U.K. Prime Minister Rishi Sunak Calms Markets—for Now

The arrival to power of the former hedge-fund manager and the departure of former Prime Minister

Liz Truss

has stabilized markets, which are now largely back to where they were or even stronger than before Ms. Truss’s ill-fated experiment with unfunded tax cuts sparked a selloff by investors worried that the plans and spending on energy subsidies would fuel inflation and debt.

The pound is now trading 3% above its levels before the Truss administration’s tax-cut plans, announced on Sept. 23, while the U.K.’s 10-year government-bond yield has also nearly erased its surge. That brings the price the U.K. government pays for new borrowing back in line with other industrialized nations. U.K. stocks have also been on a tear, with the domestically focused FTSE 250 up 4.3% this week.

“Given Sunak’s CV, from a market perspective, there’s a feeling that you’ve got someone who understands the market, who understands finances, who will be much more conservative,” said

David Coombs,

head of multiasset investments at U.K. fund manager

Rathbones.

“I do feel relatively optimistic that fiscal policy will be quite stable and monetary policy might not have to be as aggressive.”

But now that markets can see beyond the day-to-day turmoil in British politics, they are returning their attention to more traditional drivers like the economy, inflation and monetary policy, where the outlook remains challenging, investors say.

The U.K. economy is expected to enter a shallow but long recession in the coming months. Inflation in the U.K. is higher than in most other industrialized nations because the country has suffered from a Europe-style energy price shock from the war in Ukraine along with a U.S.-style labor shortage from the pandemic, as well as a departure from the European Union that has driven up labor costs for businesses. The pound has slid nearly 15% against the U.S. dollar this year, stoking inflation by making imports more expensive.

Capital Economics expects U.K. output to fall 1.5% in 2023, in line with France, but a smaller drop than the 2.5% decline it projects for Germany, which is more reliant on energy-intensive factories. U.K. inflation rose to 10.1% in September and is expected to peak at about 11% in the coming months.

“The U.K. had largely been shunned by international investors even before the last month,” said

Edward Park,

chief investment officer at

Brooks Macdonald

in London. “I don’t think this means that the U.K. will now be seen as a beacon of economic strength and fiscal moderation because of the problem with inflation that the U.K. is currently wrestling with.”

International investors have already fled U.K. stocks. An October survey from BofA Global Research shows that investors have been the most bearish on U.K. stocks since November 2020. In September, international investors pulled a net $3.7 billion from U.K. stock mutual and exchange-traded funds—an all-time monthly record, according to fund-flow tracker EPFR.

Mr. Sunak is also expected to introduce tax increases and cut spending to help plug a budget deficit, which could add further pressure on the U.K. economy, Mr. Coombs said.

“I do think it means the recession could be slightly deeper and longer because of that,” he said.

The good news for Mr. Sunak is that the reversals of tax cuts announced by his predecessor in the days before her ouster have lowered the cost of borrowing for the government and eased the pressure on the Bank of England to raise its key interest rate, which would likely have further slowed the economy.

Mr. Park of Brooks Macdonald has been buying short-dated U.K. government bonds in the past two weeks, in part due to expectations that the BOE won’t raise rates as aggressively as some have been expecting. Markets on Wednesday were pricing a peak central-bank policy rate of around 4.9% by the middle of next year, down from roughly 6% after the tax-cut announcement, according to Tradeweb data.

“Falling gilt yields are very important for the U.K. government because it allows them cheaper access to funding but it’s also a vote of confidence from the market,” he said. “But context is key: The U.K. has still got an inflation problem and interest rates are still going to rise, just slightly less than they would have done a week ago.”

Dario Perkins,

an economist at TS Lombard who coined the phrase “moron premium” to describe the surge in borrowing costs after Ms. Truss announced her package of tax cuts, said that most of the premium has now been erased. But he warned that cutting spending too much also had its downsides.

“The fact is that we are going into recession, and there is no way they can tighten fiscal policy going into a recession,” said Mr. Perkins, who previously worked at the U.K. Treasury. “You give the impression you’re tight, and you spend as much as possible within that framework.”

The U.K. government last embarked on big spending cuts in the wake of the global financial crisis in 2009, which some economists say were counterproductive since they slowed economic growth and made it difficult to lower government debt as a share of output.

Those years of cuts have left many of the largest government-spending priorities with little obvious spare capacity. “It would be challenging to cut spending on health, education or defense, although Sunak has not ruled out the latter,” said

Paul Hollingsworth,

an economist at BNP Paribas.

The state-run health service has yet to recover from the strains of the Covid-19 pandemic, and the backlogs of people who have long-term illnesses is one of the reasons why workers are in such short supply in the U.K.

Schools, which are key to the country’s future ability to boost economic growth, have also been weakened. According to the Institute for Fiscal Studies, real spending on students in the final years of high school fell 14% in the decade through 2020.

“Under these circumstances, cutting planned spending in this sector would not be an easy option for a government looking to repair the public finances,” said Imran Tahir, an IFS economist. “It would also sit uncomfortably with a commitment to focusing on skills and economic growth.”

Still, the U.K. government must mind its finances. While most of Ms. Truss’s tax plans were rolled back, some remain, which together with the energy subsidy will raise U.K. borrowing needs to 4.5% of annual economic output from 2023 through 2025, according to estimates from S&P. That is down from 5.5% in the wake of Ms. Truss’s plans but up from around 3% estimated by the ratings firm before they were announced.

Write to Paul Hannon at [email protected] and Chelsey Dulaney at [email protected]