LONDON (Reuters) – Investors on Monday welcomed Rishi Sunak as Britain’s new prime minister, but they are likely to give him little leeway to back away from spending restraint and tax hikes after his predecessor shaken their confidence in the Conservative Party’s leadership of the economy.
Sunak will become Britain’s next leader – and third in two months – after beating ex-Prime Minister Boris Johnson and senior lawmaker Penny Mordaunt in a race to lead the ruling Conservative Party.
Government bond markets seemed to welcome Sunak’s rise to the top, with the benchmark 10-year gilt yield falling 30 basis points to 3.75% on Monday. Yields fall when prices rise.
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A month and a half in power of outgoing Prime Minister Liz Truss wreaked havoc on UK financial markets. Her Finance Minister Kwasi Kwarteng’s plans for huge unfunded tax cuts caused gilt yields to surge, rocking the country’s pension system and forcing the Bank of England to intervene.
Paul Donovan, chief economist at UBS Wealth Management, said the fall in gilt yields in recent days has shown that markets are no longer charging such a “credibility risk premium” to the UK.
However, Donovan said last month’s chaos means Sunak will have almost no room to make bold decisions lest he risk the wrath of the market.
“The credibility risk is not zero,” he said. “Much of what could be described as economic soft power has just been destroyed in the events of the last two weeks.
“There can be times when it’s good to have a bit of flexibility in terms of market reaction. And I don’t think the new prime minister has that.”
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The pound has rallied strongly after hitting a record low of $1.0327 on Kwarteng’s mini-budget. It last traded around $1.1283. It has lost 17% against the dollar and 4% against the euro this year.
Analysts said the UK government still has work to do before investors are confident of returning to the UK.
“You can’t go straight back to where you were a few months ago,” said Michael Michaelides, fixed income analyst at Paris-based wealth manager Carmignac.
“When you introduce unpredictability, you have to spend more time examining it because you have to understand the risks better, and that requires a premium.”
A combination of tax hikes and politically realistic spending restraint is needed to regain market credibility, Michaelides said. If the government intends to keep helping consumers on gas prices or offer tax cuts, “these must be rolled back in full, with a plan to pay for them in a quick timeframe,” he added.
It will not be easy. High inflation means government budgets from healthcare to defense are being squeezed, the Bank of England expects a recession by the end of the year, and Sunak now leads a party bent on getting rid of its leaders.
GLOBAL MARKET PRESSURE
One relief for international investors is that by staying away from the UK, they may have less to worry about UK politics than they were in the days just after Kwarteng’s mini-budget.
“The UK government craves influence on the world stage – well we finally did it, we pushed global markets around, for a while the chaos in the gilt market pushed up government bond and bund yields,” said Paul Jackson, global head of asset allocation research at Invesco.
“The calming of the situation in the UK means that what’s happening in politics is now more of a idiosyncratic thing that only affects UK markets, and also in the UK what the global markets are doing is becoming increasingly important.”
However, Sunak will take little comfort from this notion.
Central banks are intentionally raising interest rates, adding pressure to overstated housing markets. The Fed’s rate hikes are particularly hurting, sending the dollar higher and weighing on currencies like the pound.
The bigger picture is that Sunak is taking charge of a country mired in an energy crisis, likely headed for recession, and inflation stuck in double digits. It’s an unenviable legacy, even without the specter of the markets hanging over us.
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Reporting by Alun John and Harry Robertson; Editing by Mike Harrison
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