FX
Sterling becomes “release valve” for UK’s ambitious and un-costed fiscal strategy
Posted on- GBP: Among others and in addition to a flurry of supply-side reforms outlined on Friday, UK unveils a new fiscal plan that contains provisions for – (1) creation of new investment zones; (2) surprise income tax cuts of 1p in the basic rate to 19% in April 2023 and the abolition of the additional income tax rate of 45%; (3) cutting stamp duty on home purchases; (4) accelerated tax relief schedules for business; (5) no employer national insurance contributions on the first £50k in pay; (6) cancelling the planned increase in the corporation tax from 19 % to 25% and (7) the freeze in energy bills for households and businesses. UK chancellor Kwarteng hopes that the ‘Growth Plan’ (set to cost the UK Treasury £60bn over 6 months that could be running for much longer) will be instrumental in boosting UK’s trend growth rate of 2.5%. This would be the main source of much higher tax revenues that the UK Treasury will need to repay the large amount of net debt issuance required to finance these measures. The Institute for Fiscal Studies indicates that one must go back to 1972 to find UK tax cuts of a similar magnitude to those just announced. Chancellor Kwarteng also makes two important comments in his statement – (1) notes the importance of expanding the supply side of the economy, and (2) re-affirms his previous commitment to reduce UK’s debt to GDP ratio over the medium term.
- GBP: Markets on the other hand, see Friday’s fiscal announcement as a huge and un-funded gamble for the UK economy. Citi analysts estimate that as a result from this new fiscal strategy, underlying UK debt to GDP will be locked on an upward trajectory over the coming years, increasing to around 110% GDP by 2026 while effectively tying the medium term prospects for the UK to developments in wholesale gas markets - if gas prices remain high, this plan will likely defer and compound considerable economic pain into the years post 2024 but with the UK also seeing a higher risk of entering the mid-2020s with still very large fiscal and current account deficits, and funding costs well above nominal GDP growth. If on the other hand, gas prices come down however, the plan may well leave the UK better positioned to subsequently accelerate out.
- GBP: Chancellor Kwarteng also re-affirms UK government’s commitment to the operational independence of the Bank of England ie. no potential mandate review. Citi analysts therefore expect the BoE MPC to now likely having to go further and sooner in order to offset the demand effects of this new fiscal spending strategy - alongside 75bps in November, the team now expects similar moves in December, with terminal rate of 4.25%. This is well below market pricing of a 5.5 – 5.75% terminal rate by Q3’2023. Regardless, monetary policy is now likely to be aggressive for 2 main reasons - (1) the longer outside lag on monetary policy means the response also has to be relatively forceful when acting against fiscal policy; and (2) upside risks to long-term inflation expectations may become a function of institutional credibility, rather than just spot inflation.
No respite for EUR as euro area data signals deepening recession risks
- EUR: European Commission’s flash estimate of consumer confidence drops to an all-time low of -28.8 in September, some 3.6 standard deviations below its historical average. Despite significant government measures taken to protect households from the high cost of energy, tightening labor markets and rising wage growth, it seems that recession fears, coupled with the possibility of energy restrictions, ECB rate hikes and intensification of the cost of living crisis are impacting household confidence going into autumn that is ultimately also likely to feed into sharply declining business confidence.
- EUR: Euro area September PMIs: Recession in Germany, stagnation overall – the eurozone composite PMI falls by 0.7 point to a 20-month low of 48.2 in September according to data compiled by Markit, matching consensus forecasts. Both the manufacturing and services PMIs fall in September, by 1.1 point and 0.9 point to a 27-month low of 48.5 and a 19-month low of 48.9 respectively, slightly undershooting expectations. The flash composite measure of PMI rises in France by 0.8 points to a two-month high of 51.2 in September but falls in Germany by one point to a 28-month low of 45.9, indicating that private sector activity in the euro area’s largest economy has contracted meaningfully in the final month of Q3.
US economic outperformance vs rest of the world continues to drive flows into USD
- USD: In data released Friday, the US S&P Manufacturing PMI is little changed for September, rising modestly to 51.8 compared to 51.5 the prior month. Output remains slightly in contractionary territory at 49.5 but new orders jump to 50.9, indicating expansion. The employment index also bumps up to 53.4 from 51.1 and the supplier delivery times index improves to 41.7 from 38.9 the prior month, but still indicating slowing delivery times. The input prices index drops to 64.1 but the output price index rises a touch to 63.5. Meanwhile, the Services PMI index jumps to 49.3 from 44.6 the prior month – while still in contractionary territory, new business activity moves back into expansion at 51.3 but the employment index falls slightly to 52.2 though still in expansionary territory. The backlog of works index, which has been below 50 for the last three months, also rises to 50.7 this month (from 45.6 the prior month). Both input and output prices however decline modestly while still well above 50.
