Markets are currently on edge as fears grow that the world economy is slowing, at a time when Central Banks are determined to raise interest rates and unwind their stimulus packages. In this article, we will look at the current economic risks that the UK and the US are facing and how these could affect the British currency.

Risks that the British economy is facing

Britain’s recovery from the Covid-19 pandemic is at risk as price pressures have increased while business confidence has weakened following Russia’s invasion of Ukraine.

Business expectations are now at their lowest for almost one and a half years which indicates there will be a significant slowing in the pace of economic growth in the coming months.

Price pressures have surged due to growing energy and commodity prices after the Russian invasion. Escalating inflationary pressures and concerns related to Russia’s invasion of Ukraine have hurt business optimism and consumer spending. They have also made the situation very difficult for the Bank of England which will have to walk a tight line between protecting struggling households and avoiding recession while taming rising inflation.

Recession fears and business investment opportunities

Following the Bank of England’s latest recession warning, the risk of a possible recession is building, according to new forecasts by leading UK economic forecasting group EY Item Club.

The new EY ITEM Club Spring Forecast has pointed out that inflation, geopolitical uncertainty, skills challenges and increasing supply chain issues are continuing to add pressure on the outlook for business investment.

The EY ITEM Club expects UK growth to drop, with UK GDP to grow 4.1% in 2022 before growing 1.9% in 2023 and 2.2% in 2024. Growth is now depending on struggling households and whether they choose to start spending by saving less and borrowing more. The EY ITEM Club said that the possibility they may choose not to spend raises the risk of recession.

Martin Beck, chief economic advisor to the EY ITEM Club, explained that consumers “faced with a sustained squeeze on their finances, may cut spending in response.” Also, not all households are the same, and some are more vulnerable than others.  Lower income households, for example, will be affected by higher energy bills while any benefits increases will be outpaced by inflation this year.

Hywel Ball, EY UK Chair, highlighted the risks for businesses but said bigger companies might be able to thrive as they have cash holdings and have recovered from the pandemic. She said: “Uncertainty about the pandemic has been replaced by geopolitical uncertainty, which has also had consequences for the cost of capital goods and supply chain frictions. The temporary super-deduction tax incentive should support an investment pick-up this year, but its impact is being countered by strong headwinds. Some businesses also appear to be grappling with labour shortages and aren’t always able to access the talent needed to identify or deliver investment opportunities. At the same time, many large businesses are actually well-placed to invest, having paid down bank debt during the pandemic and built cash holdings which could can be used to fund new projects.”

Risks the US economy is facing

The main risks to the US economy are rising inflation, volatility in stock and commodity markets and the war in Ukraine. The Federal Reserve reported on Monday in a biannual update on financial stability that these risks could lead to a "sudden" disruption. The US financial system is already under pressure as treasury yields continue to rise and oil markets are in trouble, with the risk of a significant deterioration to be higher than normal.

Fed Governor and vice chair-designate Lael Brainard said in a statement accompanying the report that “households and businesses have decreased their borrowing as a percentage of gross domestic product, and currently appear to have resources to cover debt burdens, which is an important aspect of resilience in an environment of rising interest rates."

Indeed, there have been many changes recently including a more hawkish Fed that is determined to tighten monetary policy faster, rising interest rates and inflation that could become more persistent. As with other big economies, the US economy has been struggling with higher and more persistent inflation before the invasion of Ukraine, but uncertainty over the inflation outlook threatens financial conditions and economic activity.

Threats from the Covid-19 pandemic have now receded, only to be replaced by geopolitical uncertainty following the Russian invasion of Ukraine. Higher inflation could affect economic activity, asset prices, credit quality, and financial conditions more generally, the Fed report warned.

As the report said, "the effect of high inflation, rising interest rates, supply chain disruptions, and the ongoing geopolitical conflict on corporate profitability is uncertain. A significant decline in corporate profitability or an unexpectedly large increase in interest rates could curtail the ability of some firms to service their debt." In addition, hard-hit industries such as airlines could find it difficult to recover due to the rising cost of oil.

Both in the UK and the US, higher inflation exacerbated by the war in Ukraine and heightened uncertainty have created significant risks to the economy. Business sentiment is weak while consumer spending is increasingly squeezed. The gloomy economic sentiment will continue to put more pressure on risk-sensitive currencies such as the pound. As it was seen last week, following the BoE’s dovish meeting, the pound fell, with concerns about the outlook for the UK economy and a high risk of recession to continue to build.

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