This morning’s release of UK flash purchasing managers indices from May highlight the difficult macroeconomic backdrop currently facing the Bank of England, which in our view gives policymakers bandwidth to conduct one more 25bp hike at June’s meeting this year at a maximum.
The flash composite PMI fell from 58.2 to 51.8, the fourth fastest monthly decline (-6.4 points) since records began. The composite measure was predominantly dragged lower by a collapse in services activity. The flash services PMI fell from 58.9 in April to 51.8, with survey respondents citing reduced demand due to economic and geopolitical uncertainty. Comparatively, the manufacturing index fell just 1.2 points from 55.8 to 54.6. This mix of lower services output and more stable manufacturing activity starkly contrasts with the opposing mix in the eurozone PMIs this morning, evidencing how reopening effects have largely faded in UK economic activity.
While the stability in the manufacturing PMI partially offset the downturn in services output, the manufacturing sector’s small share of GDP means this offered only a thin silver lining to what was a bleak activity report on the whole.
The downturn in services sector activity sent the pound plummeting back below 1.25 against the dollar, a 0.75% drop, to completely reverse yesterday’s gains. Sterling’s depreciation coincided with a repricing of BoE expectations in SONIA futures, with the whole strip pricing out around 10 basis points worth of hikes in the aftermath of the release.
Downturn in UK services PMI has only been larger during previous lockdown periods
The details of the latest PMI report are as concerning as the downturn in the headline figures.
Average cost burdens increased rapidly in May, with input price inflation at private sector firms hitting a fresh survey record. However, despite the rise in input costs, some firms are facing resistance from weaker consumer demand conditions and are thus seeing their margins compressed as they are unable to pass on the higher input costs to the consumer. This blocked transmission, due to weaker demand, highlights not only a weaker growth profile going forward as consumers tighten their belts but the increasing role weaker demand conditions are going to play with regards to disinflation. Coupled with anecdotal evidence that firms are trying to reduce costs by not replacing voluntary leavers, the increasing pressure on inflation from reduced consumer demand reinforces our view that the Bank of England’s path forward is likely to be more cautious than markets are currently pricing.
The market reaction today is merely reflective of this realisation. Front-end Gilt yields have dropped considerably more than other developed market bond yields, while the pound is leading losses in the G10 this morning.
GBPUSD falls sharply to trade below 1.25 as markets react to the deteriorating UK macroeconomic outlook
Simon Harvey, Head of FX Analysis