UK’s new PM: Difficult challenges ahead

Liz Truss has a tough job ahead of her – of that there is no doubt. She wasn’t the out-and-out favourite among her Tory MPs, and then went on to clinch the race to become the UK’s new prime minister by just a slim margin. And so now, at the start of her term, what indeed are the major challenges that lie ahead?

A daunting to-do list

The key drivers that swung the Tory leadership vote in Liz Truss’ favour and ultimately helped her to win the contest – with 57% of the votes – were a promise to cut taxes, plus a sense of disloyalty around rival Rishi Sunak and his attitudes/behaviour towards Boris Johnson. And now, her to-do list is certainly not for the faint-hearted.

David Riley, of Bluebay, suggests:

“The immediate issues she faces – the energy and cost-of-living crises and a stagnating economy – reflect longer-term problems of low investment and productivity.”

While Philip Saunders, of Ninety One, adds:

“A serious and considered attempt to address these problems would be a positive outcome. However, on the basis of statements made by Truss in the leadership campaign, there has been little to suggest that much will be forthcoming.”

A key battleground had been that of taxation. Truss’ flagship policies included doing a U-turn on both the recent National Insurance increase and the planned hike to corporation tax – totalling around £40 billion per year (1.7% of GDP). Having petitioned to cut taxes “from day one”, she may find this a tough commitment to stick to. In the March Budget, there was additional headroom in the public finances that Truss has proposed she will use to fund these cuts, yet additional borrowing will potentially be required to meet all her tax commitments. Unfunded tax cuts would essentially add to the long-term burden on public finances.

Riley adds:

“The gilt market and sterling are unlikely to take too kindly to a big increase in government borrowing at a time of high inflation and rising interest rates unless backed up by a credible plan to reduce government borrowing and debt over the medium term.”

Saunders is well aware of the sizeable task ahead:

“The crisis is of a similar magnitude to the Global Financial Crisis and the COVID-19 crisis, and an effective response to it would mitigate the hit to the economy in terms of extent and duration as well as setting the conditions for recovery thereafter.”

Given the concerning cost-of-living crisis, Truss has recently intervened in the energy markets – introducing a new Energy Price Guarantee, which will essentially fix unit rates for domestic customers as of October and freeze the price cap at £2,500 for a typical household for two years. By cushioning the blow of high gas prices in this way, the Truss government hopes to curb inflation – currently close to a 40-year high at 9.9% – by up to 5%.

BoE on the front line

Truss asserted her commitment during the leadership campaign to reviewing the Bank of England’s (BoE) mandate. However, a certain level of unease was voiced about some of her comments, which AXA Investment Managers believe “failed to acknowledge the significant external developments that have driven inflation higher”.

On the eve of her premiership, she then seemingly tempered her stance, and her comments were considered by some as being a peace offering to BoE governor Andrew Bailey – yet worries abound.

Riley, of Bluebay, adds:

“Like many other central banks, the Bank of England has been guilty of being too late to respond to the inflation threat. But anything that smacks of reducing the independence of the Old Lady of Threadneedle Street would worry international investors that are funding the UK’s big twin budget and trade deficits at a time when inflation is the highest amongst the G7 economies.”

What’s more, a research note published by Deutsche Bank further emphasised that the “risk of a UK balance of payments crisis is rising” under a Truss government: “A large, unfunded and untargeted fiscal expansion, accompanied by potential changes to the BoE’s mandate, could lead to an even bigger rise in inflation expectations.”

The next chapter for Brexit

Truss was on the ‘Remain’ side during the Brexit referendum, yet has since become militant over the UK–EU relationship, insisting that she would trigger Article 16 of the Brexit Agreement over Northern Ireland so as to force a deal. However, a senior Truss ally has maintained that, if this were to happen, it would only be a “stopgap” until legislation is passed.

AXA Investment Managers observed:

“We continue to expect that there will be a negotiated agreement. The prospect of a trade war between the UK and the EU – the country’s closest trading partner – would be a costly endeavour. Imposing additional costs on UK trade would add to inflationary pressure at a time when consumers already face price growth at 40-year highs. However, we consider such an outcome as more likely under a Truss, rather than Sunak, government.”

Saunders, of Ninety One, concurs that it would be an oversight to trigger Article 16:

“Doing so would arguably squander an opportunity to reset relations with Europe and potentially lead to a further phase of turmoil and uncertainty, negatively impacting the UK’s growth prospects for political purposes.”

Hope on the horizon?

Richard Colwell, of Columbia Threadneedle, recognises that many UK families are facing extremely difficult circumstances. On the other hand, he asserts that, under the bonnet of UK plc, the data looks pretty hardy.

“UK consumers are much less indebted than at the start of COVID-19, with higher aggregate savings, while wage growth remains strong and housing wealth is at an all-time high.

“Non-financial corporations have enough excess cash that they could comfortably withstand a 2008-09-style cash burn, while banks’ capital ratios at the start of 2022 were nearly four times higher than pre-global financial crisis.

“The UK remains an excellent hunting ground for patient, long-term investors, with private equity and overseas investors snapping up undervalued, world-leading UK businesses.”

According to Nick Purves, of Redwheel, the UK is one of the cheapest developed markets, and therefore there could be an advantage to any outcome that is not as disastrous as the one being priced in.

“The fact that the government now seems likely to cap energy bills should take some of the pressure off the beleaguered consumer, and tax cuts and deregulation could also prove stimulative for the economy in the medium to long term.

“Finally, the reduction in the value of the pound has historically had a stimulative effect and at the very least has a positive translational impact on the profits of some of the largest companies in the FTSE 100, which earn a sizeable portion of their profits in dollars.”

Riley summarises:

“Hard choices rather than wishful thinking are required to boost the long-term growth potential of the British economy and maintain confidence in the monetary and fiscal policy framework. The credibility of the new prime minister’s economic policy programme will be judged in the bond and foreign exchange markets.”

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