Wednesday, September 7, 2022
The United Kingdom (UK) welcomed a new Prime Minister (PM) on Tuesday September 6, 2022, as outgoing PM Boris Johnson officially offered his resignation to Queen Elizabeth II and was replaced by Liz Truss. Truss, who was formally the UK’s foreign secretary, becomes only the third woman to lead the UK, joining Margaret Thatcher and Teresa May. Cloudy skies in the UK are far from unusual, a downpour actually delayed the new PM’s first news conference, but Truss looks to have been served up a particularly stormy economic environment: an energy crisis, rampant inflation, a creaking National Health Service and labor strikes providing immediate concerns.
“The new British Prime Minister, Liz Truss, faces a baptism of fire as she faces down an energy driven cost-of-living crisis and annual inflation running at over 10%” explained LPL Financial Portfolio Strategist George Smith. “Her plan to provide shelter to UK consumers and businesses from the energy crisis storm could come at huge financial cost, with the UK Government facing huge liabilities if the cost of natural gas escalates”
Prime Minister Truss has proposed an energy price cap that would keep natural gas prices where they are now, which is approximately 4 times higher than the recent past. 87% of UK homes rely on natural gas for heat so sharp rises in the cost of this commodity are felt keenly by many, especially as the weather cools. According to UK government sources, the price cap plan could cost $228 billion (8% of the UK’s Gross Domestic Product) over the next 18 months. Rising energy costs have contributed to a steep increase in UK inflation. As shown in the LPL Chart of the Day, the latest inflation numbers reported by the UK Government show that in July inflation rose to an annual rate of 10.1%, the highest in 40 years.
The energy price cap may mean that UK inflation has now peaked and give the Bank of England cover to slow the speed and reduce the magnitude of the rate hikes they have been implementing. While the cap will likely help to control inflation, and hence reduce some of the UK government’s index-linked liabilities, overall it will not be good for the UK’s finances, which had already been battered by pandemic related stimulus. The UK debt-to-GDP ratio is now predicted to remain firmly above 100%, up from around 83% pre-pandemic, joining European countries such as Greece, Italy, Portugal, and Spain among others with debts greater than their annual GDP.
A debt-to-GDP ratio above 100% does not necessarily spell immediate financial difficulties, in fact the Group of 7 (G7) major economies, including the US and Japan, runs at an average of 137%. International debt markets want to have confidence in the government’s plan to control budget deficits and if credibility is lacking in those plans it can cause escalating costs to service debts and declines in the value of local currencies. So far the markets don’t appear to be convinced by Liz Truss’ plans to increase spending at the same time that she plans to cut income and corporate taxes. The yield on UK 10-Year government bonds (gilts) is up 120 b.p. since the start of August to over 3%, the first time 10-year gilts have had a three handle in 11 years. Pound sterling also appears to be acting as a secondary escape valve with the US dollar-British Pound currency pair trading at around 1.15 Dollars per Pound, its lowest level since 1985, and down 7 cents in the past few weeks alone.
Across Europe, a similar story of escalating energy prices, caused by fallout from Russia’s invasion of Ukraine, and devaluing currency is playing out. Gazprom formally shut off the natural gas supply through the Nord Stream 1 pipeline to Germany on Friday, with the Russian government now stating that flows would not resume until the West lifts sanctions against Moscow. Flows of natural gas have been slowing for months but this full stoppage of Russian gas that once made-up 40% of Europe’s supply is an extremely bearish development for European markets and economies. This week the Euro also hit a 20-year low versus the US Dollar, dropping below parity for the first time since 2002, with the potential to sink further. As a result, we maintain our negative view on developed international markets (of which Europe makes up almost half of the MSCI EAFE index) and recommend an overweight to domestic U.S stock markets. A synchronized global expansion could be supportive for developed international markets but this has been delayed, especially in Europe, by the energy crisis. Risks to our view are a faster and/or smoother than expected resolution to the Russia-Ukraine war leading to a corresponding return to normalcy in energy markets, and/or an overly aggressive US Federal Reserve potentially plunging the US into a worse recession than Europe appears headed for. This however is not our base case.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
All index and market data from FactSet and MarketWatch.
This Research material was prepared by LPL Financial, LLC.
Securities and advisory services offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC).
Insurance products are offered through LPL or its licensed affiliates. To the extent you are receiving investment advice from a separately registered independent investment advisor that is not an LPL affiliate, please note LPL makes no representation with respect to such entity.
- Not Insured by FDIC/NCUA or Any Other Government Agency
- Not Bank/Credit Union Guaranteed
- Not Bank/Credit Union Deposits or Obligations
- May Lose Value
For Public Use – Tracking # 1-05322834