September 15, 2022

Frédérique Carrier
Managing Director, Head of Investment Strategy
RBC Europe Limited

While the UK is not dependent on Russian gas, which represented just four percent of total UK gas supply in 2021, the country is heavily dependent on the fuel in general and is suffering from the high prices set in international markets. Natural gas represents more than 40 percent of UK energy usage. Moreover, the 2017 closure of the UK’s largest storage facility left the country in a precarious position. Remaining storage capacity of a mere 1.5 billion cubic meters, according to Ofgem, the UK’s energy regulator, is insufficient for a country that consumes 77 billion cubic meters of natural gas annually.

Households are feeling the crunch of higher energy costs. On average, a household with income of £31,400 saw its energy bill increase to £2,500 currently from £1,339 last year. It was set to increase to £6,000 by next summer according to Cornwall Insight, a consultancy, a crippling level for many households and businesses.

Higher energy prices, coupled with soaring food prices and supply chain disruptions, conspired to lift UK inflation to 9.9 percent year over year in August, the highest level of G7 countries. The Bank of England (BoE), worried it would peak much higher, was one of the first central banks to take action in Q4 2021. The base rate increased to 1.75 percent from 0.1 percent in just eight months. The country is heading towards recession if it isn’t already in one. Q2 GDP contracted by 0.1 percent, and sterling has fallen by 14 percent against the dollar and by 3.5 percent against the euro since the beginning of the year, despite the BoE’s interest rate increases.

New government, bold announcement

Amid this economic crisis, former Prime Minister Boris Johnson resigned. During the conservative leadership campaign, Liz Truss (now the prime minister) campaigned on reforms and tax cuts and appeared little concerned about fiscal rectitude. Anyone who doubted her didn’t have to wait long to see proof of her conviction as she announced a bold, if blunt, support package within days of her ascension.

Truss announced a package to cap the average annual household energy bill at £2,500 for two years. Similar, though as yet unquantified, guarantees were given to businesses and public bodies such as schools – for only six months, although extensions may be possible. A £40 billion liquidity facility for energy suppliers struggling with collateral repayments will also be made available.

The package is expensive because it is universal, covering both high- and low-income households. Targeting only the most vulnerable would have been less expensive. Though the final cost will depend on future wholesale energy price moves, initial indications of a two-year cost of £125 billion–£150 billion, or some six percent of GDP, suggest a higher price tag than that associated with the UK banks bailout during the global financial crisis (£133 billion), and more than twice that of the pandemic’s furlough scheme (£70 billion) which ran for 18 months. The package, combined with promised tax decreases including a cut in National Insurance Contribution and rolling back the planned corporate tax increase to 25 percent from 19 percent, measures worth just over one percent of GDP, represent a very sizeable fiscal expansion.

Details of the financing are still scarce, which is unusual for a package of this size, and should emerge along with a mini emergency budget later this month. Swelling national debt levels should not be a surprise following Truss ruling out windfall taxes on energy companies.

We think the package removes some important downside risks to growth in the short term. Any upcoming recession may be shallower than would have otherwise been the case. With the energy bills capped, we think inflation will likely peak sooner and lower than the Bank of England’s expectation of a 13 percent peak by the end of the year.

However, offering such a large stimulus package at a time inflation is so high, may incentivise the BoE to continue to hike rates aggressively. Markets currently expect peak interest rates beyond 4 percent, a level which would likely crimp future growth.

Moreover, the package, by freezing prices, also removes the incentive to reduce consumption. To the extent that high natural gas prices are due to a shortage of the commodity, the possibility of blackouts in the winter remains. The government’s measures to increase supply by lifting a ban on fracking and increasing drilling in the North Sea are not likely to have any immediate impact on scarce energy supplies, in our opinion.

New government’s long-term plans

Beyond the immediate emergency measures to help the country navigate what promises to be a treacherous winter, Truss’ programme aims to raise the UK’s growth to 2.5 percent, from the Office for Budget Responsibility’s expectation of 1.7 percent, by lowering taxes and deregulating.

Rolling back the proposed increase in corporate tax to 25 percent from 19 percent may help, although the UK already has the lowest tax rate of the G7 by far. As for deregulation, efforts may be constrained by free trade agreement requirements.

Getting this right is important to unleash growth as business investment has not returned to trend growth since the 2016 Brexit vote, nor has it bounced back to the pre COVID-19 level. A stable and clear regulatory environment would also help, as would a less volatile relationship with the country’s largest trading partner, the EU.

UK business investment struggles

UK business investment from 2010 to 2022

The line chart depicts UK business investment from 2010 to 2022. It shows that it grew strongly up until the 2016 vote to leave the EU. From then on and until the onset of the COVID pandemic, UK Business investment flattened. In early 2020, due to COVID-19, UK business investment plummeted. Despite picking up since then, thanks in part to a fiscal incentive, UK Business investment remains much below the pre-2016 level.

  • Business investment (outturn)
  1. Brexit vote
  2. COVID-19
  3. Period in which a fiscal incentive has been available to encourage investment

Note: UK business investment (Q4 2019 = 100)

Source - Office for National Statistics, RBC Wealth Management

Equity strategy

Given the challenges ahead, we think it is prudent to take some profit in UK equities, which have outperformed year to date in local currency terms. We recognise the overall FTSE All-Share Index remains very cheap on an absolute and relative basis, at less than 10x next year’s earnings estimate. UK equities also offer the highest dividend yield among the major regional equity markets (FTSE All-Share: four percent), a feature that may be very relevant for UK-based income-focused investors.

We maintain our strong preference for internationally-orientated companies and remain cautious on UK domestics. We continue to have a strong bias to quality, resilient companies, with market-leading competitive positions and strong balance sheets. Within cyclicals, we believe there are select opportunities in companies whose valuations already largely reflect short-term recession risks but remain well positioned for medium- to long-term structural trends, such as the decarbonisation of the economy.

Thomas McGarrity, CFA contributed to this report.

This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.

The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.

This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.

Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.

Frédérique Carrier

Managing Director, Head of Investment Strategy
RBC Europe Limited