UK debt to soar throat!

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Liz Truss, the shortest-serving prime minister in British history, is replaced by Sunak. Her main economic initiative, the so-called “mini-budget,” was rejected by investors, resulting in a collapse of the financial markets and a decline in U.K. assets.

The budget forced the Bank of England to intervene to stabilize bond markets because it proposed a number of unfunded tax cuts at a time when the government was already dealing with a sizable current account debt, a weak currency, high inflation, and an economy that was on the verge of recession.

In an effort to maintain her position as a premier, Truss fired Kwasi Kwarteng, her finance minister, and replaced him with Jeremy Hunt. Prior to Truss’ resignation and Rishi Sunak’s official appointment as prime minister, Hunt effectively undid most of her financial plans.

When his predecessor promised “economic stability and confidence,” Sunak claimed that “mistakes were made.” The economic crisis, which many Britons are struggling to manage due to the sharp increase in the cost of living and rising energy prices, will now be the new prime minister’s top priority.

What is the UK’s Growth Outlook?

Markets responded favorably to Sunak’s victory because he was the favorite to succeed Truss. The former chancellor, who has warned of a “profound economic challenge” that calls for “stability and unity,” is now tasked with trying to stabilize the U.K. economy after a period of intense market volatility.

Hunt, who has established a significant multi-year fiscal tightening plan totaling about £70 billion ($79 billion) or (2.5% of GDP by 2025), is anticipated to remain in his position as finance minister for the time being. According to media reports, the U.K. Treasury is considering a number closer to £72 billion.

The estimated tightening that is necessary to ensure fiscal sustainability has grown larger as a result of growth disappointments and higher interest rates, in part because of the mini-budget. This goes beyond merely rolling back the Truss tax cuts. Despite the government’s recent U-turn, yields have not returned to their previous levels and don’t appear to be doing so anytime soon.

We anticipate that a sentiment shock coupled with a significant tightening of fiscal policy will lead to a longer and deeper recession, which will be followed by a very sluggish period of growth over the following few years.
UK economist Allan Monks works for J.P. Morgan

According to Research, the fiscal deficit will be close to 5% of GDP next year before reverting to 2% over the next few years. As a result, the debt to GDP ratio would reach its peak in 2023–2024 at just under 100% and then begin to decline.

According to Allan Monks, a U.K. economist  “we think the risks surrounding these projections are still to the downside: a larger fiscal tightening may be necessary if growth disappoints or if interest rates move higher than expected.”

Financial markets in the UK

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London is generally regarded as one of the three “command centers” of the global economy, and the United Kingdom is home to some of the oldest and most developed financial markets in the world (along with New York City and Tokyo). The UK is the third-largest country in terms of its share of global equity markets, despite having the sixth-largest nominal GDP in the world (behind the U.S. and Japan). The nation also has the biggest off-exchange derivatives market and the biggest foreign exchange (forex) market in the entire world.

The London Stock Exchange (LSE), which has roots in the late 16th century and was established in 1801, was operational during the era when Britain ruled the world as the dominant economic and imperial power. The Milan Stock Exchange was acquired by the LSE in 2007, resulting in the formation of the LSE Group, the eighth-largest stock market operator in the world at the time. With some of the biggest companies trading on the LSE being multinational juggernauts like Japanese automaker Toyota, French oil and gas company Total, as well as American companies IBM and Honeywell, the LSE’s international nature plays a significant role in its appeal. The FTSE 100, which is composed of the 100 largest qualifying UK companies by market capitalization, serves as the main index used to follow the growth of the LSE.

Derivatives market in the UK

In fact, London has been at the forefront of financial innovation since the 19th century, when the industrial revolution first began. The 20th and 21st centuries saw a continuation of this emphasis on innovation, with the United Kingdom generally regarded as the world’s largest market for derivatives. For “over the counter” (OTC) derivatives—derivatives not traded on a regulated stock exchange—the UK is the largest market in the world. The UK is the largest country for trade in derivatives denominated in euros, making the EU a significant part of this market. However, with the UK leaving the European Union (EU) in 2021, there is uncertainty regarding whether post-Brexit standards will permit the continued trading of derivatives denominated in euros in the UK, casting doubt on whether the UK can maintain its dominant position.

UK government debt paths

It predicted that in 50 years, debt levels could more than triple. Interest rates are rising as a result of high inflation. They reached £7.6 billion in May, the highest monthly total ever and an increase of £3.1 billion over the previous year. Without spending cuts and tax increases, the UK’s debt is on an “unsustainable path,” the government’s independent forecaster has warned. According to the Office for Budget Responsibility (OBR), pressures from an aging population and rising energy prices could push the UK into a recession.

Debt is the total sum of money the government owes that has accumulated over time. It was £2.36 trillion in May 2022. With debt at 95.8% of GDP, the amount is almost larger than the size of the UK economy (GDP). According to the OBR, the ongoing conflict in Ukraine, the nation’s soaring energy costs, and long-term financial strain “add up to a challenging outlook for this and future governments as they steer the public finances through inevitable future shocks,”. “Many threats remain, with rising inflation potentially pushing the economy into recession, lingering doubts about our future trading relationship with the EU, a resurgence in Covid cases, a changing global environment, and rising interest rates,” it said.

