Last week saw a ‘mini-budget’ delivered by the Chancellor. It’s been widely reported but in summary there were a series of tax cuts for both companies and individuals. Markets had largely expected a modest to moderate easing adjustment to the UK tax system; Kwasi Kwarteng was far more aggressive with the fiscal easing. This has resulted in investors reassessing the UK’s fortunes and sterling and UK government bonds reacted accordingly.
It wasn’t just the UK that fell. Most markets and asset classes are in decline as interest rates rise around the world. Rates are rising sharply for the first time in a long while. Investors have enjoyed a good run since the global financial crisis, with the odd dip over time. Investing requires risk, and that means investments will sometimes fall in value. How long it will be is hard to tell, but over time, the cycle will progress and mature.
The market's response
The response from financial markets was swift and very negative. Sterling has been falling against the dollar for most of the year but almost as soon as Kwarteng had started speaking sterling began to tumble. It ended the day down more than 3% as it fell below $1.09, as markets were spooked by the prospect of potentially inflationary tax cuts. Sterling continued to drop as trading reopened after the weekend on the prospect of further tax cuts and the lack of a government to pay for them. Sterling has continued to be extremely volatile and has fluctuated between $1.035 (its lowest ever against the US dollar) and $1.08.
UK government bonds were also shaken by the chancellor’s announcements. Gilts sold off heavily as investors factored in the huge additional issuance needed to pay for the tax cuts, in addition to the additional borrowing needed to pay for the recently announced energy price cap. The Bank of England is also due to begin selling some of its stock of gilts as part of the plan to reduce the stock of gilts it purchased as part of the quantitative easing programme.
The potential for more aggressive interest rate hikes from the Bank of England to counter any additional inflation caused by Kwarteng’s tax cuts and the need to help protect sterling from further devaluation has added to the downward pressure on gilts.
Tumbling gilt values pushed up yields up to levels not seen since before the financial crisis and UK equities also dropped as investors took a dim view of all UK assets.
The domestic side of the economy
Cutting taxes traditionally stimulates the economy, which will likely cause the Bank of England to raise rates further to ease domestic inflationary pressures. The issue with tax cuts is that they are aggressive and will stimulate the domestic economy: this can be inflationary. Combined with weaker sterling, which increases the cost of externally sourced goods and services, it will push the core measure of inflation upward. The UK imports a lot. So whilst some external inflationary forces – such as transportation, oil/petrol and now gas - are contained or falling internal pressures in the UK and a weak currency will provide a counterbalance.
These external and internal pressures could offset each other to some extent, or consumer sentiment could remain very low and limit the impulse to spend. The market has reacted with a strong degree of certainty within a complex environment so markets have been very volatile as investors look to digest the Chancellor’s strategy. A lot depends on where we go from here and whether the political machine can turn around a stark and poorly managed fiscal manoeuvre.
Borrowing may be smaller than expected
It is easy to buy into concerning headlines about the size of the debt required to fund the price cap. Gas prices have fallen and, at the time of writing, it is estimated to save £70bn from the amount of borrowing initially estimated. Geopolitical risk is hard to estimate but Russia could also, at some point, unravel. Regime change or a Ukrainian victory may result in easier energy prices. A new president in Russia would be keen to rebuild diplomatic relations with the world, cheaper energy would likely be a priority, but Russia would not be so influential in a more diversified Western energy system.
Bonds have fallen but equities have held up
Interest rates are rising and will continue to do so until for the foreseeable future. Fixed income markets have priced this in which is why we have seen falls in bonds. Equites, however, have held their value while inflation eats into the economy, both for consumers and companies. But a lot can change in a short period of time.
There is a lot of uncertainty in markets and sentiment can change very quickly. Equities could possibly fall – their valuations are near long-term averages – which means they are not that cheap. Bonds have fallen a lot and they could fall a little more. The alignment of risk and return will reorder itself over time, but which investment changes first, do bonds rise, or equities fall?
The Chancellor's move will take time to digest
The mini-budget has introduced more volatility into markets, along with uncertainty about how the ‘bold’ growth-orientated strategy of tax cuts and the energy cap will be paid for. Markets are trying to find an equilibrium point to price in the effect on the economy and asset prices. It is impossible to say what the longer-term effects will be and these could change dramatically as the political landscape evolves and may not be as bad as some expect. The government could very well provide a better narrative and plan about their policy, something that was absent and caused markets to reel. A combined PR campaign by the Bank of England and the government, with a high level plan for funding the tax cuts would set markets on better foundations.
In the meantime, markets are demonstrating signs of mispricing which occurs during short periods of stress in the market cycle. This stress and volatility indicates that the impact of the new mini-budget is not completely digested and will take time to settle, with the potential for markets to fall further or retrace back to the higher prices seen pre-announcement. Upside will likely come to those investors who are in the market and ready to wait for the longer-term.