The state of the UK economy

The death of Queen Elizabeth II has come at a particularly bad time for the United Kingdom, which is fraught with economic uncertainty and dampening national sentiment. The Queen—whose 70-year reign spanned the aftermath of WWII, the winding down of Britain’s vast empire, the 2016 Brexit vote, and a global pandemic—was seen as a symbol of continuity and stability in a world of constant change.

For the next few days, the eyes of the world will remain focused on the UK as it prepares for the Queen’s funeral and the coronation of her successor, King Charles. Normal business in parliament has also been suspended for the next several days, including the impending emergency budget, which will now be delayed. All this comes a couple of days after the UK installed its new prime minister, Liz Truss, who was appointed on Tuesday by the Queen herself in her final act of public service.

Truss enters 10 Downing Street at a time of unique flux for Britain, inheriting a country saddled by a host of economic challenges. For months, the UK has endured a leadership vacuum while the country has skidded toward a recession and confidence crisis. Some of the issues she is facing are domestic and some are international, but combined they create one of the trickiest stories in the global economy.

First among these challenges is inflation. Rising costs for energy have driven consumer prices in the UK up 10% year-over-year, but even excluding volatile food and energy, UK core inflation is not expected to abate any time soon. The Bank of England anticipates that inflation will jump to 13% as the energy crisis intensifies. Citigroup estimates inflation in the UK could peak at 18% in early 2023, while Goldman Sachs warns it could reach 22% if national gas prices remain elevated at current levels.  Frustration over the rising cost of living has compelled hundreds of thousands of workers at ports, trains, and mailrooms to go on strike. 

Those elevated prices have driven UK interest rates higher but even so, UK rates relative to inflation are still some of the lowest of any major economy, which makes holding the currency less attractive. That has weakened the Pound Sterling, which in August logged its worst month since the aftermath of the 2016 Brexit referendum, hitting its lowest level against the US dollar in more than two years. Moreover, since the UK runs a current account deficit and imports more than it exports, imported goods have become more expensive, creating even more inflationary pressure.

The UK’s decision to leave the European Union, its largest trading partner, is another complication. The Office for Budget Responsibility has projected that exports and imports will be about 15% lower in the long run than they would have been if the UK stayed in the EU. Moreover, by restricting the movement of labour, it created a negative supply shock and increased costs. Furthermore, it has increased the friction in trading abroad, especially with Europe, making it harder for UK exporters to take advantage of the country’s weaker currency.

In her campaign for the PM’s job, Truss has vowed to jumpstart the economy by slashing taxes. However, many economists fear this approach could fan inflation and hurt fragile public finances. The UK government borrowed heavily to provide support during coronavirus lockdowns. The country’s debts are now almost 100% of its gross domestic product and with rising interest rates, that will make it increasingly expensive for the government to service its debt.

For UK assets, the fact that a 10-year UK Government bond yields less than a 6-month US Treasury bill, and much less than UK inflation, creates a poor risk/reward proposition. The Pound could continue to weaken given all of these myriad economic challenges. But one bright spot might be the equity market, more specifically the FTSE 100 Index. Trading at about 9x next year earnings, and benefitting from a weaker currency in a context where many of the Index components sell products abroad, it may well be that UK equities outperform the broader European market. 

Disclaimer: This article is brought to you by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is published by Calamatta Cuschieri Investment Services Ltd, which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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