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In: Finance, Forex

U.K. markets are sounding the alarm over a potential recession, piling pressure on the Bank of England to balance curbing surging inflation with protecting growth.

An index of discretionary retail stocks has tumbled 26% this year as consumer confidence slumps to the lowest since 2008, while nearly 2,000 businesses are in critical financial distress. The pound is trading at levels not seen since the early days of the pandemic, and money markets bet central bankers will have to cut rates in coming years after sharp hikes in 2022.

It’s a “pretty ugly backdrop” to set the scene for the BOE’s meeting next week, according to BlueBay Asset Management’s Mark Dowding. Policy makers will have to take in a rash of bad news, with retail sales weaker than anticipated and inflation at a three-decade high.

The central bank is widely expected to lift interest rates again Thursday and money markets expect more hikes at each meeting this year, piling further pain on borrowers. BOE Governor Andrew Bailey has already noted the difficult path bankers need to tread to avoid potentially triggering a recession.

Britain’s inflationary shock will be harder to address than in any other leading industrialized nation, the International Monetary Fund has warned.

An index tracking discretionary retail stocks, including companies such as Marks & Spencer Group Plc and JD Sports Fashion Plc, is faring even worse, as price rises hit demand for non-essential goods. British consumers are being squeezed even harder than elsewhere due to a recent hike in the National Insurance tax and the removal of a cap on household energy prices, just as gas costs spike during the war in Ukraine.

The negative mood has led investors to flee the pound, down more than 4% to about $1.25 in April in its worst month since the aftermath of the Brexit referendum in 2016. Traders are favoring the dollar as a haven to global growth risks stemming from Covid-19 lockdowns in China as well as the energy standoff brewing between Europe and Russia.

The slump may not be over yet, with analysts starting to talk of $1.20 and options traders lifting bets on further declines in coming months. The fear-greed indicator — a gauge of momentum that compares buying to selling strength — implies that bears haven’t controlled price action this much since the early days of the pandemic shock.

For State Street Global Advisors portfolio manager Aaron Hurd, the long-term fair value for the pound comes in north of $1.50. But even he is reluctant to buy despite these cheaper levels, citing an absence of heavy short positioning in the currency that could pre-empt a reversal.

The growth risks mean money markets have not only trimmed bets on the extent of the BOE’s hiking cycle, but are pricing in interest-rate cuts as early as 2024.

In the corporate debt market, signs of a U.K. recession would show up first in the sterling high-yield bond sector, which is dominated by domestic issuers. Spreads have widened nearly 100 basis points to 474 basis points year-to-date, but remain below peaks seen in early 2016 and late 2018. That suggests the sector “is not signaling an elevated risk of a U.K. recession,” said Song Jin Lee, a credit strategist at HSBC Holdings Plc.

Some sectors are being hit worse than others. The construction industry saw a 51% jump in firms in critical financial distress, according to research by insolvency practitioners Begbies Traynor. Overall U.K. insolvencies are already on the rise and there may be a new wave coming as pandemic-era support for companies is no longer available.

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