Key challenges facing the UK’s new prime minister

The UK’s new prime minister Liz Truss faces an in-tray of burning issues that need urgent attention. These include a cost-of-living crisis sparked by inflation at a 40-year high, rocketing energy prices, a raft of strikes and the unresolved difficulties of the UK’s decision to leave the European Union.

The cost-of-living crisis

UK households face an income squeeze on multiple fronts in coming months. Double-digit inflation is expected by the end of 2022, alongside double-digit falls in discretionary spending, as the near doubling of wholesale gas prices since May 2022 feeds through into the retail energy prices paid by UK households. The median UK household income (after tax) is £31,400 (US$36,375): a £1,500 (US$1,740) rise in energy bills for the typical household amounts to around 5% of annual income. The rise in mortgage costs looks likely to be of a similar magnitude.

So far in 2022, household disposable income has grown due to a buoyant labour market and the drawing down of savings built up during Covid lockdowns. The income tracker from grocery chain ASDA (which started in 2011) shows a year-on-year decline for July 2022 of 16.5% in UK household income (excluding bonuses) after tax and spending on essential items. This is equivalent to a loss of £40 (US$46) per week. This is likely to fall much further.

The savings built during the pandemic – estimated at £190 billion (US$220 billion) – are not equally spread amongst households. Lower-income households typically have limited or no savings, and the poorest households will feel the squeeze more acutely than middle- or higher-income households. Almost a quarter of all households have no savings and a further 9% have savings of £250 (US$290) or less. With inflation likely to exceed the 13% peak forecast by the Bank of England (BoE), workers will be no better off by mid-2023 than they were 20 years earlier (according to research by the Resolution Foundation).

Policy changes: but what about businesses?

Liz Truss has called for more than £30 billion (US$35 billion) of tax cuts in a bid to stimulate the economy and ward off a possible recession. Further political support could come through reversing the rise in National Insurance contributions brought in by the current administration to boost funding for adult social care.

A further £30 billion (US$35 billion) could be delivered through Universal Credit (social security payments), raising the income tax personal allowance thresholds (the level for when people start paying tax) or through reductions in the level of VAT (value-added tax).

Strike action set to continue

UK workers are experiencing the biggest falls in real pay (wages adjusted for inflation) since 1977. With inflation set to remain high throughout 2023, industrial action is set to increase. In 2022 we have seen strikes by transport workers, postal workers and barristers, and this unrest is set to expand to other industries. However, it is also possible that strike action turns out to be less severe than currently feared and discussed in the media. This could be due to the low level of reserves in trade union funds, which combined with the cost-of-living crisis might constrain industrial action.

The private sector is at full employment and employees are set to demand higher nominal wages to cover rising living costs.

The public sector, where wage deals have lagged those in the private sector, is most at risk of further industrial action as we move into the winter and 2023. A wage price spiral, where higher wages cause prices to rise, which in turn causes wages to further increase, is becoming a key risk for the UK economy and the level of the pound sterling against other currencies.

Recession ahead: how will companies fare as costs rise and spending falls?

The BoE is now predicting that the UK will experience a recession (defined as two consecutive quarters of economic decline) lasting 15 months due to the impact of higher interest rates and soaring energy costs. UK consumer confidence has fallen to 50-year lows.

A study by the BoE indicates that UK companies are confident that they can pass on rapid cost increases to consumers to protect margins. Although this offers some comfort to investors, it will be worrying for policymakers and the central bank as it indicates that higher inflation could become embedded.

Larger companies will have been in the position to hedge some of their energy costs, so they will not be so exposed to energy price rises in the short term. However, many small- and medium-sized businesses will feel an acute squeeze on costs. The consumer discretionary sector will be most at risk from higher energy costs as consumers rein in spending on big ticket items, such as cars and household goods, as well as clothing and footwear.

Another big question that the new prime minister will need to address is what, if any, measures can be provided to help support businesses. Their price increases have reflected the rises in the wholesale cost of gas immediately, without the benefit of a lag through a price cap, as is the case with domestic consumers. Small businesses have experienced a four-fold increase in energy costs over the past 18 months.

Energy companies will continue to benefit from higher gas and oil prices, as evidenced by the soaring profits announced by some of the major energy firms. A number of industries should also offer safe havens for investors. These include banking (with banks benefiting from higher interest rates), pharmaceuticals and aerospace.

Throughout 2022, stock markets have begun to price in this bad news. Falls in share prices have led to a contraction in valuations, most particularly for the domestic and cyclically exposed areas. Typically markets reach a bottom in advance of the worst point of recessions. As investors we are looking through today’s gloom to identify the best opportunities for the future.