Receding risks of summer political turmoil could partially restore the supremacy of economic fundaments as the main driver of the market outlook. But markets should be cautious – and prepare for turbulence ahead. The medium-term outlook (the next year or two) remains challenged for the UK, economically and politically. The way in which any future leader responds to the cost-of-living crisis remains uncertain. Uniting the Tory party around any one leader could prove difficult.
All of this has important implications for the direction of UK policy, the outlook for the economy, and markets – here’s our quick take.
Early elections are now more likely
We believe an early election – perhaps autumn, or even the spring of 2023 – is likelier than not, and that would be negative for the pound. Not just because it raises the risk of a less market-friendly contender to gain traction; it also puts political risk back in the driving seat, where issues like another Scottish Independence referendum or a change in tac on Brexit come into play.
Raising the risk of more government spending
Early elections also raise the risk of higher (politically influenced) public spending in the near term to tackle the cost-of-living crisis and “level up” the economy. But this in turn could mean that inflation pressures shift even higher, alongside higher government borrowing to finance additional expenditure.
This could mean higher interest rates sooner than expected
If inflation does accelerate, we could see the Bank of England (BoE) spring into action sooner than expected. Our most recent forecast called for one 25 basis point (bp) interest rate hike in August this year, and two 25bp hikes in February and May next year. But we now think there’s more pressure to bring some of next year’s hikes forward, with one 25bp in August 2022, another in November 2022, and another in February 2023. At the same time, additional public spending raises the risk that the BoE delays or downsizes its quantitative tightening programme.
What does that mean for markets and businesses?
Higher interest rates sooner than later may translate into higher borrowing costs for capital markets issuers. But fixed income markets are pricing in larger interest rate hikes sooner than we expect (and in our view, at odds with BoE, which sees a soft economy ahead). A softer economy coupled with fewer interest rate hikes than the market expects could work to contain bond yields.
The pound is sensitive to anything that affects the growth outlook, so the prospect of more accommodative fiscal policy could help support the currency near term. So too is the prospect of tighter monetary policy sooner. But a drawn-out leadership contest means that strength could fade into higher volatility. An early general election would also increase the risk of another Scottish Independence referendum, which would likely add to FX market jitters.
Get in touch
Login to Agile Markets to get deeper analysis on this. Don’t have access? Get in touch with your NatWest representative or contact us here.
