We have never seen anything quite like it before. The price of gas this autumn and winter will determine how high inflation goes and whether the UK economy – and others – will slide into recession. The gas price, itself a direct by-product of Russia’s war in Ukraine, has become not just a key economic indicator, but the only one that really matters.
Having come out of a recession caused by Covid-19 and the responses to it – though one in which the lifting of restrictions always provided the route to recovery – we have entered a period of even greater uncertainty. Nobody knows what the consequences would be if Russia shuts off all gas supplies to Europe this winter and persists with such restrictions. Eventually, other energy sources will replace Russia gas but that cannot be done quickly.
Not only that, but if the Bank of England is right and the UK economy slides into recession in the final quarter of this year on the back of a rise in inflation to more than 13 per cent, and remains in it throughout 2023, one of the cardinal rules of recession would have been broken. This is that they are not like London buses; you wait for ages and then two come along at once. Recessions, and the Covid recession of 2020 was the deepest since 1921, normally clear the air for a few years. But not, it appears, this time.
This was supposed to be a period of post-pandemic recovery, albeit by now a rather muted one after the initial bounce. Instead, if the Bank is right, the UK will be embarking on a renewed recession. The closest parallel in the 1970s, when the economy also suffered recession alongside very high inflation. Then, the economy went into recession in mid-1973 for three quarters, pulled out of it, but was in and out of recession for several quarters from late 1974.
The comparison with the 1970s is interesting. Before this energy shock, one source of comfort was the decline in energy dependency. The, every 1% rise in gross domestic product required a 1% increase in energy consumption. Now, thanks to the decline in heavy industry and improved energy efficiency, the ratio is roughly three to one; each 1% rise in GDP requires about 0.3% in extra energy consumption.
This is just as well for, as the deputy governor of the Bank Ben Broadbent pointed out recently, the energy shock faced by households is five times what it was in the 1970s. Energy has gradually declined in its share of household spending though now, of course, it is shooting up again.
What does all this mean? The nature of the gas shock means that, unlike most energy price spikes, it could last for some time yet. After reaching more than £3,500 in October the cap, now updated every three months, will rise further next January, with some expecting a cap as high as £4,200, and, according to analysts at Cornwall Insight, will remain above £3,000 until 2024.
This has many implications. Economists tend to focus on inflation, the rate of change of prices, rather than price levels. But what matters for households and businesses in the level of prices, which will continue to exert intense pressure above £3,000 a year. Falling inflation will not ease the pain and government support, a partial re-run of the support required during the pandemic will be needed for some time to come. The public finances, having been on the road to repair, will take another battering. The supposed headroom Tory leadership candidates have left themselves or tax cuts will disappear.
The task for financial services
For financial services, this will be an important challenge. Customers, both households and small and medium-sized businesses (SMEs) will come under pressure, even if, as is likely, the new prime minister comes forward with more large-scale support. People will get into difficulty, with some also put under strain by higher mortgage rates. The biggest squeeze on real disposable incomes for 60 years will come at a cost. The squeeze will be worse that during the financial crisis or the pandemic. Lenders will have to judge how much forbearance to offer, while other providers will have to adjust to the prospect of customers being in difficulty.
For investors, the prospects of a sustained energy price shock may mean another rotation. The rotation into recovery stocks has been brought to a shuddering halt by the prospect of recession. Energy firms have been benefiting from higher prices but already face a windfall tax in the UK as well as potential political backlash. Banks appear well-placed, with balance sheets strong, and interest rates rising. Equity analysts remain bullish despite the bad news, with J P Morgan offering 10 reasons why share prices should rise between now and the end of the year. While gas prices are the big negative factor in the UK and Europe, more important in America is the price of gasoline, petrol, and that is starting to fall.
Where does this leave ESG? There is an argument that Vladimir Putin is doing for European energy consumption what policymakers hoped to achieve, but over a longer period. There is a renewed emphasis on renewables and nuclear, as countries seek to steer themselves away from reliance on Russian energy, though there has also been a shift back to coal in some countries.
Much as some would like it, however, and amid signs in the Conservative leadership contest of a shift away from net zero, ESG is not going away. Though this energy price spike is lasting longer than most, it will eventually pass, and the likely result of that will be much lower energy prices in future, possibly for a substantial period. There will still be a need for businesses to adopt and maintain appropriate environmental policies.