Trouble Brewing for the U.K?

Celebrations may be short-lived for our chaps in the U.K. this holiday season as they could face rising unemployment and stubbornly high inflation come 2011. These problems don’t just vanish into thin air just because the holidays are here, you know!

Last week, investors were surprised to see an unexpected rise in the U.K. unemployment rate. For the first time since Q1 of 2010, unemployment ticked higher, rising from 7.7% to 7.9%.

According to the report, the public sector is the main culprit behind the sharp drop in jobs. Do you remember the austerity measures the government announced a while back? Well, the government has been forced to lay off thousands of workers to cut back on spending and stay on budget. It ain’t the best way to end the year, but I guess Christmas isn’t really complete without a Grinch.

The problem is that this might not even be the end of it. Belt-tightening is a lengthy process, and the austerity measures could mean that more job losses are in store for the U.K. Actually, I wouldn’t be surprised to see the unemployment rate rise further next year.

And lest we forget, inflation is still as stubborn as ever in the U.K. Last month it clocked in at 3.3% year-on-year, still way above the Bank of England‘s target of 2.0%. What’s bad about it is that the worst has probably yet to come. When the value added tax rate is increased from 17.5% to 20.0% in January 2011, expect prices of goods and services to shoot up even higher.

With these figures, it isn’t much of a shocker to hear talks about the possibility of stagflation for the British economy.

Stag-a-what?!

Take a chill pill, my young Padawan. Stagflation is just the horrid combination of high inflation and stagnant economic growth

Some naysayers believe that the U.K. is showing signs that it is slowly slipping into a rut. You see, one of the characteristics of stagflation is high unemployment. Economics 101 tells us that inflation and unemployment have an inverse relationship because in times of economic growth, fewer jobs are lost and prices usually increase.

However, with the unemployment rate up at 7.9%, I think it’s safe to say that the British economy isn’t exactly showing much swagger. While the BOE can provide further stimulus to spur growth, it exposes the economy to a rapid increase in inflation. This means that the 2.5 million jobless Britons will have to pay more for goods and services. Talk about the BOE being stuck between a rock and a hard place!

Truth be told, we may not even have to wait for the austerity measures to come into full swing next year before we see the economy take another hit. Retailers are expecting consumer spending to weaken further before the year comes to an end because harsh snow storms have been threatening holiday sales. I’m sure this is hardly the white Christmas they were dreaming of.

As expected, the poor fundamental outlook has weighed down the pound, which has been struggling the past couple of months. Since it peaked just under the 1.6300 handle, GBP/USD has fallen nearly 5%. In fact, the pair fell more than 200 pips when the most recent unemployment report was released!

Making things even worse for the currency are the external risks that could lead to its further demise. Like what, you ask?

First, the European sovereign debt crisis is STILL a trending topic in the markets. Yes, yes, I know you’ve heard this about a billion times already, but what’s one more time, right? It is the major theme in the market right now, and as long as it remains one, both the euro and pound will have trouble sustaining any gains.

Also, there are concerns about the British banking system’s exposure to toxic debt. If we start seeing foreign banks post loss after loss, we could see risk aversion push the pound even lower.

As you can see, there is a lot on the plate for the U.K. heading into 2011. I can’t wait to see how this all plays out. Maybe I should start planning a vacation to London soon…