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- [00:01]
A
Welcome to Thoughts on the Market. I'm Andrew Sheets, global head of Fixed Income Research at Morgan Stanley.
- [00:07]
B
And I'm Brunes Karaka, Morgan Stanley's chief UK economist.
- [00:10]
A
Today, the debate around growth and debt in the United Kingdom. It's Wednesday, May 20th at 2pm in London. Bruna, I'm so glad you could join us today because I actually really did want to talk about what's going on here in the United Kingdom. I don't think it's an exaggeration to say that this is the country where you hear some of the strongest divergence of opinions. Pessimists point to political uncertainty, vulnerability to oil prices from the Strait of Hormuz and rising bond yields. And yet UK growth this year has been pretty good. Inflation is set to come down and the currency's been pretty stable. Hardly the stuff of big instability. So Bruna, I was hoping you could help us set the scene. Let's start with how you see the economy.
- [00:57]
B
Actually, I think your framing is perfect. For the past five years there has been a striking divergence of opinion on the uk, which I do think mimics to a degree some of the divisions on the bank of England's Monetary Policy Committee. The question really is has the country underwent structural changes in the past decade of supply side shocks such that its potential growth is very low, perhaps as low as 1% on the year? And has the inflationary process shifted in such a way that for example, we need much higher jobless rate in order to generate enough economic slack to to get inflation down to 2%? Or the other question is, has the UK just had a unique string of external shocks amplified perhaps by domestic policy choices, which mean that we have seen a prolonged period of low growth and high inflation. But again, without major structural changes, we are in the more constructive structural camp. I actually think that's probably Morgan Stanley's biggest out of consensus call on the uk. In recent years in particular, we have seen quite robust capex and last year actually very healthy private sector productivity gains. When you adjust for accurate Labour market data, UK's private sector productivity growth is just under 2% as of the end of 2025, actually not too far from the US. But for these good structural trends to persist and continue to improve, we do need a more supportive cyclical environment and there unfortunately, given the rise in oil prices, it's hard to be overly constructive about growth and inflation. In the UK this year we've downgraded our growth forecasts to around 1% over 26 and 27 and we have lifted our inflation projections by around 150 basis points at their peak to a peak of around 3.5% later in the year.
- [02:39]
A
So, Bruna, how much does the price of oil or the price of natural gas matter for this outlook, especially as the Strait of Hormuz remains effectively shut?
- [02:50]
B
Yeah, it does matter a fair bit. We use Morgan Stanley's commodity team's forecasts in our own scenario analyses for the UK economy. Now, their base case still sees a gentle decline in oil prices this year, which leads to outcomes. I've already mentioned the activity flatlines from the second quarter. We have a rise in inflation from April onwards, but we don't have a recession. However, if we fail to see any movement lower in oil, and as you rightly pointed out, natural gas prices as well, or if we even saw a move higher over the summer, we do think that risks of a recession would be quite pronounced in the second half of the year. UK consumers are already in for a year of flat, real disposable income growth. Higher prices of food and energy than in our base case could result in even lower discretionary spending growth than what we're already modeling. And if the bank of England had high rates in this inflationary scenario, we think they would act twice in this kind of a scenario. We also have these tight financial conditions which would weigh on household spending.
- [03:50]
A
So, Bruno, I think that's a great segue into that. At a consensus call that we have on the bank of England. The market is expecting the bank of England to raise interest rates. We think that they'll be on hold. And if you take a step back, it's a view that kind of puts the UK and the bank of England a little bit. Between the Federal Reserve, which we think is going to be lowering rates over the next 12 months modestly, and the European Central bank, which we think will raise rates in the near term. Could you talk a bit more about why you think it will remain on hold and why you differ from what the market's seeing?
- [04:24]
B
Yeah, absolutely. So in our base case, the one where we do see a bit of a decline in oil and gas prices over the course of this year, we think the bank of England remains on hold. It's important to remember that they were about to cut rates prior to the closure of the Strait of Hormuz. So there is a bit of restrictiveness there in the starting stance, which we think can just be maintained for a longer period of time than would have otherwise been the case. And so for the bank of England, to avoid having to tighten rates. Now, with respect to the market, I think it's fair to say that the market price is a probability weighted outcome where there is some chance, a non negligible one, that the bank of England will have to hike rates aggressively if oil prices were to rise from here. To give you a bit of clarity here, Bank's own analyses suggest that in a scenario where oil prices were to rise towards $130 per barrel and stay there for a few months, the bank could hike rates by four times. Now, it's interesting that in this scenario the bank actually doesn't forecast a recession. Now, we think that in the case of such elevated commodity prices, as I've already mentioned, we would certainly see high inflation, potentially as high as 6%, but also recessionary impulses. So even in this scenario of elevated oil prices, we think the bank could only deliver around two hikes. And so this kind of probability weighted outcome that we have, which differs a little bit from our model case even that is actually fairly lower than what the market is pricing. So I think that's maybe one of the main differences that we have versus the market. The market is expecting a repeat of 2022. So elevated inflation with growth just about holding on. We disagree that's possible because there's far less scope for a fiscal response to shield growth from an inflationary external shock.
