Sterling dropped to its lowest level since 1985 ahead of Liz Truss’s succession as the UK’s new prime minister, with investors concerned about the potential impact of unfunded handouts.
Truss, who emerged victorious from a two-month process to elect a new leader of the governing Conservative Party, has pledged to cap household energy bills – a move that could cost between £50bn and £130bn, or 2-5 per cent of gross domestic product, depending on how the policy is implemented. This is on top of other pledges she has already made including tax cuts and a reversal of April’s 1.5 per cent increase in National Insurance contributions.
The pound fell to around $1.15 on the day Truss’s victory was announced, a 15 per cent slide since the start of the year.
Sterling is currently at “a crossroads” and the UK risks a balance of payments crisis if international investors’ confidence in the pound weakens further, Shreyas Gopal, a Deutsche Bank analyst said.
Confidence interval
The UK’s external balance (its current account deficit plus foreign direct investment inflows) is the worst of any major developed or emerging market economy, he said. It also has the highest inflation rate of any G10 country and a weakening growth outlook.
“With the global macro backdrop so uncertain, investor confidence cannot be taken for granted. The risk premium on UK gilts is already rising, coincident with unusually large foreign outflows,” Gopal said in a note.
Yields on 10-year gilts soared by more than 100 basis points to 2.92 per cent last month, and this week climbed over 3 per cent.
The Bank of England is no longer a buyer as it tightens monetary policy in a bid to bring down inflation, while the level of government borrowing is expected to soar – Citi Economics has raised its expectations on sovereign debt issuance by £33.5bn to £165bn in the current fiscal year, rising to £287bn next year.
However, Kit Juckes, a macroeconomic strategist at Société Générale, argued that there was little evidence a large balance of payments deficit was bad for a currency in a developed economy such as sterling.
Given the relatively low level of yield on offer in other developed markets, further rises in gilts could suck in more international investors, particularly if inflation expectations were dampened by some of the proposed government policies, he said.
Currently, the UK’s domestic energy price cap is set to rise by 80 per cent in October to £3,549, with Cornwall Insights analysts forecasting another 52 per cent increase by next January to £5,386.
Such an unfettered rise would likely push UK inflation to a peak of 14.5 per cent in January but a freeze of the current cap could reduce this by 3.5 percentage points to 11 per cent by October, according to Capital Economics. If this freeze were maintained next year, inflation would likely average between 5.5-6 per cent, as opposed to its current forecast of 9 per cent, it estimates.
No bounceback
The main outcome of the energy crisis on both sterling and the euro is that they’re likely remain at their current depressed levels for longer, Juckes said.
He had expected sterling to break $1.15 but not $1.10 and does not see it threatening the $1.05 level last hit in 1985.
In Europe, recent events such as the 2010 debt crisis uncovered structural weaknesses that meant the euro never regained much of the ground lost against the dollar.
“It’s the same for sterling,” he said.
“We have opened the market’s, the world’s and our own eyes to the fact that Europe is dependent on imported energy in a way that the US isn’t anymore … and here in the UK we’re as much in Europe geographically as we’ve ever been, whatever we’d like to think,” he added.
“That caps where you can imagine sterling going as much as it does the euro.”
Equity markets also look set for a fairly rough ride. In theory, the more that gilt yields remain elevated, the less attractive holding shares should be. Oxford Economics’ chief UK economist Andrew Goodwin expects 10-year gilt yields to rise to about 3.25 per cent as the Bank of England continues to tighten monetary policy.
A stronger US dollar “typically leads to lower UK markets”, with value and quality shares tending to suffer more than growth companies, Liberum analyst Joachim Klement said.
UK active funds suffered a $7.8bn outflow last month, equating to around 4.6 per cent of assets under management.
“As long as investors focus on the coming recession, the dollar is likely to remain strong,” Klement said. “This clearly benefits exporters that earn most of their revenues in US dollars, while importers and domestically-oriented companies suffer.”
Domestic earners underperformed international ones by around 10 per cent in the first six months of the year, but even the latter haven’t performed as well as in past periods of sterling weakness, Liberum said in an earlier note in July. Companies that suffered bigger sell-offs than the average dollar earners included the likes of Genus (GNS), Carnival (CCL), Auction Technology (ATG) and XP Power (XPP).
