Andrew Sheets: The U.K.’s Struggle to Bring Down Inflation

The U.K.’s economy continues to face a host of challenges, including high inflation and a weak currency, and while these problems are not insurmountable, they may weigh significantly on the economic outlook.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, October 21st at 2 p.m. in London.

The eyes of the financial world remain on the United Kingdom, the world's 6th largest economy that is facing a complicated, interwoven set of challenges. We talked about the U.K. several weeks ago on this program, but I wanted to revisit it. It's a fascinating cross-asset story.

First, among these challenges is inflation. High U.K. Inflation is partly due to global factors like commodity prices, but even excluding food and energy core inflation is about 6.5%. And since the U.K. runs a large current account deficit, importing much more than it exports, a weak currency is driving even higher costs through all those imported items. Meanwhile, Brexit continues to reduce the supply of labor and increase the costs of trade, further boosting inflation and reducing the benefit that a weaker currency would otherwise bring.

The circularity here is unmissable; high inflation is driving currency weakness and vice versa. High inflation has depressed U.K. real interest rates, making the currency less attractive to hold. And high inflation relative to other countries undermines valuations. On an inflation adjusted basis, also known as purchasing power parity, the British pound hasn't fallen that much more than, say, the Swiss franc over the last year.

If inflation is high, why doesn't the Bank of England simply raise rates to slow its pace? The bank is moving, but the Bank of England has raised rates by less than the market expected in 6 of the last 8 meetings. The Bank of England's hesitation is understandable, most UK mortgage debt is only fixed for 2 to 5 years, which means that roughly $100,000 loans are resetting every month. The impact is that higher rates can flow through into the economy unusually fast, much faster than, say, in the United States.

Another way to slow inflation will be through tighter fiscal policy. But here we've seen some rather volatile recent political headlines. The U.K. government initially proposed a plan to loosen fiscal policy, but following a volatile market reaction has now changed course and reversed a number of those proposals. It still remains to be seen exactly what policy the U.K. government will settle on and what response the markets will have.

The UK's problems are not insurmountable, but for now they remain significant. Our U.K. interest rate strategists think that expectations for 5 year inflation can move higher, along with yields. While our foreign exchange strategists are forecasting a lower British pound against the dollar.

The one bright spot for the U.K. might be its credit market. Yielding over 7%, U.K. investment grade credit actually represents issuers from all over the world, including the United States. While less liquid than some other markets, we think it looks increasingly attractive as a combination of stability and yield amidst an uncertain environment.

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