Fundamental Analysis of the BRITISH POUND STERLING

GBP Outlook Clouded by Political and Economic Uncertainties

Thursday, 25 May 2024, Week 21: This report provides a fundamental analysis of the British pound (GBP), examining the currency's five-week outlook based on available economic data, fiscal policy developments, and prevailing geopolitical risks. The analysis draws upon official government documents, including the Office for National Statistics (ONS) publications on GDP, inflation, and labour market data, as well as the Bank of England's (BoE) Monetary Policy Summary and minutes of the Monetary Policy Committee meeting. The report is structured to provide a comprehensive overview of the factors influencing the GBP, with a focus on their potential impact on Forex traders.

Geopolitics and Risk Tolerance in U.K. Markets

Geopolitical events are contributing to a climate of uncertainty in UK markets, impacting risk tolerance and potentially influencing the GBP. The surprise announcement of a UK snap election on July 4th has injected a dose of political risk into the markets. While the Labour Party is currently projected to win, the possibility of a closer-than-expected result or a hung parliament could lead to GBP volatility. The election outcome will also have implications for Brexit negotiations and the UK's future economic policies.

The ongoing Russia-Ukraine war continues to weigh on global sentiment, with Russia's renewed offensive in Ukraine raising concerns about further escalation. The potential for further Russian territorial gains and the threat to Kharkiv, a major economic and population center, could further destabilize the region and weigh on the GBP as investors seek safe-haven assets.

The potential for US-Mexico border tensions also poses a risk to the UK, albeit indirectly. The upcoming Mexican presidential election on June 2nd adds complexity to the US's plans to address the border crisis. Any executive actions by President Biden before the election could be perceived as interference and trigger pushback from Mexican candidates. The lack of cooperation from Mexico, crucial for any effective border strategy, could exacerbate the situation and lead to trade disruptions, potentially impacting the UK economy and the GBP.

U.K. Fiscal Policy

The UK's fiscal policy has undergone significant shifts in recent months, moving from an initial stance of consolidation to one of stimulus. The Autumn Statement, delivered in November 2023, introduced tax increases and spending cuts aimed at stabilising public finances. This was followed by the Spring Budget in March 2024, which surprised markets with a frontloaded package of net tax cuts, estimated to increase borrowing by an average of £8.0 billion a year.

This shift towards fiscal stimulus has raised concerns about the long-term sustainability of the UK's public finances, particularly given the already high level of public sector net debt. The latest data shows UK public sector net debt to GDP reached 97.60% in 2023, slightly exceeding the OBR's November forecast. The OBR projects debt to GDP to peak at 93.2% in 2027-28 before slightly falling to 92.9% in 2028-29. However, achieving this projection is subject to significant risks, including the potential for higher inflation, weaker productivity growth, and changes to government policy.

The upcoming general election adds further uncertainty to the fiscal outlook. The outcome of the election could significantly impact the UK's fiscal policy trajectory, with implications for government spending, taxation, and the overall level of public debt.

U.K. Economy

The UK economy is recovering from the technical recession experienced in late 2023, but the recovery remains fragile and uneven. The ONS reported that UK GDP increased by 0.6% in the first quarter of 2024, exceeding market expectations. This positive growth follows two consecutive quarters of contraction, marking the end of the technical recession. The services sector was the primary driver of growth, expanding by 0.7% in Q1 2024. However, the construction sector continued to contract, falling by 0.9% in Q1 2024.

The labour market presents a mixed picture. The ONS reported that the UK unemployment rate rose to 4.3% in the three months to March 2024, up from 4.2% in the previous quarter. This is the highest unemployment rate since May to July 2023. However, employment increased by 17,000 to 33.0 million, primarily due to a rise in full-time employees. Wage growth remains robust, with average regular pay, excluding bonuses, increasing by 6.0% year-on-year in the three months to March 2024.

Inflationary pressures are easing but remain elevated. The ONS reported that the UK's annual inflation rate eased to 2.3% in April 2024, the lowest since July 2021, down from 3.2% in March. The decline in inflation was largely driven by falling energy costs, but food prices also slowed significantly. However, rising motor fuel costs highlight the potential for persistent inflationary pressures in certain sectors.

The UK's trade deficit narrowed to £1.098 billion in March 2024, the smallest in three months, from a revised £1.478 billion in February. The narrowing trade deficit is a positive development for the UK economy, but the continued decline in both imports and exports suggests weakening demand both domestically and internationally.

Monetary Policy

The Bank of England's Monetary Policy Committee (MPC) voted 7-2 to maintain the Bank Rate at 5.25% in its May meeting, following a unanimous decision to increase the rate by 0.25 percentage points in the April meeting. This decision marked the 12th consecutive rate hike since December 2021, highlighting the MPC's commitment to curbing inflationary pressures. However, the emergence of a dissenting minority advocating for a rate cut signals a potential shift in the MPC's stance as inflationary pressures show signs of easing.

The minutes from the latest MPC meeting reveal a growing divergence of views among committee members regarding the future path of monetary policy. While the majority voted to maintain the Bank Rate at 5.25%, two members preferred a 0.25 percentage point reduction, citing the need for a "smooth and gradual transition in the policy stance" as inflation shows signs of returning to the 2% target.

The minutes also highlight the MPC's assessment of the current economic landscape and its potential implications for monetary policy. The committee acknowledged the recent easing of inflationary pressures but remains cautious about persistent inflationary pressures, particularly in the services sector. The minutes state that "Monetary policy will need to remain restrictive for sufficiently long to return inflation to the 2% target sustainably in the medium term," indicating that the MPC is not yet ready to declare victory in its fight against inflation.

Conclusion

The GBP outlook for the next five weeks is clouded by a confluence of political and economic uncertainties. The upcoming general election, coupled with the ongoing war in Ukraine and potential trade disruptions stemming from US-Mexico border tensions, is contributing to a climate of risk aversion that could weigh on the GBP.

While the UK economy is showing signs of recovery, the recovery remains fragile and uneven. The high level of public sector net debt, persistent inflationary pressures, and the potential for further BoE rate hikes pose downside risks to the GBP.

The BoE's monetary policy stance will be a key determinant of the GBP's performance in the coming weeks. The emergence of dissenting voices within the MPC suggests that the BoE may be nearing the end of its tightening cycle. However, the MPC's commitment to returning inflation to the 2% target suggests that interest rates will likely remain at elevated levels until there is clear evidence that inflationary pressures are easing sustainably.

Overall, the GBP outlook for the next five weeks is uncertain. The currency could weaken if the economic recovery falters, if the BoE adopts a more dovish stance, or if political uncertainty intensifies in the lead-up to the general election. Conversely, the GBP could strengthen if the economic recovery proves more robust than anticipated, if the BoE maintains its hawkish stance, or if the outcome of the general election is perceived as positive for the UK economy.

Given the current environment of heightened uncertainty, Forex traders should closely monitor economic data releases, BoE communications, and political developments in the UK to assess the potential impact on the GBP.