Sunak new UK prime minister: The more market-friendly outcome, but formidable challenges await

After Liz Truss' resignation as the shortest-serving UK prime minister (PM) of all time and four days of frantic campaigning, Rishi Sunak became the leader of the Conservative Party and the new PM today. This is the outcome favoured by financial markets due to Mr Sunak's stated fiscal restraint. A more severe crisis has been averted for now, but formidable challenges await him, not the least making difficult tax and spending trade-offs and keeping his party aligned.

Over the weekend, it became increasingly clear that Mr Sunak would win the race to become the UK's third PM this year. Markets reacted with a big sigh of relief after former Prime Minister Boris Johnson ruled himself out of the running on Sunday evening. The pound rose in early Asian trading in response to the news. Mr Johnson failed to gain enough backing in the Parliamentary Conservative Party. Had he managed to garner 100 supporters among Conservative Members of Parliament (MPs), he may have even gone on to get the nod from the party membership. However, this would have been deeply divisive among his MPs and would likely have resulted in a highly unstable government.

In contrast, Mr Sunak has increased his economic reputation by having forewarned of the dangers of fiscal profligacy during the summer leadership campaign won by Liz Truss. The new PM is likely to stick with Jeremy Hunt as chancellor. Mr Hunt managed to calm markets by reversing almost all of his predecessor's unfunded tax cuts and limiting the energy bill support. Make no mistake, while the fiscal reversal was unavoidable, the zig-zag course comes at a high cost. The spending cuts and tax hikes that are yet unannounced will be very painful and involve difficult trade-offs. It's hard to see anything other than sluggish economic growth for the UK for the next two years.

As I have previously argued, a sterling and UK government bond crisis can be averted if the government puts the UK back on a path of fiscal sustainability. On that score, Mr Hunt has made progress. The Bank of England also played an important role in restoring confidence with its intervention in the gilt markets. Now, the Bank needs to demonstrate its independence by doing what's necessary with interest rates, however painful that may be to mortgage borrowers. At its next meeting on 3 November, it is expected to raise the base rate by at least 75 basis points. Had it not been for the fiscal U-turn, that rate hike arguably would have been larger.

The bottom line

Today's news that Rishi Sunak will become the UK's prime minister after the shortest of campaigns within the Conservative Party reduces political uncertainty. It has been welcomed by financial markets. In our view, it lessens the downside risk to sterling substantially. It doesn't mean the pound will go up in a straight line from here, but the cheap valuation of sterling1 should act as a support. After some earlier policy errors, the room for the new government to manoeuvre is extremely limited. Calls for an early election will grow louder as Mr Sunak will have to keep his party united to avoid a similar fate as his two predecessors.

1 The purchasing power parity exchange rate for GBP/USD is around 1.43. Source: Organisation for Economic Cooperation and Development.