Every year, a few big surprises hit the markets and catch investors off-guard. So, Morgan Stanley’s done a little creative thinking, and envisioned ten possible surprises that could throw your assumptions into chaos in 2023. I’m intrigued by one of them in particular: the idea that the UK economy might pick itself up, dust itself off, and drive a rally in the British pound. Let’s take a look at this scenario…

How are things looking for the UK right now?

Not great. The UK is estimated to have entered into a recession in the third quarter of 2022 – it’s just waiting for the data to confirm it. The country’s been facing some of the developed world’s highest rates of inflation in the past year, which the Bank of England (BoE) has been trying to subdue with nine-straight interest rate increases (so far).

So, yeah, the notion that the UK economy and its “stock price” as some see the British pound might spring back to life this year is something of a long shot. It’s not a consensus view in the market, and it’s not Morgan Stanley’s base case either. Then again, when it seems like everyone’s feeling negative about an asset, that’s exactly when positive surprises can catch them out and propel that asset – in this case, the pound – higher.

Barring a big surprise, Morgan Stanley’s economists actually expect the UK economy to be at the bottom of the heap compared to its advanced-economy rivals, in terms of growth, dragged down by high energy prices, the government’s plans to limit borrowing, and interest rate hikes from the BoE.

Eight of the G10 economies (Canada and New Zealand omitted, for some reason) and their 2023 GDP growth expectations from Bloomberg and MS. Sources: Bloomberg and Morgan Stanley Research.

So what could happen to turn things around?

The outlook for the UK (and the pound) is, naturally, all about expectations. So, turn one or two of those on their head, and things could turn out really differently. (That’s how you get a surprise.) Here’s how that could play out, according to Morgan Stanley:

1. Energy prices could fall further.

The UK’s still sky-high levels of inflation (10.7% in November) have been fueled primarily by the sharp rise in energy costs, and they’ve put a dampener on consumers, and also on the whole economy. If energy prices were to fall even more and stay lower, that’d have a positive ripple effect across the economy. It would ease the country’s cost-of-living crisis, giving a boost to businesses and leaving consumers with more money to spend on nice-to-have goods and services – all of which would stimulate growth. And, since the government has been carrying some of the burden for consumers, through a price cap that’s set to extend until April 2024, lower energy costs would leave the government in better financial shape too. Lately, at least, energy prices have been playing ball – with the price of natural gas in the UK falling 72% from its August high –  but the ongoing Russia-Ukraine war makes future prices far from certain.

UK inflation broken down by key components. Sources: Office for National Statistics and Morgan Stanley Research.

2. The number of workers could increase.

A big chunk of the UK’s inflation has to do with the country’s labor shortage. With companies forced to compete for workers, they’ve been offering bigger paychecks – and passing those higher salary costs along to consumers. While other advanced economies are seeing labor shortages as well (the US is a prime example), the UK’s had it particularly bad. Morgan Stanley says the UK’s labor participation rate – the percentage of the working-age population that’s actively working or looking for work – has been dragged down by long Covid, and by some very UK-centric factors: wait times in the UK’s health system, and a post-Brexit exodus of foreign workers.

The investment bank says the UK government can resolve much of the labor shortage by providing more funding to the National Health System to clear its patient backlogs (and on that front, the recent series of labor strikes certainly isn’t helping). It also recommends return-to-work programs for younger workers and targeted job permits to bring lower-skilled foreign workers into the UK labor force. Easier ways of boosting the labor supply could be done through a relaxation of immigration rules as well as a softer Brexit, according to Morgan Stanley.

Reasons driving the UK’s labor shortage. Sources: Office for National Statistics and Morgan Stanley Research.

3. Consumers could start spending again.

UK consumers are sitting on a nest egg of just over £200 billion ($243 billion) and monthly deposit inflows are still above their pre-covid monthly average of £5 billion ($6 billion). If those consumers were to gain enough confidence in their own financial situation, perhaps because of another surge in wage growth, and begin to spend more freely from their savings, the economy could see a welcome boost. While Morgan Stanley doubts that will happen, it sees it as a possibility – one that would certainly help keep growth more resilient through this year.

UK household spending growth base case. Sources: Office for National Statistics and Morgan Stanley Research.

What’s the UK’s political environment like now?

It’s still a bit volatile. Just this week, the pound strengthened after the European Union and the UK reached an agreement to use the UK’s live database to track the flow of goods between Great Britain and Northern Ireland. The deal, which resolves a Brexit-related sticking point, will likely help reduce customs paperwork and could lead to potential progress on other areas of dispute. And that could be even better for the pound.

But there’s also the prospect later this year of a Scottish referendum – with the country planning a vote on whether to leave the United Kingdom. And, while a Scottish exit is unlikely to elicit the same shock to the pound as Brexit did, it would still be a blow for the UK’s economy and its currency. Scotland represents around 7.5% of the UK’s economy. Now whether a second referendum will actually take place (Scotland held a similar vote in 2014) is still uncertain. Scottish leadership has called for a vote in October, but it’ll require approval from the UK prime minister to proceed. And under this government, that seems unlikely. This risk is something to keep an eye on: the pound lost around 5.5% of its value against the dollar in the lead-up to the 2014 vote.

What’s the opportunity then?

If you believe the above-mentioned issues can be resolved and this could be the Great British pound’s year (or if you just like being a little contrarian to consensus sometimes), you could consider buying the Invesco CurrencyShares British Pound Sterling Trust ETF (ticker: FXB; expense ratio: 0.4%). Or, you could consider using a brokerage account to buy the pound against the dollar using a contract for difference, a type of margin product popular outside the US, or straight margin if you’re based in the US. On the other hand, if you think a sterling rise is just a pipe dream, then consider the WisdomTree Short GBP Long USD ETP (SGBP; 0.39%), which would allow you to bet against the pound.