According to a BBC-commissioned survey, it has caused many people to reduce their spending, particularly on food and travel. It has also increased worries that the UK may experience a recession, which is defined as a decline in the size of the economy for two straight quarters. The energy price problems right now, according to the OBR, might not be as bad as they were in the 1970s.  There are reasons to believe that the overall impact on inflation, output, and unemployment will be less severe and less persistent this time around than it was during the oil crises of the 1970s, which saw a similar increase in global energy prices as we have seen in the wake of the pandemic and Russian invasion of Ukraine.

Reasons for National debt

• Enables the government to spend more during periods of national crisis, e.g wars, pandemics, and recessions.
• In a recession, the government will automatically receive lower tax revenues (less VAT and income tax) and will have to spend more on benefits (e.g. more unemployment benefits) This causes a cyclical rise in debt.
• Extra government borrowing during a recession can help provide fiscal stimulus to promote economic recovery. By borrowing and then spending more, the government is injecting demand into the economy and this can help to reduce unemployment. This is known as fiscal policy and was advocated by J.M. Keynes.
• Strong market demand for government debt. Private investors buy gilts because they are seen as risk-free investments and there is also an annual dividend from the bond yield. Since 2009, there has been strong demand despite very low-interest rates, meaning the government can borrow very cheaply.
• Finance investment. The government could borrow to finance public investment projects that can lead to higher growth in the future.
• Political convenience. There is usually political pressure to cut taxes and increase government spending. Allowing debt to rise can be a way for the government to avoid difficult choices.

Inflation drives UK interest rates to a record high 

People reduce their consumption of food and fuel as prices rise. According to the OBR’s fiscal risks and sustainability report, the government has already spent 1.25 percent of GDP this year to assist households in coping with the cost-of-living crisis, which is equal to the amount it spent to support the economy during the 2008 financial crisis.

According to the OBR, raising taxes, cutting spending, or a combination of the two would be required to reduce debt to 75% of GDP, the level at which it stabilized in the government’s March 2020 Budget prior to the pandemic. The OBR stated that the public debt is on an unsustainable path in the long term due to the pressures of an aging population on spending and the loss of existing motor vehicle taxes in a decarbonizing economy. Beginning in 2030, the government intends to prohibit the sale of new gasoline and diesel vehicles. Currently, fuel taxes are a significant source of tax revenue.

Recent revisions to research’s U.K. growth forecasts assume an additional 0.2 percentage point drag from these sources in 4Q22, bringing the impact over the following year closer to 0.8%. Taking into account that this is the time when the public spending cuts will be concentrated, the cumulative GDP drag then increases to over 1% by 2025.

These estimates are based on a number of assumptions, and there is a great deal of uncertainty surrounding the projections. However, we anticipate that a sentiment shock coupled with a sizable tightening of fiscal policy will lead to a longer and deeper recession, followed by a very sluggish period of growth over the following few years. Our year-ahead GDP profile has been reduced by 0.8%, and by 2025 the total drag will be 1.3%.

What are the prospects for the British pound and UK stock market?

After Rishi Sunak was appointed prime minister, U.K. assets increased. British stocks were mixed, the 10-year government bond yield in the UK edged lower, and the pound rose against the dollar. Despite the recent political unrest, research is still bullish on U.K. stocks; after six years of caution, it upgraded the FTSE 100 to OW (overweight) last November.

The U.K. has performed the best this year among regions measured in local currency. The relative performance of the FTSE 100 is significantly influenced by currency. Nearly 70% of the index’s income comes from outside the country, according to Mislav Matejka, Head of Global Equity Strategy at J.P. Morgan.

Since there has historically been a strong inverse correlation between the relative performance of U.K. equities and the British pound, the weaker currency is expected to continue to provide a significant boost to earnings for U.K. large caps. Additionally, Matejka continued, “U.K. equities continue to be exceptionally well priced, trading at the lowest forward price to earnings vs. global peers on record.” This year, the United Kingdom has performed the best in both local currency and US dollars.

Even after Liz Truss’ resignation, the outlook for the British pound in 2023 is muted. Since the majority of the tax cuts and fiscal generosity had already been undone, the appointment of Jeremy Hunt as chancellor had a greater positive impact on the pound than the resignation of the prime minister.

The fiscal U-turns carried out over the past week have already exhausted a sizable portion of sterling’s upside potential, according to analysts led by Meera Chandan, Co-Head of Global FX Strategy at J.P. Morgan.

This implies that the financial risk incorporated into the pound has already been significantly deprived, leaving rather little room for further upside to raise the pound from its current levels. This roughly agrees with the J.P. Morgan scenario analysis, which predicts a peak in the British pound/U.S. dollar exchange rate of $1.15 under the best-case fiscal and monetary policy scenarios for the Truss regime.

In light of the upcoming general elections in 2024 and the ongoing Scottish referendum, Chandan continued, “Taking a step back, but consistent with the above – this week’s events are the latest in a series of political disruptions that reaffirm our view that investors should rightly expect a semi-permanent political risk premium embedded in GBP.”