Liz Truss became Britain's new Prime Minister today. The former UK Foreign Secretary inherits economic troubles that include soaring food prices and energy bills. AFP
New UK Prime Minister Liz Truss enters office facing several major crises.
Source: Bank of Singapore, Bloomberg.
UK inflation is at four-decade highs of 10.1% as the first chart shows. Pandemic disruptions, trade frictions from the UK’s exit from the European Union and soaring energy prices from Russia’s invasion of Ukraine are set to raise inflation well into double digits. The energy shock is also likely to push the UK into recession before the end of 2022 and activity may contract throughout 2023. We forecast UK GDP will fall by 0.8% next year. At the same time, public services are fragile after the pandemic and years of under-funding. Last, disputes with the EU following Brexit are affecting UK trade. Given the multiple crises, we think the start of the new Truss government will have the following implications for financial markets.
Source: Bank of Singapore, Bloomberg.
Firstly, a large fiscal response to the energy crisis will be announced this month. Relief for low-income households, national insurance contribution (NIC) cuts and lower taxes on utility bills are likely. Caps on energy prices may also be considered.
Secondly, the large extra government borrowing needed to fund the measures, potentially GBP50 billion initially, may worsen inflation. We expect the Bank of England (BoE) to respond with 50bps rate hikes at its September and November meetings before slowing UK growth causes the BoE to step down to a 25bps hike in December. Its Bank Rate may thus rise from 1.75% to 3.00% by year end.
Thirdly, despite larger BoE rate hikes, the outlook for the GBP remains bearish. The chart shows the GBP has hit two-year lows below 1.15 against the USD, close to our three-month forecast of 1.14. And the GBP has been as low as 1.05 in 1985.
The risks for GBP and UK assets still seem skewed to the downside. A deeper recession may occur in 2023 if inflation surges far over 10%. Recession may also make the BoE stop hiking before the Federal Reserve, leaving its Bank Rate below the fed funds rate. Last, the UK current account deficit at a huge 8% of GDP, puts the GBP at risk if capital inflows dry up. This month, PM Truss may decide the UK should over-ride its EU exit treaty regarding trade with Northern Ireland. This could spark strong retaliation from the EU. An EU-UK trade war would hurt sentiment sharply and risk the GBP revisiting its 1985 lows against the USD.
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