UK’s economy still faces financial austerity under a new government

Key takeaways

• The UK’s Conservative Party has appointed Rishi Sunak, a former finance minister, as the country’s next prime minister
• A new administration faces the long-term economic challenges of high inflation, rising interest rates and increasing poverty with a historically broad current account deficit
• In real GDP terms, the UK economy has not yet fully recovered to its pre-Covid levels. We expect UK growth to stagnate in 2023
• We see EURGBP potentially rising above 0.90, and GBPUSD eventually falling below 1.05.

After weeks of political theatre, Rishi Sunak, a former chancellor of the exchequer, will become the UK’s third prime minister in three months. The country’s economic challenges have intensified in the wake of Liz Truss’ administration, but not changed. Financial markets and foreign investors are looking for confirmation that the next government is committed to a fiscal policy path that the country can afford.

Mr Sunak, who served under Prime Minister Boris Johnson and lost September’s Conservative Party leadership race to Ms Truss, had warned that her economic proposals would be catastrophic for the country. Earlier in 2022, Mr Sunak was wrapped up in questions over his wife’s tax status as a foreign national living in the UK. Mr Johnson pulled out of the contest on 23 October.

The UK finds itself in the same position as many other European economies with high, energy-driven consumer inflation and large, post-pandemic government debt. However, its choice to leave the European Union is having slow but far-reaching effects, and in recent weeks a fiscal experiment in unfunded tax cuts unraveled confidence in the government’s ability to manage the economy. In the meantime, UK citizens’ living costs are rising with increased mortgage costs. In addition, another 1.3 million more people may be tipped into poverty this winter, according to a think-tank.

That had dramatic consequences on financial markets. On 21 October, Moody’s investor services, a ratings agency, confirmed its ‘Aa3’ grade for the UK, but cut the outlook for the British economy from “stable” to “negative”, citing weaker growth prospects, higher inflation and greater policy uncertainty. The country faces less-affordable debt with more borrowing, and “risk of sustained weakening in policy credibility,” the agency said. Investors’ verdicts on the British economy have been visible in the currency and sovereign bond markets. As gilt yields rose in recent weeks, the market sold off when pension funds faced liquidity concerns in the form of margin and collateral calls to generate additional cash by selling long-dated sovereign debt. The Bank of England (BoE) stepped-in, promising to spend GBP 65 billion to buy gilts through 14 October, at a time when it had planned to be selling its GBP 80 billion post-pandemic holdings in government bonds. The yield on the UK government’s 10-year gilts has risen dramatically in 2022 from below 1% in January, to reach a high of 4.54% on 27 September. The benchmark sovereign bond now trades at 3.8%.

Liz Truss’ resignation on 20 October made her the shortest-serving prime minister in British history, and followed her appointment of a new chancellor, the country’s fourth in four months. The latest, Jeremy Hunt, immediately reversed almost every tax measure pledged by the Truss administration just three weeks earlier. In addition, Mr Hunt set a limit of April 2023 on the open-ended energy price guarantee; potentially saving around GBP 32 billion in total revenue compared with the September proposals, which the Institute for Fiscal Studies estimated would create an annual shortfall of GBP 60 billion.

Rising rates

Because of the reversal, there will be less fiscal stimulation on offer by the government to drive the economy, but also less danger of driving inflation even higher than its annualised 10.1% September reading. That in turn translates to less pressure on the BoE to keep tightening interest rates from the current 2.25%. We expect the Bank’s benchmark interest rate to peak at 4.5% late this year or early next. The crucial question for investors will be how quickly the central bank now dares to raise interest rates to fight inflation without further damaging the sensitive housing market.

The UK economy still faces fundamental questions about its path to growth. How will it finance energy subsidies for consumers after April 2023, whether another Conservative government can propose a fiscal plan to generate economic growth while addressing its debt and without spooking financial markets. Markets are waiting for a more detailed budget, for now scheduled for 31 October.

In real GDP terms, the UK’s economic output has yet to rise above its pre-Covid metrics, with Germany on a par with 2019 levels, and activity in Italy and France at about 1% above their pre-pandemic readings. Our expectation is that the UK economy will stagnate next year, compared with the IMF’s forecast for 0.3% growth in GDP. The Fund sees the French economy expanding by 0.7% in 2023, and Germany and Italy contracting by -0.3% and -0.2% respectively.

Parliament and elections

The Conservative party, which has enjoyed an 80-seat majority in the House of Commons since December 2019, has now appointed a new leader and de facto prime minister without holding a general election. It cannot be forced to hold a general election unless two-thirds of parliament’s members back one, or pass a vote of no confidence in the government. The current five-year parliamentary term runs until 17 December 2024, making the latest date for a general election January 2025.

Mr Sunak becomes the fifth Conservative prime minister in the six years since the Brexit referendum. In part, the Conservatives’ political woes can be traced to attempts to reconcile wildly partisan positions when the then-Prime Minister David Cameron decided to hold a non-binding, ‘advisory’ EU referendum in 2016.