Market View

The UK faces challenges, whoever the next Prime Minister is

With Parliament in recess and many MPs on holiday, combined with the leadership election, there is little or no action to combat the growing difficulties many people face.

The UK economy
Jonathan Marriott, Chief Investment Officer

Conservative party members have received their ballot papers and the result will be announced on the 5th September. The next day, either Liz Truss or Rishi Sunak will be the new Prime Minister. With Parliament in recess and many MPs on holiday, combined with the leadership election, there is little or no action to combat the growing difficulties many people face.

The new Prime Minister and their Cabinet will have a lot on their plate from day one. The energy price cap is about to be lifted again, meaning the average household is likely to be paying over £4,000 a year. We have industrial unrest with rail and postal service strikes. Meanwhile, the drought, high fertilizer costs and a lack of workers are making life hard for farmers. Importing food and other products from the European Union has become harder, with hold-ups at the docks and increased documentation. It is going to be a difficult autumn for all, with higher interest rates to fight inflation applying extra pressure.

Are central banks to blame?

The Governor of the Bank of England (BoE), Andrew Bailey, said after the last rate rise that they were fighting inflation, no "ifs or buts".  He has come under fire from Liz Truss for reacting too slowly and could become a convenient scapegoat for many of the difficulties we face. While the BoE may shoulder some of the blame for reacting too slowly, I do not think it is fair to blame them entirely.

The fiscal stimulus to counter the pandemic could have been reduced earlier and been more specifically targeted. However, no one saw the war in Ukraine and the knock-on effects of this last year. The war itself could have had little effect on prices, but the sanctions on Russia and subsequent cutting of gas, oil and fertilizer supplies from the region has had an enormous impact. The continued pandemic in China, in particular, has led to supply disruption that is only now gradually easing. These are global supply issues that UK interest rates have little or no impact on.

Liz Truss and her supporters have been particularly vocal critics of the Bank of England, suggesting a change of mandate and more control for politicians. When Donald Trump was President, he was a vocal critic of the Federal Reserve and Jay Powell, who he had appointed. As we go into the mid-term elections in the US, we can also expect the Federal Reserve to come under fire.

The UK cost-of-living crisis

The cost-of-living crisis, combined with higher interest rates, will constrain demand in the economy. It will lead to higher wage demands and the rail and postal strikes may just be the start of much wider industrial action. If this country is to remain competitive, we should do what we can to avoid a wage price spiral.

In the 1970s, rising wage demands and poor productivity wiped out large parts of the manufacturing economy. The Bank of England openly predicts a 15-month recession and yet are raising interest rates.  Norman Lamont when Chancellor said a recession was a price worth paying to get inflation under control.  While Andrew Bailey appears to agree, it seems that not all today’s politicians do. Liz Truss proposes immediate tax cuts to support the economy. Rishi Sunak on the other hand is more cautious and proposes targeted hand-outs to help the worst affected. He would only cut tax when inflation is under control. 

There are signs that the international inflationary pressures are easing already as demand slows. The oil price has fallen back from its highs. My local petrol station diesel has come down from over £2.00 a litre to £1.86, still substantially higher than last year. US wheat futures, which soared after the Russian invasion of Ukraine, have nearly returned to the level they were at last year. However, gas prices remain astronomically high in Europe as supplies are restricted from Russia. Ukraine’s grain export supplies are only just starting again, but there will still be shortages in areas dependent on these. So, it is a mixed picture geographically.

In the UK, some crops will be reduced by the drought and reduced use of fertiliser - this will make us even more dependent on imported food. While alternatives now make up an increasing proportion of our energy supply, we still remain heavily dependent on gas and oil. The energy price cap only delays increases and inflation is expected to peak at over 13% later this year before falling back next year. With wages rising much more slowly, there will be real constraints on spending. With similar constraints in the US and Europe, global demand should fall helping ease the inflationary picture.

In the UK, we have the additional issue of adapting to post-Brexit trading conditions. The Northern Ireland issues remain unresolved and additional checks are causing delays and supplementary costs. I suspect that this would have been much more of a talking point if it were not for the pandemic to disguise the impact and now Russia.

Through the pandemic and into this year house prices have held up well. The latest Royal Institute of Chartered Surveyors’ survey indicates that prices continue to be firm. Continued demand and a lack of supply appears to have supported this. However, the latest survey indicates that new buyer enquiries are starting to fall. Many people with fixed rate mortgages are protected against the impact of interest rate rises, but when they come to refix, they may find the rate as much as double what it was before. So, the impact of higher rates is delayed but not removed. This combined with falling real incomes will eventually weigh on house prices. Conversely, those that don’t buy and instead rent, rising rental costs are likely to add to their cost of living. This may magnify the difficulties next year.

Overall, it will be a difficult start for the new Prime Minister and the UK economy may have a very difficult year ahead. In the end, inflation may come down and then interest rates can ease, but that seems some way off. For investors, we need to remember that stock market indices are not directly linked to the economy.

The FTSE 100 index has mostly international companies with overseas earnings and thus remains somewhat unaffected by the UK economy. If the pound weakens, this supports the price in sterling terms. Global stock markets have recovered in recent weeks, but remain substantially lower than they were at the end of last year. Stock markets look ahead and much of the risks noted above may already be priced into the market already. For investors with diversified portfolios, the UK leadership may give us plenty to talk about but have little impact on portfolio returns.

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