UK can’t shake pound negativity after weeks of political chaos

Prime Minister Liz Truss is on her way out, just as markets wanted. But the huge economic and fiscal headwinds ahead spell further pain for the pound regardless of who wins the contest to become the UK's next leader.

Investors distracted by the political circus engulfing the nation may start turning back to the economy's woeful outlook: inflation at a 40-year high, soaring interest rates, depressed consumer sentiment and a potential return to austerity.

Throw this week's premiership race and dollar's strength into the mix too, and that implies that sterling's bounce from an all-time low last month is on borrowed time. And while the bond market meltdown has also subsided, there are plenty of challenges there too. Even with Truss' sweeping unfunded tax cuts now scrapped, net issuance of gilts for the next fiscal year remains vast and borrowing costs are sky high. 

Whoever prevails in this week's Conservative Party leadership contest will need to focus on damage control rather than chasing meaningful economic growth. 

"We continue to see the UK as a structural underperformer in the G10 given weakening growth," Morgan Stanley strategists including Marie-Anais C Francois wrote in a note to clients this weekend. "The watered-down fiscal plan is now a drag on growth, and the UK's weak net international investment position still leaves it reliant on foreign inflows."

The pound rose as much as 0.9 per cent to US$1.1401 early in the Asia session after ex-premier Boris Johnson pulled out of the leadership race, leaving Rishi Sunak on the brink of becoming the next prime minister. But the British currency is still down around 16 per cent against the greenback this year. 

"A Sunak-led government seems more welcome for stability," said Mahjabeen Zaman, head of FX research at Australia & New Zealand Banking Group. "While the risk premium in FX from the original budget has been reduced by the U-Turn, the pound still faces ongoing challenges."

Strategists at ING Bank see sterling slipping back to US$1.05 by year-end, and Bank of America is sticking with its call of parity. 

After Truss' disastrous tenure and the UK's perceived loss of fiscal credibility, it's likely that politicians will react with a tilt towards austerity, according to TS Lombard's Freya Beamish and Christopher Granville. That would heap further pressure on an economy that's tipping towards recession.

The pound is languishing well below the peaks reached during the first leadership contest over the summer, when it traded as high as US$1.23. It was around US$1.15 the day that Truss was announced the winner. 

Equities are also struggling amid questions over the economy, political leadership and the UK investment case. The FTSE 250 gauge of mid-caps fell 1 per cent on Friday, wiping out the relief rally on the day Truss quit. It's down 26.7 per cent this year.

"The main factor for the UK at the moment is we're quite short on certainty," said Baylee Wakefield, a portfolio manager at Aviva Investors. "The key question for markets is whether that normal policy making can resume."

The squeeze on the real economy is gaining pace, and a dramatic reminder of that came on Friday with a big drop in retail sales. The grim backdrop will be on show again on Monday, when business surveys for this month are expected to show further declines.

"It's hard to see under-owned UK equities or GBP (British pound) bouncing higher when the path to a deep and protracted recession is only getting clearer by the day," Viraj Patel, senior strategist at Vanda Research, wrote in a note to clients. 

There's speculation about a delay to a much-anticipated fiscal statement and how the government plans to plug a hole in the public finances of about £25 billion (S$40.2 billion). That announcement, from new Chancellor of the Exchequer Jeremy Hunt, was intended to calm markets, so a postponement is far from ideal.

"Yes, the UK will have a new prime minister at the end of next week, but the power resides with the chancellor," said Marc Chandler, chief market strategist at Bannockburn Global Forex. 

There are also plenty of doubts surrounding the investment case for gilts, which took a dive again on Friday. The 10-year yield closed above 4 per cent again for the first time in a week. 

Traders have pared bets on the extent of hikes by the Bank of England since Hunt scrapped the majority of his predecessor's sweeping tax cuts. That move accelerated last week after Deputy Governor Ben Broadbent said it's not clear that UK rates need to rise as much as investors expect. 

Yet the the outlook still leans towards aggressive tightening. Traders see another three percentage points of hikes at least, which would take the key rate to 5.25 per cent, the highest since 2008. Hiking less would put sterling "in jeopardy again", said Axel Botte, global strategist at Ostrum Asset Management.

The central bank also seems determined to push ahead with active gilt sales, already delayed once, from Nov 1, albeit with longer tenors excluded. That all amounts to a tough backdrop for the government to bring a deluge of bond sales in the next fiscal year. Citigroup strategists still see gilt issuance of more than £260 billion, even after the fiscal U-Turn.

It's also bad news for mortgage holders who'll be looking to refinance, particularly those already feeling the strain from soaring energy bills and food prices.

"If the government and the Bank of England can restore credibility in the market, that can bring interest rate expectations down, and the cost of this refinancing these mortgages may not be as bad as some people fear," said Matthew Holdgate, portfolio manager at Nikko Asset Management. BLOOMBERG

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