"We think a bullish scenario for the UK (and its currency) could come as a surprise to many in 2023" - Morgan Stanley.
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The British Pound could be one of 2023's top-performing financial assets according to analysis from investment bank Morgan Stanley that seeks to uncover the "Top 10 Surprises for 2023".
The Pound is one of 2022's laggards and is still expected to remain so again in 2023 by the U.S.-based investment bank, however financial markets have a knack for up-ending expectations.
"A year without surprises would be a surprise itself. Given every year comes with some, we discuss 10 that would make investors think differently and move global macro markets," says Mathew Hornback, Strategist at Morgan Stanley.
The Pound is one of 2022's G10 laggards as it has lost ground to the Dollar and Euro, as well as the commodity dollars and the Swiss franc.
But, "surprise #7" on Morgan Stanley's list is "the bull case for GBP".
Heading into the new year sees Morgan Stanley's economists aligned with consensus in expecting the UK economy to suffer a torrid 2023, indeed they expect UK growth to be the worst among the G10 and even amongst Emerging Markets.
The bar is therefore set incredibly low for an upside growth surprise that would challenge consensus and offer Sterling a supportive domestic narrative.
"A bearish outlook for the UK has pretty much been a consensus view for the past few months, and remains so even as GBP staged an impressive rally against the USD in recent weeks," says Wanting Low, G10 FX, Strategist at Morgan Stanley.
But Morgan Stanley's strategy team thinks this rally was driven by a combination of positioning adjustment and a broad weakening of the Dollar, rather than a change in the fundamental view.
Driving expectations for UK economic underperformance are expectations for an ongoing energy crisis to crimp growth and ensure inflation remains elevated.
But, "a material fall in energy prices would be a key positive driver, especially as elevated UK inflation is largely an energy story," says Low.
As we move into the final two weeks of December there is some good news on the energy front: UK gas prices are trading at multi-month lows.
A look at month-ahead UK gas prices (January delivery) shows the contract is now at its lowest since the middle of June.
It was in June that European and UK gas prices surged at an extraordinary pace.
In fact, a look at the chart below shows gas prices to be approaching levels seen ahead of Russia's invasion of Ukraine.
A lack of workers must also be addressed, says Low.
The UK maintains high vacancy rates as businesses are unable to find the staff they require, therefore the return of these workers could boost output.
However, the reasons for the dearth of workers are complex and unlikely to be filled too soon.
The labour shortage comes despite the UK recording record levels of immigration, according to the most recent official statistics covering migration flows.
A new report by the House of Lords, out on December 20, meanwhile confirms that since Brexit the UK labour market has changed on a structural level, albeit in a more dysfunctional direction:
"In recent years many EU workers, who filled lower paid roles (especially in sectors like agriculture and hospitality), have left the UK. In numerical terms, their departure has been counterbalanced by the arrival of non-EU workers, who were granted visas under the new immigration system which prioritises skilled workers. This has contributed to a mismatch within the labour force, accentuating vacancies and labour shortages in certain sectors."
The same report however touches on a potentially bigger issue for the UK's labour market woes: "early retirement and an ageing population are causing labour shortages".
Economic inactivity has increased by 565,000 people since the start of the pandemic in what is described as "a stark reversal of what was happening before 2020".
The biggest contributor to this change has been an increase in early retirement, the House of Lords Economic Affairs Committee concluded.
"Taken together these findings are, like mid-winter, bleak. The rise in economic inactivity makes it harder to control inflation; damages growth, and puts pressure on already stretched public finances. That’s why it’s critical the Government does more to understand the causes of increased inactivity, and whether this trend is likely to persist," says Lord Bridges of Headley, Chair of the House of Lords Economic Affairs Committee.
But should the UK government find a fix or the labour market starts to correct itself from recent shocks the Pound could benefit, according to Morgan Stanley.
Another potential boost to the Pound could come from a more resilient consumer, either through tapping on excess savings or on a fresh surge in wage growth, says Low.
She finds UK consumers have continued to build up on their excess savings which they have been tapping over the past two years to boost consumption.
"While we don't expect this to be the case especially as the high cost of living erodes purchasing power, consumers tapping into savings to fuel consumption could be a potential driver of a more resilient growth outlook in 2023," says Low.
Although the Pound could prove to be one of 2023's surprises, Morgan Stanley maintains a view that the UK will be short on luck over the coming months.
They forecast the Pound to Dollar exchange rate at 1.13 by the end of the first quarter of 2023, 1.14 by the end of June, 1.15 by the end of September and 1.16 by year-end.
The Euro to Pound rate's forecast profile is 0.90, 0.91, 0.92 and 0.93 for these points in time. This gives a Pound to Euro forecast of 1.11, 1.10, 1.09 and 1.08.
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