Sunak faces substantial economic challenges as new PM

The selection of Rishi Sunak as leader of the Conservative Party and next prime minister of the UK brings a pause to the turbulence in British policymaking in the last several weeks. Markets have responded positively so far with gilts rallying substantially—the 10yr gilt yield dropped about 31bps at the start of the week—in anticipation of Prime Minister Sunak bringing in more conventional fiscal policy. However, while there may be a brief ‘honeymoon’ period for Sunak, substantial challenges for the UK economy persist which will weigh on UK assets going forward.

PM Sunak—with current chancellor Jeremy Hunt likely staying on—represents a turn toward the centre of Conservative policymaking but he faces a UK economy still beset by multiple challenges: inflation at decades-high levels, tighter monetary policy, a fractured relationship with the EU, and labour shortages among others. While markets haven’t had a chance to hear from PM Sunak with respect to his economic plans, when he campaigned for the leadership earlier in the summer he sounded more aligned with the economic plan outlined last week by chancellor Hunt, essentially a return to austerity in all but name.

A new medium term fiscal plan is still expected by the end of this month where “efficiencies” will likely be the main word directed at government spending. Along with a rollback of the Truss government’s planned extensive, and unfunded, tax cuts, fiscal policy is also set to tighten from present levels. While that will work in tandem with the Bank of England’s plans to hike rates and sell down its holding of gilts in fighting against inflation, the negative impulse from fiscal policy will be a drag on growth for the British economy. Another barrier will be the shortening of the government’s energy price cap from two years until just April next year. That will help to eliminate a seemingly open-ended fiscal liability for the government but at the cost of raising inflation expectations for some parts of the economy.

With a change in government leadership what is the trajectory set for sterling? The pound has recovered from its historic lows hit on release of the Truss government’s fiscal event in mid-September but is still down more than 16% year-to-date, trading currently just shy of GBPUSD 1.13. Markets may give a new government a brief “benefit of the doubt” period though we still expect negativity around the UK economy to weigh on sterling. Moreover, expectations for how much the Bank of England will need to hike rates are being pared back. A week ago, 100bps of hikes were priced in for the November 3rd MPC meeting; that has been pared back to 80bps now with the peak in the Bank Rate also falling to around 5% from 5.25% previously. A speech from deputy BoE governor Ben Broadbent seemed to suggest that rates won’t need to move as high as markets expected but only because demand will be so negatively affected by high prices.

Our expectation was that GBPUSD would weaken into year-end before staging a modest recovery over the course of next year while staying weak by the standards of the last few years. The trajectory now for sterling and UK assets in general looks as though it will be set by the release of the medium-term fiscal plans at the end of October. Downside risks for the currency remain substantial though the reversal of the more costly planned fiscal easing should help to improve the credibility of economic policy-making in the UK and present a floor to any precipitous sell-off.