New Prime Minister, Same Problems

4 min read 5 Sep 22

All eyes were on 10 Downing Street this week, as Liz Truss was selected by members of the Conservative party to be the new party leader and UK Prime Minister. There were differences in the proposed policies of the two candidates. However, we don’t think the choice of Prime Minister significantly changes the short-term outlook for the UK.

The scale of issues facing the UK economy overwhelms everything else:

  • Lower energy supply and higher energy prices
  • High (and rising) inflation, damaging real incomes
  • Slowing economic growth, driven by weakening consumer demand and foreign investment
  • High current account deficit – which is the metric that measures how much the UK imports vs. exports. The UK imports much more than it exports, leaving a “deficit” to be funded

These issues require longer-term solutions; in the case of energy adding more production through diversified sources (nuclear, solar and, or wind) and reducing consumption through improved building insulation.

The UK government has already provided some support to households for energy bills, and it’s likely more measures will be announced in the coming weeks. The near-term proposals put forward to deal with the ‘cost of living crisis’ will heap more pressure on public finances. This comes at a time when higher interest rates and higher inflation are pushing up social security spending and debt interest payments.  Interest payments on debt and higher welfare payments are already forecasted to cost more than £30bn a year more than planned by 2024-251.

Investors are paying attention to the challenging backdrop facing the UK economy. The UK government borrows by issuing gilts (UK government bonds). The yield is the interest paid to the bondholder relative to the par value of the bond.  Yields move inversely to prices, with investors demanding a higher yield to be compensated for taking more risk. The yield on 2-year UK gilts has increased from around 1.1% in January to nearly 3% in August. Higher interest rates to tackle rising inflation mean that cost of servicing the debt also rises.  The UK then needs more tax revenue in the future. This is counter to Truss’s intent to cut taxes by keeping corporate tax rates at 19% and reversing national insurance tax rises.  Higher energy prices also mean the UK imports even more relative to exports, putting downward pressure on sterling which has fallen from $1.35 at the start of the year to $1.15.

While there is significant structural demand for gilts from pension funds and other investors, this may not be enough to stop further rises in UK gilt yields and sterling weakness. For this reason, we don’t own UK gilts within our portfolios. The UK equity market, in contrast, may benefit from a weaker sterling. Investing across multiple regions and asset classes can shield UK investors from this risk and is a key part of how we manage our model portfolios.

The outlook for the public finances under the Bank of England’s August 2022 forecast, Institute for Fiscal Studies, August 2022.

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