- USD: The rebound in the Services PMI index helps close the gap with the ISM Services index, which remains at much higher levels. The divergence between the two data sets over the last few months is perplexing as hard activity data has not been consistent with substantially softening demand for services. Meanwhile, manufacturing remains relatively strong but still with some lingering supply issues. Price indices continues to decline but remain well above 50 while the increase in the supplier delivery times index suggests some easing in supply issues.
Week Ahead
- USD: A lot of Fed speak this week starting with Boston Fed President Susan Collins to be followed by Atlanta Fed President Bostic, Dallas Fed President Logan, Cleveland Fed President Mester, Chicago Fed President Evans, St. Luis Fed President Bullard, Fed President Daly, Chair Powell, Governor Bowman, Governor Brainard, Fed President Williams and fed President Barkin (who will speak about inflation).
- USD: US August Personal Income – Citi: 0.4%, median: 0.3%, prior: 0.2%; Personal Spending – Citi: 0.6%, median: 0.2%, prior: 0.1%; Core PCE MoM – Citi: 0.5%, median: 0.5%, prior: 0.1%; Core PCE YoY – Citi: 4.7%, median: 4.8%, prior: 4.6% - Citi analysts expect a 0.4%MoM increase in personal income in August, with strength in incomes still led by aggregate labor incomes. That should remain a near-term support for spending. As such, the team expects a 0.6% increase in August personal spending, with strength led by services and a modest increase in goods spending following soft retail control group sales. Based on elements of a strong 0.6% increase in core CPI and PPI data in August, Citi analysts expect a solid 0.47%MoM increase in core PCE inflation in August. The Y/Y reading is likely to rise to 4.7%, with further increases likely over the next three months as base effects are likely to push Y/Y core PCE higher through November.
- EUR: Italian parliamentary election – the right bloc is set for a sweeping victory in Sunday’s snap election but this seems largely priced in by markets. A 2/3 majority for the right would be a negative surprise, an inconclusive outcome probably a positive. Risks of a clash with the EU are limited in the near term but rising over the medium (i.e. 2023) term.
- EUR: Eurozone September inflation – sizable jump in core inflation is seen to 4.9% YY, from 4.3% in August, with a whopping 0.8% MM gain in SA terms. Both energy and food should still print up, despite falling Brent and TTF. ECB President Lagarde also testifies in the European Parliament. Euro Area: HICP Inflation, September – Citi Forecast 9.8%, Consensus 9.7%, Prior 9.1% YY; Euro area core inflation: Citi Forecast 4.9%, Consensus 4.8%, Prior 4.3% YY (0.8% MM in SA terms).
- EUR: Euro Area Recession Watch – last week saw the euro area PMIs slide further towards recession territory, but overall business confidence remains far more resilient than consumer confidence, which has plunged to new all-time lows. This week, the Ifo index will provide more forward-looking recession indicators, while EU Commission’s economic sentiment survey could help localize the thrust of the recession (probably in Germany). German IFO Business Climate, September - Citi Forecast 86.5, Consensus 87.1, Prior 88.5; German IFO Expectations, September – Citi Forecast 78.5, Consensus 78.7, Prior 80.3 (90 = recession territory); German IFO Current Assessment, September – Citi Forecast 94.5, Consensus 96.0, Prior 97.5; Euro Area: Economic Sentiment Indicator, September – Citi Forecast 94.5, Consensus 96.0, Prior 97.6 (95 = recession territory).
- AUD: Australian August Retail Trade: Citi forecast MoM; 0.3%, Previous; 1.3% - when compared to the drivers of the upwardly strong and surprising 1.3% July retail trade result, Citi analysts expect fewer tail winds in August. The risk though to the forecast is possibly to the upside.
- CNY: China Manufacturing PMI September: Citi Forecast 49.9, Consensus 49.2, Prior 49.4 – Citi analysts expect manufacturing PMI to inch up further to 49.9 in September from 49.4 in August. The team’s high-frequency trackers are showing continuous improvement in operating rates of industrial activities in September and the impact from the Covid-19 outbreaks and lockdowns on manufacturing could be smaller this time. Meanwhile, the infrastructure push from the government could continue to come through, supporting the expansion of demand and industrial production.
