An article by Kirstin Greatorex.
The Economic climate usually reflects the state of the jobs market, stock market, the availability of credit, and how consumers, businesses, economists, and investors view economic conditions.
The current economic climate in the UK reflects a picture of rapidly intensifying global inflationary pressures following Russia’s invasion of Ukraine. This has led to a collapse in the outlook for world and UK growth. These developments have further worsened the supply side shocks and disruptions. Twelve-month CPI inflation rose to 7.0% in March and reached a 40 year high of 9.1% in May. That is well above the 2% Bank of England (BOE) inflation target. The BOE projects it to increase further to 11% by autumn 2022. The UK is specifically experiencing cost push inflation which occurs when firms respond to rising costs by increasing prices in order to protect their profit margins.
High energy bills have played a big role, as oil and gas prices remain at high levels in part due to the Ukraine war. Due to a rise in the UK's energy price cap in April, average gas and electricity prices jumped by 53.5% and 95.5% respectively compared with a year ago. Fuel prices are also surging, with average petrol prices hitting 186.59p per litre in June 2022 - the highest price on record. Due to the war in Ukraine squeezing global grain production, food prices are rising. Another supply side factor is that the costs of raw materials and household goods are increasing. As economies around the world opened after the easing of Covid restrictions, demand for goods increased, however, due to supply bottlenecks, sellers struggled to meet demand. Hence, leading to higher prices, particularly on goods imported from abroad.
The problem lies where prices are rising faster than incomes for many people. As a result, people will be able to buy less with their money. Surveys of business activity have generally remained strong. But there have been signs from indicators of retail spending and consumer confidence that the squeeze on real disposable incomes is starting to have a major effect on the household sector. Consumer spending is falling and therefore, consumers are more likely to buy necessity items, with discretionary spending falling. The UK economy is recovering from the effects of Covid, but the cost-of-living crisis is expected to slow growth overall. All these factors increase costs for both businesses and consumers.
The BOE monetary policy committee’s role is to meet the 2% inflation target in the medium term and in a way that helps to sustain growth and employment. The global supply problems and the soaring energy prices can’t be controlled by them. The main tool used to make sure inflation falls back to 2% is to increase interest rates. The Bank rate was raised from 0.1% to 0.25% in December 2021, to 0.5% in February 2022, to 0.75% in March 2022, and to the current rate of 1.25% in June 2022. Governor Andrew Bailey has hinted that a further 0.5%-point rise is possible soon. Committee member Adam Posen has recently predicted rates could need to rise to 4% to contain inflation. Inflation is expected to decrease next year and be close to target in around 2 years. But it all depends on what happens in the economy.
UK GDP is estimated to have risen by 0.8% in 2022 Q1. The services sector increased 0.4%, with the largest contributions coming from: information and communication, accommodation and food, and the transportation and storage industries. On the other hand, there was a decline in wholesale and retail. Both production and consumption increased to 1.2% and 0.6% respectively. However, a slowdown is expected in the coming months mainly due to the adverse impact of the rise in tradeable goods and global energy prices which affects household incomes and profit margins of companies. KPMG‘s GDP forecast dated [ 27 June 2022] models how a sharper deterioration in the external environment causing a recession in some of the UK’s major trading partners, together with a stronger fall in domestic consumer spending, could see the UK economy enter a mild recession next year, with a 1.5% fall in GDP in the year between 2022 Q3 and 2023 Q3.
The unemployment rate fell to 3.8% in the three months to February and remains at that level currently. It is expected to fall slightly further in coming months, consistent with a continuing tightening in the labour market and the current excess demand for labour.
The labour market is tightening due to the impact of covid and Brexit. It is becoming more challenging to recruit and retain staff. During covid, many employees were furloughed and as a result had a unique experience of increased free time while maintaining a large proportion of their income. This led to many people placing higher value on their free time. This has led to many potential employees retiring early or moving to jobs which allow more flexibility and involve shorter working hours. Brexit is also a major factor in labour market developments. New migration restrictions have had a significant impact on the number of migrants entering the UK. The number has more than halved. These issues have been compounded by the post-COVID excess demand for labour. There was a record 1.3 million job vacancies in March 2022. These factors make it difficult for companies to retain and recruit workers. This is leading to higher wages, which in turn, leads to higher inflation. In the longer term, as inflation bites, the unemployment rate is expected to rise to 5.5%.
So, the question remains how do all these factors which shape the economic climate effect companies seeking funding?
High inflation lowers confidence and increases company default risk, therefore lenders such as banks who focus on how likely the loans that they extend are to be repaid could become less likely to fund companies. Alternative lenders, including organisations which have a fund which they are looking to invest on behalf of their clients, are more likely to accept higher risk levels. However, for taking that risk they are likely to be charging a greater interest rate, which may no longer be viable for the companies seeking funding to afford or justify.
High inflation will also increase funding costs for lenders, which they will likely pass on to companies in the form of higher rates and charges.
Some lenders themselves may collapse since higher levels of defaults could reduce their capital reserves, which could create gaps in the lending market. Businesses may struggle to locate the necessary funds required to grow and expand. This then has a negative impact on the wider economy and could contribute to a fall in UK GDP growth.
The current economic climate creates industries which are more and less favourable to funding as some will find it easier to pass on higher costs than others. As a result, lenders may only lend to businesses selling essential products as the demand for these is likely to remain consistent. Whereas companies selling discretionary products may experience a drop in demand and so lenders may not fund these companies.
Sectors which are more likely to be resilient against high inflation and high energy bills are SaaS (software as a service) and other sectors that can easily re-price and don’t have a high fixed cost base. Whereas sectors such as retail and hospitality may find it harder to pass on higher prices, and could thus experience both a fall in demand and profit margins.
As a result, high inflation will be likely be harmful to companies seeking funding as it could become harder to acquire appropriate funding or it will also likely come at a greater cost.