Rishi Sunak will be the new UK prime minister. Markets have responded favourably to this prospect, with the UK 30y bond yield reversing most of its mini-budget surge and realigning with other countries’ bonds (Chart 1). But the good news may end there.
For one, we are likely at peak optimism for the UK. Everyone, including investors, can project their most positive outcomes onto the new UK administration. But reality will hit soon. The government will have to make cuts to public spending, including on defence, which could fracture party unity. This could raise the prospect of the spending bills not passing parliament and consequently the prospect of new elections.
Second, while the Liz Truss administration mismanaged their fiscal plans, both Rishi Sunak as chancellor and the Bank of England laid the foundation for surging inflation today. Sunak engaged in large fiscal stimulus programmes while the Bank of England offset the supply of bonds by printing money (quantitative easing) through the COVID lockdowns. This injected too much demand into the economy when (economic) supply was falling. The Russia-Ukraine war only compounded this, and that is still with us whoever becomes UK prime minister.
Third, we still think the mini-budget that led to the surge in UK bond yields was not just about UK fiscal policy but also the weak state of UK pensions. Their poorly managed derivative positions saw a dash for cash, and pension funds having to sell their bond holdings. The Bank of England provided a lifeline for them by buying bonds (now at an end) and through the expanded repo facility (ending in November). As this support disappears, and pension funds re-assess their other investments, we may yet still see another UK pension crisis.
Therefore, we turn more cautious on the UK. The risk of asset weakness is likely higher than most think, and we would stay away from UK risk assets until we get more clarity on the political risks.