UK Suffers Surprise Contraction in Private Sector Activity

UK private sector firms suffered their first contraction in seven months, revealing the growing economic toll of higher interest rates and the squeeze on households.

(Bloomberg) — UK private sector firms suffered their first contraction in seven months, revealing the growing economic toll of higher interest rates and the squeeze on households.

S&P Global said its composite purchasing managers’ index slipped from a score of 50.8 to 47.9 in August, the lowest in 31 months. The scale of the downturn will come as a surprise to economists, who had expected only a modest slowdown with activity remaining above the 50 level dividing expansion from contraction.

The figures coincided with a broader slump across the rest of Europe. PMI figures for the euro area also released Wednesday showed a contraction in private-sector activity intensified as services ceased being a bright spot and followed the industrial sector into a downturn.

British companies blamed the biggest UK decline in new business since November on the impact of rocketing borrowing costs as the Bank of England struggles to tame inflation. S&P said both services and manufacturing contracted in August, indicating a 0.2% decline in GDP in the third quarter so far.

What Bloomberg Economics Says …

“The drop in the composite PMI below 50 is a red flag for the UK economy and suggests the Bank of England’s rapid hiking cycle is taking a heavy toll on activity. It provides support for our view that the economy is headed for a mild recession, though we’re still inclined to think it will eke out growth in 3Q23, with the downturn starting in the final three months of this year.”

—Dan Hanson and Ana Andrade, Bloomberg Economics. Click for the REACT.

The figures will strengthen the case for the BOE to call time on its most aggressive monetary tightening in over three decades. While money markets are currently pricing in a peak of around 6%, the BOE did not predict a third-quarter contraction in its latest forecasts. Instead, it expected a 0.4% expansion as the economy bounced back from days lost to the coronation of King Charles III and labor strikes.

Faltering Services

“A renewed contraction of the economy already looks inevitable, as an increasingly severe manufacturing downturn is accompanied by a further faltering of the service sector’s spring revival,” said Chris Williamson, chief business economist at S&P Global Market Intelligence. “While a further hike in interest rates in September looks to be on the cards, the August PMI data will add to speculation that rates could soon peak.”

While the PMIs historically have been a guide for how official figures on economic growth will turn out months later, they wrongly pointed to a sharp downturn for six months through January. The UK defied forecasts from many economists and the Bank of England for a lengthy recession, delivering sputtering and stagnant growth for most of the past two years.

UK government bonds extended gains after the data, with the 10-year yield dropping 13 basis points to 4.52%, its lowest in over a week. The pound sank 0.4% against the dollar to 1.2681. The moves came as traders pared wagers on further hikes from the Bank of England. Money markets see a peak rate of 5.90%, compared to more than 6% earlier.

“This combination of a slowdown in both activity and inflation should give the Bank of England food for thought in advance of its next interest rate decision in September and suggests an increase is no longer a certainty,” said Martin Beck, chief economic adviser to the EY Item Club, which uses the Treasury’s forecasting model.

The darkening economic backdrop in Britain piles further pressure on Prime Minister Rishi Sunak, whose Conservative Party trails far behind the Labour opposition in opinion polls ahead of a general election widely expected next year.

Until now the dominant services sector has been the most resilient part of the economy, helping to offset a shrinking manufacturing sector. Now, however, both are in negative territory, with the contraction in services this month the joint fastest since the start of 2021 when the economy was in lockdown. Manufacturing activity slumped to a 39-month low.

“Any economist observing the UK economy at the moment is worried about our poor growth outlook,” Anna Valero, a member of the Chancellor’s economic advisory council, said on Bloomberg TV. “If you look at the recent data, there is some good news on inflation. There’s also some bad news. So of course, there’s going to be this balancing act about how we can tame inflation while avoiding pushing ourselves into an unnecessary recession.”

S&P said prices charged by firms rising at the slowest pace since February 2021, a “rate commensurate with consumer price inflation cooling to 4% in the months ahead,” Williamson said. Private-sector employment rose at the slowest pace since March, which should ease wage pressures that remain “persistently strong.”

“Companies are reporting reduced orders for goods and services as demand is increasingly hit by the cost-of-living crisis, higher interest rates, export losses and concerns about the economic outlook,” said Williamson.

–With assistance from Alice Gledhill, Alex Mortimer, Lizzy Burden and Joel Rinneby.

(Updates with market reaction and comment.)

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