New prime minister, same challenges

But her pledge to cut taxes, plus a lingering sense that her rival Rishi Sunak had betrayed Boris Johnson, were key factors that persuaded 57% of voting members and enabled her to clinch the race to become the UK’s new prime minister. The in-tray awaiting her is a daunting one.

“The immediate issues she faces - the energy and cost of living crises and a stagnating economy - reflect longer-term problems of low investment and productivity,” suggests David Riley of Bluebay.

“A serious and considered attempt to address these problems would be a positive outcome,” adds Philip Saunders of Ninety One. “However, on the basis of statements made by Truss in the leadership campaign, there has been little to suggest that much will be forthcoming.”

Taxation had been a key battleground. Reversing both the recent National Insurance hike and the planned increase to corporation tax were Truss’s flagship policies, amounting to around £40 billion per year (1.7% of GDP). She had campaigned on a commitment to cut taxes “from day one” but may struggle to follow through on her promise. Truss has suggested she would use the additional headroom in the public finances identified in the March Budget to fund these cuts, but further borrowing will likely be needed to meet all her tax commitments. Unfunded tax cuts would only add to the long-term pressure on public finances.

“The gilt market and sterling are unlikely to take too kindly to a big increase in government borrowing at a time of high inflation and rising interest rates unless backed up by a credible plan to reduce government borrowing and debt over the medium term,” adds Riley.

Saunders is in no doubt as to the size of the task. “The crisis is of a similar magnitude to the Global Financial Crisis and the COVID-19 crisis and an effective response to it would mitigate the hit to the economy in terms of extent and duration as well as setting the conditions for recovery thereafter.”

In response to the cost-of-living crisis, Truss is reportedly considering a big intervention in the energy markets, freezing the price cap at a cost of up to £100 billion – equivalent to 4% of GDP. Such a move would make a major difference to inflation and, by giving households more money to spend on non-energy goods and services, could mean the UK recession is shallower than currently expected.

Bank of England in the firing line

During the leadership campaign, Truss confirmed her commitment to reviewing the Bank of England’s (BoE) mandate. But concerns were raised about some of her comments, which AXA Investment Managers believe “failed to acknowledge the significant external developments that have driven inflation higher”.

Truss appeared to soften her stance on the eve of her premiership, in comments that some perceived as an olive branch to BoE governor Andrew Bailey, but concerns remain.
“Like many other central banks, the Bank of England has been guilty of being too late to respond to the inflation threat”, adds David Riley of Bluebay. “But anything that smacks of reducing the independence of the Old Lady of Threadneedle Street would worry international investors that are funding the UK’s big twin budget and trade deficits at time when inflation is the highest amongst the G7 economies.”

A research note published by Deutsche Bank also highlighted that the “risk of a UK balance of payments crisis is rising” under a Truss government. "A large, unfunded and untargeted fiscal expansion, accompanied by potential changes to the BoE's mandate, could lead to an even bigger rise in inflation expectations.”

Brexit – what next?

Despite campaigning for ‘Remain’ during the Brexit referendum, Truss has since become hawkish over the UK’s relationship with the EU and has long maintained that she would trigger Article 16 of the Brexit Agreement over Northern Ireland to force a deal. A senior Truss ally has insisted that such a move would be a “stopgap” until legislation is passed.

“We continue to expect that there will be a negotiated agreement,” observed AXA Investment Managers. “The prospect of a trade war between the UK and the EU – the country’s closest trading partner – would be a costly endeavour. Imposing additional costs on UK trade would add to inflationary pressure at a time when consumers already face price growth at 40-year highs. However, we consider such an outcome as more likely under a Truss, rather than Sunak, government.”

Saunders of Ninety One agrees that triggering Article 16 would be a mistake. “Doing so would arguably squander an opportunity to reset relations with Europe and potentially lead to a further phase of turmoil and uncertainty, negatively impacting the UK’s growth prospects for political purposes.”

Glimmers of hope

Richard Colwell of Columbia Threadneedle acknowledges that many UK families face the prospect of real hardship, but maintains that, under the bonnet of UK plc, the data looks pretty robust. “UK consumers are much less indebted than at the start of COVID-19, with higher aggregate savings, while wage growth remains strong and housing wealth is at an all-time high.
“Non-financial corporations have enough excess cash that they could comfortably withstand a 2008-09-style cash burn, while banks’ capital ratios at the start of 2022 were nearly four times higher than pre-global financial crisis.

“The UK remains an excellent hunting ground for patient, long-term investors, with private equity and overseas investors snapping up undervalued, world-leading UK businesses.”
Nick Purves of Redwheel points out the UK is the one of the cheapest developed markets, and suggests that there could be upside to any outcome that is not as cataclysmic as the one being priced in. “The fact that the government now seems likely to cap energy bills should take some of the pressure off the beleaguered consumer, and tax cuts and deregulation could also prove stimulative for the economy in the medium to long term.

“Finally, the reduction in the value of the pound has historically had a stimulative effect and at the very least has a positive translational impact on the profits of some of the largest companies in the FTSE100 which earn a sizeable portion of their profits in dollars.”

“Hard choices rather than wishful thinking are required to boost the long-term growth potential of the British economy and maintain confidence in the monetary and fiscal policy framework”, summarises Bluebay’s Riley. “The credibility of the new prime minister’s economic policy programme will be judged in the bond and foreign exchange markets.”

The opinions expressed by the quoted fund managers are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or St. James's Place.