UK can't shake pound negativity after weeks of political chaos

• Soaring inflation, weakening economy all weighing on outlook
• Mordaunt, Johnson are risk-off, cable-off candidates: BMO

Prime Minister Liz Truss is on her way out, just as markets wanted. But the huge economic and fiscal headwinds ahead spell further pain for the pound regardless of who wins the contest to become the UK's next leader.

Investors distracted by the political circus engulfing the nation may start turning back to the economy's woeful outlook: inflation at a 40-year high, soaring interest rates, depressed consumer sentiment and a potential return to austerity.

Throw this week's premiership race and dollar's strength into the mix too, and that implies that sterling's bounce from an all-time low last month is on borrowed time. And while the bond market meltdown has also subsided, there are plenty of challenges there too. Even with Truss' sweeping unfunded tax cuts now scrapped, net issuance of gilts for the next fiscal year remains vast and borrowing costs are sky high. 

Whoever prevails in this week's Conservative Party leadership contest will need to focus on damage control rather than chasing meaningful economic growth.  

"There would need to be a significant change in how international investors view the UK's prospects to see a sustained change in direction," said Hugh Gimber, global market strategist at JPMorgan Asset Management.

Strategists at ING Bank NV see the pound slipping back to $1.05 by year-end, from around $1.13 on Friday, and Bank of America Corp. is sticking with its call of parity. The pound rose 0.6% on Friday, leaving it down about 16.5% against the greenback this year. 

After Truss' disastrous tenure and the UK's perceived loss of fiscal credibility, it's likely that politicians will react with a tilt toward austerity, according to TS Lombard's Freya Beamish and Christopher Granville. That would heap further pressure on an economy that's tipping toward recession.

The leadership contest is coalescing around three names: Former Chancellor Rishi Sunak, Cabinet minister Penny Mordaunt and ex-premier Boris Johnson. So far Sunak has the largest group of publicly-stated supporters in the Tory lawmaker ranks.

For some investors, the prospect of a contentious race raises the risk of renewed turbulence in already fragile markets. 

"Mordaunt and Johnson are the risk-off, cable-off, gilts-off candidates," said Stephen Gallo, European head of FX strategy at BMO Capital Markets, on Sunday. "Sunak is most likely the opposite."

The pound is languishing well below the peaks reached during the first leadership contest over the summer, when it traded as high as $1.23. It was around $1.15 the day that Truss was announced the winner. 

Equities are also struggling amid questions over the economy, political leadership and the UK investment case. The FTSE 250 gauge of mid-caps fell 1% Friday, wiping out the relief rally on the day Truss quit. It's down 26.7% this year.

"The main factor for the UK at the moment is we're quite short on certainty," said Baylee Wakefield, a portfolio manager at Aviva Investors. "The key question for markets is whether that normal policy making can resume."

Troubled Economy
The squeeze on the real economy is gaining pace, and a dramatic reminder of that came Friday with a big drop in retail sales. The grim backdrop will be on show again Monday, when business surveys for this month are expected to show further declines.

"It's hard to see under-owned UK equities or GBP bouncing higher when the path to a deep and protracted recession is only getting clearer by the day," Viraj Patel, senior strategist at Vanda Research, wrote in a note to clients. 

There's speculation about a delay to a much-anticipated fiscal statement and how the government plans to plug a hole in the public finances of about £25 billion pounds. That announcement, from new Chancellor of the Exchequer Jeremy Hunt, was intended to calm markets, so a postponement is far from ideal.

There are also plenty of doubts surrounding the investment case for gilts, which took a dive again on Friday. The 10-year yield closed above 4% again for the first time in a week. 

Traders have pared bets on the extent of hikes by the Bank of England since Hunt scrapped the majority of his predecessor's sweeping tax cuts. That move accelerated last week after Deputy Governor Ben Broadbent said it's not clear that UK rates need to rise as much as investors expect. 

Heading Higher
Yet the the outlook still leans toward aggressive tightening. Traders see another 3 percentage points of hikes at least, which would take the key rate to 5.25%, the highest since 2008. Hiking less would put sterling "in jeopardy again", said Axel Botte, global strategist at Ostrum Asset Management.

The central bank also seems determined to push ahead with active gilt sales, already delayed once, from Nov. 1, albeit with longer tenors excluded. That all amounts to a tough backdrop for the government to bring a deluge of bond sales in the next fiscal year. Citigroup Inc. strategists still see gilt issuance of more than £260 billion, even after the fiscal U-Turn.

It's also bad news for mortgage holders who'll be looking to refinance, particularly those already feeling the strain from soaring energy bills and food prices.

"If the government and the Bank of England can restore credibility in the market, that can bring interest rate expectations down, and the cost of this refinancing these mortgages may not be as bad as some people fear," said Matthew Holdgate, portfolio manager at Nikko Asset Management. "It's in the government's interest to continue with the steps they've taken so far in terms of calming markets."

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.