – Andrew Sheats [06:44]

• "if the bank of england does cut interest rates more than the market expects... that could be pretty supportive for the UK bond market." – Andrew Sheats [06:44]

---

This episode offers a comprehensive analysis of the UK's current economic hurdles and the strategic factors that could foster a surprising and robust rebound. By integrating macroeconomic indicators with fiscal and monetary policy insights, Morgan Stanley provides valuable perspectives for investors and stakeholders interested in the UK's market dynamics.

Transcript

[A]

Welcome to Thoughts on the Market. I'm Andrew Sheats, Head of Corporate Credit Research at Morgan Stanley.

[B]

And I'm Bruno Skaraka, Chief UK Economist at Morgan Stanley.

[A]

Today we're going to talk about the United Kingdom and why, despite a downbeat outlook by many in the market, we remain more optimistic. It's Friday, May 2nd at 2pm in London. Bruna, it's great to talk to you again about the UK and not just because this is an unusual day in London where it's sunny and warm and at the moment warmer than Los Angeles. When discussing the uk, I do think you kind of need to take a step back. This is a country and an economy that's had a tough number of years where growth has been sub trend, inflation's been higher and a lot of assets have traded at a discount. So maybe just to give some context, talk to us a little bit about the last couple of years in the UK and the challenges the economy has faced.

[B]

Indeed, Andrew, I do think it's important to take a step back to appreciate just the amount of supply side shocks the UK has seen in recent years. First, between 2016 and 2020, of course the country had to navigate Brexit negotiations. The elevated uncertainty kept the lid on business CapEx in 2020, of course, as the rest of the world we saw the lockdown and the pandemic. What followed were supply chain disruptions and then the European energy shock in 2022. I do want to zoom in on this final point because in its scale the natural gas price surge in the UK was twice more of a growth compared to the 1970s oil price shock. We've also seen a fair share of volatile market moves, most notably around the mini budget in the autumn of 2022. On top of all of this, the bank of England into these supply side shocks had to hike interest rates to cap the inflation surge and they went to above 5% and have recently been relatively slower in reducing policy restrictiveness than most of its peers. So when you tally all these factors up, it's really no surprise that the UK has seen an exceptionally weak post.

[A]

Covid recovery and that's continued right into this year. I remember a lot of conversations with global investors heading into 2025 and again the sentiment around the UK was kind of downbeat. Growth was pretty soft, inflation was still high because inflation was high, interest rates here were still quite high. And so you really had this unattractive mix of weak growth, high inflation, tight monetary policy and then you could throw onto that this uncertainty around the US and Trade. And you had a Trump administration that was adopting a more adversarial policy towards trade and towards Europe, which the UK was getting caught up in. So again, did I miss any of the challenges that the UK was facing entering this year? No.

[B]

I think that's a great summary. First, at the end of last year, of course, the government faced some pretty tough decision in the October budget and they hiked a tax, a payrolls tax really, in order to balance the books, which created somewhat subdued sentiment around the labor market this year. Now the labour market has been soft in the UK at the start of this year, but it did hold up a little bit better perhaps than the expectations from the end of last year. At the start of the year we also saw the energy inflation forecasts rise. So that led to a more cautious tone by the bank of England in February and March, as you mentioned. And now on the trade front, although we have a small manufacturing sector, we are a small open economy. We're a big beta to global growth dynamics. I would just like to mention here that one of the real bright spots of the UK economy in recent years have been services exports to the us, the kind of value added white collar services exports which rose between 2019 and 2023 by 50%. Now, with the growth in US slowing and obviously the euro area as well, UK growth will be affected too. This year we actually took our growth forecast down by around 30 basis points in our latest GDP revisions.

[A]

But Bruna, we're here to talk about the future and you know, I do think it's fair to say that going forward we think this picture is starting to look better. So let's jump right into that across a number of specific points. Why do we think the UK story could look better as you look ahead?

[B]

Absolutely. I mean the last point that I mentioned, I do think I want to put it in context. The trade related revisions in the UK are still less than what our colleagues in the euro area and the U.S. had undertaken in recent months on the back of the US trade policy shifts. So the UK does look a little bit like a relative winner there. Second, we now think that inflation can come down faster than both the bank of England and the market expected at the beginning of the year year. Commodities prices will do a fair bit of heavy lifting this year. But we do think that next year in particular domestically generated inflation could slow fairly sharply as wage growth sticks around 3 to 3.5%, which we think is fairly inflation target consistent. This all means the bank of England should be able to cut more than the markets expect, we anticipate, 125 basis point worth of cuts between May and November, and we think the terminal rate could fall to as low as 2 and 3/4. So we think the neutral rate in the UK is between 2.5% to 3.5%. And we do think the market still has a bit of adjustment to do in the sense of the pricing of the terminal rate one and two years ahead. The third point around, fiscal policy, I think, is quite interesting. Fiscal policy has been in great focus in the UK in recent years. We had a big fiscal event in October. We had another fiscal event just now in March. The borrowing increase was less than what the market expected. Deficit projections are such that we are expecting deficit to fall from around 4, 0.8% this year to 3% over the course of the next three years and for debt to GDP ratio to remain at around 100% of GDP. I would perhaps contrast that with France, where our economist is expecting the deficit to remain north of 5% over the course of the next two years. Finally, an important point to make is that the UK government, amid trade shifts in the us, is looking for a closer relationship with the eu, or rather a trade reset with the eu. EU remains our closest trading partner and in the aftermath of Brexit, the current government has an ambition to improve trading in food and goods and also to ensure that the UK is part of the European Defence Program, which would allow UK defence companies to partake in the Defence and Security pact that the European Union presented in recent weeks. There is a summit being held on May 19, and obviously the Trade and Cooperation Agreement is coming up for revision in 2026. So we do think those relations between UK and the EU could become somewhat closer over the course of this year and next. But now a question from me, which is, what does all this mean on the strategy side? UK assets have obviously been quite unloved in recent years. Do you think that's about to change?

[A]

So, again, I think it's pretty interesting that markets are anticipatory and I think markets are pretty smart here. So you've already seen the British pound, the currency, do quite well this year. It's up against the dollar. You've seen the UK stock market do quite well. It's up about 5% this year, despite the S&P 500 being down quite significantly. So you're already seeing, I think, some signs that investors are warming up to the uk, and I do think that if our expectations play out, that could continue. UK stocks do tend to be concentrated in slower growing, less exciting sectors, but their valuations are also less demanding. The US stock index trades at about 21 times next year's earnings. The UK stock market trades a little bit under 13 times next year's earnings. And I also think it's really important that if the bank of England does cut interest rates more than the market expects, which again, as you discussed one of our expectations here at Morgan Stanley, that could be pretty supportive for the UK bond market, which continues to offer pretty high yields. Bruna, thanks for joining me for this conversation. It's always great to catch up with you.

[B]

My pleasure, Andrew.

[A]

Thank you for the invite and thanks for listening. If you enjoyed the show, leave us a review wherever you listen and share thoughts on the market with a friend or colleague today.

[B]

The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for.