Liz Truss is now Conservative party leader and UK Prime Minister. All eyes are on the fiscal measures to ease the cost-of-living crisis, which we expect to be announced over the next week or so. Market reaction, at this stage, is rather limited, with no discernible impact after the announcement. Our tactical asset allocation has no active UK overweights and is underweight UK government bonds.
-- Truss wins & market reaction: In line with indications from polls and betting markets, Liz Truss is now Conservative party leader and UK Prime Minister. This is in line with expectations, which is why markets aren’t moving on the back of these headlines. This follows the resignation of Boris Johnson in early July. Market reaction looks rather muted so far. UK equities are flat after these headlines (but, for the moment, down on the day), though the FTSE SmallCap continues to underperform the energy-driven FTSE 100. Gilt yields continue to rise on ongoing/expected Bank of England rate hikes and given the potential for Truss’s tax cuts to be mostly unfunded (no offsetting spending cuts). The pound sterling has pared some of its marginal morning gains vs the US dollar but has remained stronger vs the euro (as the Nord Stream 1 shutdown weighs on the euro). Our GBP view is playing out: we expect the currency to weaken vs the USD in the near term and to stabilise further out; it should also remain somewhat stable vs the EUR (but not over the next two or three quarters). We see less room to hike interest rates for the European Central Bank vs the Bank of England, given that we expect a deeper recession in the euro area vs the UK (negative for the euro vs the pound).
-- Tackling the cost-of-living crisis: The most pressing issue for the next PM to tackle is the cost-of-living and energy squeeze on household incomes and business activity generally. We would expect a series of budget measures skewed toward tax cuts, along with new economic and government funding projections, over the next week or so. Last week, Truss ruled out energy rationing (but, in our view, this remains a risk) while also pledging not to introduce any new windfall taxes on the energy sector. Instead, her fiscal plan involves generalised tax cuts, which may cost well over 1% of GDP. On top of this comes cutting levies and taxes on energy bills, which would likely cost 0.4% of GDP. More broadly, it looks as if Truss will likely prioritise boosting economic growth rather than redistributing wealth. While the most important thing when it comes to supporting economic activity is a range of structural reforms, which could perhaps end up being market moving especially for equities and the currency, the details are very important here and this is what the market will likely focus on going forward. For bond markets, the detailed funding plan, along with the credibility of government debt and deficit projections, is likely to be important too.
-- How’s the UK economy faring? We recently downgraded our growth forecasts and expect the UK to enter recession in the final month of the third quarter of this year (September) or in Q4, with overall economic activity contracting for three quarters in a row or so. While we think risks to the consensus forecast of just a very mild recession are skewed to the downside, we nevertheless suspect that any economic contraction is likely to be less deep vs the euro area (where the problem isn’t just the price of energy, but also its availability). We also believe that any fiscal support, which we expect in both the UK and the euro area, is likely to come through more quickly and probably substantially in the former than the latter, as the UK’s decision-making processes tend to be faster. While not a done deal, we believe that a 50 bps rate hike to 2.25% at the 15 September Monetary Policy Meeting of the Bank of England is likely, though a step-up to 75 bps is possible too. Even though we expect a 50-75 bps rate hike to 0.50-0.75% on 8 September for the European Central Bank too, the bigger/faster fiscal stimulus in the UK and the somewhat milder recession we envisage in the UK would suggest more upside risks to the Bank of England rate path vs the European Central Bank.
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