A look at the UK

by Trent Wiseman and Sean Tweedie | February 6, 2023

In September of 2022, the UK’s former Prime Minister and her Finance Minister announced a mini-budget that would include major tax cuts financed by increasing the nation’s budget deficit. At a time when unemployment was almost at a record low of 3.5% and inflation was above 10%, levels not seen since the 1980s, the need for major stimulus to boost domestic demand was unnecessary.

This decision by the government saw investors flee from the UK economy and resulted in a subsequent balance of payments crisis. In the UK, 30% of the Gilt stock is held by foreigners. See figure 1

Figure 1

When these foreign investors disinvested following the mini-budget, the pound sterling weakened to a record low against the US dollar of 1.035. Simultaneously, UK Gilts weakened significantly as foreign investors were spooked by the risks involved with an increased budget deficit.
The Bank of England was failing on its mandate to ensure price stability in the UK. Inflation peaked at 11.1% in October of 2022. Simultaneously Foreign Direct Investment (FDI) continued to decline following the government’s decision to implement Brexit in 2016. This has resulted in the UK facing a cost of living crisis which may have been avoided if more responsible decision making procedures were implemented by the government and the BoE.

The UK economy is structurally weak through a combination of slow population growth and low productivity growth. See figure 2

Figure 2

Over the past 10 years productivity growth and population growth have expanded at a rate of 0.6% year-on-year (YoY). As a result of this lacklustre growth the Organisation for Economic Co-operation and Development (OECD) estimates that the potential GDP growth rate for the UK will only reach 1%. There are major concerns over the long-term price stability of the pound sterling and the UK gilts due to the weak potential growth. In the long run weak growth will limit the BoE’s ability to hike interest rates in order to combat inflation. Subsequently, there are risks that inflationary pressures could last longer than anticipated in the UK.

However, since Rishi Sunak and Jeremy Hunt were appointed Prime Minister and Minister of Finance respectively in October of 2022 there has been a marked shift in the UK’s fiscal and monetary policy. The Prime Minister has recalled the majority of the permanent fiscal decisions announced by the previous administration. This fiscal shift by the government has resulted in positive sentiment for the pound sterling and UK Gilts as it will reduce the reliance that the UK fiscus has on the inflow from foreign investors.

Recently, the BoE’s tentative estimates on inflation have shifted to a more positive view. After the chaos surrounding the balance of payments crisis of September, the BoE is predicting that inflation will fall to 5.2% in 2023, 1.4% in 2024, and 0% in 2025. The UK’s Office for Budget Responsibility (OBR) is also more positive, forecasting that inflation will drop to 3.8% in 2023, -0.1% in 2024, and -1.3% in 2025. This positive sentiment is driven by Rishi Sunak’s push for austerity and the subsequent BoE’s increased interest rate hikes. See figure 3

Figure 3

A nation’s central bank and government policies can have a big impact on the health of an economy, both in the short and long-term. The incorrect decision to implement policies at a time when a nation is vulnerable can have dire consequences. Conversely, a credible government and central bank can guide a nation through strenuous times. This difference is evidenced through what we have witnessed in the UK over the last six months.

The pound had a substantial recovery from the low of 1.035 against the dollar in September of 2022 to reach a high of 1.24 in January of 2023.
See figure 4

Figure 4

However, the 1.25 level is acting as a major resistance level. The team of analysts at BCA Research believe that the GBP/USD exchange rate is due for a slight reprieve in the short-term, with the pound sterling being slightly overbought at the moment. Over the longer-term BCA Research’s analysts see the pound remain strong versus its peers. However, the UK’s low productivity growth is a headwind to a stronger pound, and which may weigh on its valuation over the next few years. In order to ensure BCA Research’s bias to a stronger pound, the UK will have to invest heavily in technologies aimed at boosting productivity growth.

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