By Frédérique Carrier, Head of Investment Strategy in the British Isles and Asia at RBC Wealth Management
Amid scorching temperatures, three key events that will likely shape the regional economic outlook have marked the summer of 2022 so far: the contest to become the next UK prime minister; the EU plan to avoid winter energy shortages; and the collapse of the Italian government. We explore the potential outcomes, and suggest portfolio positioning.
UK leadership contest
Following the resignation of Prime Minister Boris Johnson, 180,000 Conservative Party members will choose their next leader. The winner, to be announced on Sept. 5, will automatically become the next prime minister of the UK. The leadership contest has now narrowed to two candidates—Foreign Secretary Liz Truss, the favourite to win according to polls, and former Chancellor of the Exchequer Rishi Sunak. Both candidates advocate fiscal easing to tackle the UK’s slow growth.
The next occupant of Number 10 Downing Street will face a very challenging economic backdrop. The Bank of England expects UK inflation to rise to 13 percent and remain above 10 percent for most of next year; it recently hiked interest rates by 50 basis points (bps) to 1.75 percent—the largest increase since 1995. The central bank estimates that the UK economy will contract in both 2023 and 2024, to the tune of 1.25 percent and 0.25 percent, respectively. Markets expect the Bank Rate to reach 2.85 percent at the end of 2022.
These projections could prove overly pessimistic if energy prices decline swiftly, or if the new prime minister’s fiscal response to the latest spike in gas prices and the cost of living crisis is significantly more substantial than the two candidates are suggesting at the moment.
Once in office, the new prime minister will likely be under pressure to act. The average household energy bill is set to increase to £3,358 a year in October, up from £1,400 a year ago, and rise again to £4,427 in April 2023, according to energy consultant Cornwall Insight. The situation is critical given the average household income was £25,971 in 2021, according to the Office of National Statistics.
Because income tax cuts do not tend to help low-income households, further direct payments or broad cuts in the sales tax or the value-added tax (VAT) are likely, in our view. A decrease in VAT proved an effective tool during the great financial crisis. Such cuts are easy to implement, stimulate consumption, and are temporary. This could entail further action by the Bank of England if this additional fiscal stimulus proves inflationary—in the neighbourhood of 25 to 50 bps beyond current market expectations, depending on the depth of the recession.
The pound has shown little sensitivity to the political uncertainty from the Conservative leadership contest. However, both candidates are expected to press on with plans to water down the Northern Ireland Protocol, the post-Brexit trading arrangement for Northern Ireland, a move which could trigger a trade war with the EU. This would weigh on the pound in the medium to long term, in our view, as would Truss’s proposed review of the Bank of England’s inflation-targeting mandate should she have the opportunity to pursue it as prime minister. Such a review would likely reduce the incentive for the central bank to follow through on its hawkish rhetoric, even as inflation remains elevated.