- [06:03]
A
But Bruna, maybe I'll take even a bigger step back here because to borrow a British phrase, it almost seems like some of these debates over oil prices are kind of small beer compared to these two big questions around the uk, which are, you know, concerns over a lack of productivity growth and concerns that the UK economy is just kind of poorly positioned over the long term, especially in the wake of Brexit and concern over the fiscal situation and this idea that, well, government debt is historically high for the uk, concern that that will continue. And I think it's no exaggeration to say that when you talk to investors about the uk, those are often kind of two of the big questions that hang over the debate. So your kind of brief thoughts on both of those issues and again, where you think the market might be potentially surprised.
- [06:51]
B
So one of the most interesting things when I talk to clients is when I mention some of these statistics around measured cyclical productivity growth last year, they're often very, very surprised. And we do think it's more important to talk about this because there is evidence, I would say nascent evidence that UK is benefiting from the AI tailwind. We are seeing more CapEx adoption. We are seeing slower hiring, but more resilient, which as I say, results in cyclical productivity growth that looks very robust, especially in UK's historical context. In the last 10 years, of course, UK's productivity growth has been very lackluster. So over the course of this year, I think that's actually my primary focus to see how much of this uplift in productivity last year is cyclical and perhaps will dissipate over 2026 with the slowdown in growth and how much of it was actually structural. Now, in terms of the fiscal question, you know, one thing that's interesting to mention is the UK is, per IMF calculations, in the middle of the most severe fiscal consolidation amongst its G7 peers. Medium term fiscal plans deliver a decline in deficit to below 2% of GDP by 2030. Again, this is hard to square with gilt yields where they currently stand. So it's fair to say that the market is just more focused on the risks of delivery. For example, departmental spending settlements look challenging to deliver. Ministry of Defence is looking for a 30 billion top up to its budgets. Labour backbench have recently come out seeking for a bit more capital expenditure. Political volatility is high. We are actually quite confident around our 2026 fiscal forecasts. We're looking for a deficit at 4%. But when it comes to 2027, I think it's fair to say that risks here really depend on the political trajectory, with risks skewed, I think towards a slightly higher deficit than around 3.5% which we have in our base case.
- [08:43]
A
But Bruna, just to be very direct, is it fair to say that for investors who are very concerned about productivity growth in the uk, you'd argue that that actually could be a bit better than people are expecting as capital deepens and that for investors afraid of the fiscal trajectory, that actually could be one of the best fiscal trajectories in the G7?
- [09:03]
B
Yeah, absolutely. One of our recent outlook titles was Everything is Relative and that's exactly the point that we always try to make with the uk. It seems like it has a lot of idiosyncratic fiscal problem. But I would say a lot of its fiscal challenges are very similar to other diem countries. Demographic aging, slowing in potential GDP growth, and when it comes to productivity growth, I'm not trying to argue that we're likely to see UK's potential GDP growth in excess of 2% anytime soon. However, we do think that the picture is actually much better in terms of productivity growth than perhaps what the average market participants think is the case.
- [09:39]
A
Finally, Bruna Just a word on politics. I'm mindful that we have a global audience and for those less steeped in the latest UK news, what's been happening and kind of what are the developments that investors are watching out for?
- [09:50]
B
Yeah, absolutely. So we had local elections in the UK in early May and they delivered quite sizable losses for the governing Labour Party. Since then, a number of Labour MPs, members of parliament, just under 100 of them, called on Prime Minister Sarmer to resign. Now, challenging a Labour leader and a Prime Minister in this case is not an easy process to trigger. However, Manchester Mayor Andy Burnham is now looking to enter the House of Commons. He will be contesting a by election, mostly likely on June 18th. I would say that's the key day to watch out for from here. Andy Burnham has previously said UK politicians should be less focused on the bond market. But perhaps it's worth reiterating more recently he said he supports the current fiscal rules, which of course require debt to GDP ratio to be on the declining trajectory over the next five years. Now Andrew, for you, what stands out in the pricing of the UK story?
- [10:42]
A
Well, Bruna, I really think this is the country where across everything that we look at, there's the biggest gap, I think between kind of conventional wisdom and what we at Morgan Stanley are forecasting. The market's conventional wisdom is that productivity growth is going to be very weak and very bad. That's not what you see in the numbers and is in our forecast. The market thinks the government finances are very weak, as you mentioned, relative to the G7. They're on a pretty good trajectory and at a pretty good level. And I think this is also a market where you have some interesting risk premium. Again, we talk a lot in this podcast about how little risk premium there is in a lot of different asset classes. That's not the case in the uk. The government bond market, in our view, is offering a lot of risk premium to take on the risk of owning the government debt. And one example of that is you look at what interest rate is implied on a UK 10 year government bond 10 years from now, it's implying that yield is 6.6%. That's a very high yield, especially if you think that growth is going to be weak in this country. I think it's a really interesting macro story. It's one certainly where we at Morgan Stanley differ and where there's some risk premium on offer. So I'm so glad you could join us today to dig into it in more detail.
- [11:56]
B
Absolutely. Thank you so much for the invite
- [11:58]
A
and thank you as always for your time. If you find thoughts of the market useful, let us know by leaving a review wherever you listen and also tell a friend or colleague about us today.
- [12:11]
B
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