UK Economy Shrinks in March, Confirming Sterling's Troubled Outlook

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The Office for National Statistics announced the UK economy shrank in March and economists warn all signs point to further underwhelming growth over coming months, forcing the Bank of England to end its rate hiking cycle as a result.

This shift in interest rate expectations in turn offers the potential for further Pound Sterling underperformance.

UK GDP read at -0.1% in the month to March, which disappointed a market looking for a flat reading.

"When UK growth data hit markets in the early hours of this morning it delivered yet another blow to GBP," says Charles Porter at SGM Foreign Exchange Ltd.

The economy nevertheless grew strongly in the first quarter as a whole as the UK consumer shrugged off fears over Covid and embraced pre-pandemic behaviours.

UK GDP grew 0.8% quarter-on-quarter in the first quarter of the year, but this was also below what analysts were looking for (1.0%) and would also contribute to the Pound's dour performance on Thursday.

Above: "Services were the main contributor to GDP’s 0.1% fall in March 2022." - The ONS.

GDP grew 8.7% year-on-year in the first quarter, which was also below the consensus expectation for 9.0% growth.

The Index of Services - a measure of the UK's key service sector performance - rose 0.4%, which disappointed against the market's expectation for a reading of 0.9%.

"Services output fell slightly in March, as consumers started to rein in their consumption towards the end of the quarter," says Samuel Tombs, Chief UK Economist at Pantheon Macroeconomics.

Consumers are expected to further rein in expenditure in the face of surging inflation which will weigh on the outlook and BNP Paribas says it is one reason they expect further declines in the Pound over coming months.

"UK consumers are particularly reliant on gas in their energy mix, leaving them vulnerable to higher gas prices, and high and still-rising inflation is likely to continue to weigh on the consumer and further erode dwindling savings accrued during the pandemic," says Parisha Saimbi, G10 FX Strategist at BNP Paribas in London.

Pantheon Macroeconomics expects UK GDP to drop by about 0.5% in the second quarter, reversing most of the economy's outperformance in Q1," says Tombs, adding that the economy will then grow 0.4% in both the the third and fourth quarters.

"While such an outlook does not meet the formal criteria for a recession—two quarters of negative growth—it would be weak enough for the MPC to stop hiking rates much sooner than markets’ currently anticipate," says Tombs.

The paring back of Bank of England rate hike expectations is one reason currency analysts say the British Pound is likely to underperform peers going forward.

"Weak growth expectations not only damage the currency directly as a component of almost all currency valuation models. They also serve to constrain and qualify the Bank of England’s policy tightening expectations that is one of last remaining factors supporting GBP," says Porter.

In the wake of the GDP data the Pound-Euro exchange rate was lower on the day at 1.1620, the Pound-Dollar exchange rate was meanwhile lower at 1.2217. (Set your FX rate alert here).

What Economists are Saying About the Outlook

"It now seems likely that GDP will contract in Q2. And with the full hit of the cost of living crisis yet to be felt, the chances of a recession have just risen," says Paul Dales, Chief UK Economist at Capital Economics.

Rupert Thompson, Investment Strategist at Kingswood, said the March decline highlights the pressure the economy is now coming under from the cost-of-living squeeze and the danger of it falling into outright recession later this year.

"This weakness should limit any further rise in interest rates to 0.5-1%, significantly less than the tightening now on the cards in the US, even though inflation is expected by the Bank of England to peak as high as 10% late this year," says Thompson.

Above: Consumer facing services are struggling: Just as Covid fades a cost of living crisis strikes.

"The UK outlook will continue to remain challenging in the coming months as consumer and business spending cools," says Barret Kupelian, senior economist at PwC.

PwC says one of the bright spots in the GDP numbers was the spending on information technology (IT) by businesses in the UK.

"The persistently strong performance of this sector was first attributed to the switch to working from home. However, it is now apparent that IT spending is likely to continue to grow at robust rates as retail spending continues to digitalise, businesses continue to embrace newer, more flexible working practices and people adjust," says Kupelian.

The ONS reported business investment fell 0.5% quarter on quarter in Q1. But Samuel Tombs at Pantheon Macroeconomics is not bothered by the data, saying it is usually subject to sizeable revisions.

"The persistence of surveys of investment intentions above their long-run average, alongside businesses’ generally healthy balance sheets, suggests that it will rebound soon," says Tombs.