Market View

The penny has finally dropped

exit strategies
Jeremy Sterngold, Deputy Chief Investment Officer

Given the recent weeks (and months) of drama in UK politics, the appointment of Rishi Sunak came somewhat as an anti-climax. Despite various reports of Boris being back in the race last weekend and Penny Mordaunt gathering votes, all hope was short-lived as the need to come together as a party became the main concern. Arguably, Rishi was the candidate that best represented fiscal discipline after the "mini-budget" caused the government’s fiscal credibility across markets to sink. So far, bond markets and the pound joined in cheering the new prime minister while homeowners are finally seeing some reversal in the spiralling cost of mortgages. Although this episode was very much driven by domestic matters, it goes to highlight how quickly investors can lose confidence in a period of high inflation. Currently, central banks globally are taking aggressive steps to tighten monetary policy in order to cool demand. However, there are more ways to cool down demand but that comes at a price.

Prior to the recent saga in British politics, Sunak was known as the Chancellor who not only brought about measures such as the furlough scheme and eat out to help out, but also the one who advocated to increase national insurance. This was a large sticking point during the debate between Rishi and now former PM Liz Truss, given that this increase would have brought the level of overall tax burden to the highest in sixty odd years. Obviously, while many sympathised with the need to increase funding for the NHS following a bruising pandemic, raising broad taxes is never popular. However, from a central bank perspective, this policy would curtail demand, thus limiting the need for interest rates to move higher still. The reverse was also true in the wake of the "mini budget", large scale tax cuts raised the prospect of the Bank of England (BoE) responding with larger increases in rates driving fears in homeowners who need to re-mortgage in the coming quarters. While the BoE and the US Federal Reserve will give us their view next week on how much tightening is still required given recent fiscal actions, this week we heard from the European Central Bank (ECB).

The ECB proceeded to raise their deposit rate by 0.75% to 1.5% as was widely expected. They also will be providing banks will less favourable lending conditions on the facilities it created during the pandemic. This will not only feed through to consumers and business but also to bank profits. However, hidden behind the main decision was a very careful warning about fiscal policy actions.  In her long opening statement, ECB president Christine Lagarde said the following: "To limit the risk of fuelling inflation, fiscal support measures to shield the economy from the impact of high energy prices should be temporary and targeted at the most vulnerable. Policymakers should provide incentives to lower energy consumption and bolster energy supply. At the same time, governments should pursue fiscal policies that show they are committed to gradually bringing down high public debt ratios. Structural policies should be designed to increase the euro area’s growth potential and supply capacity and to boost its resilience, thereby contributing to a reduction in medium-term price pressures."

A similar message was also echoed by the International Monetary Fund (IMF) a few days earlier. While it is the morally right thing to protect households from enormous increases in energy costs, the borrowing that it required to fund it, does not solve the problem going forward. Hence both the ECB and IMF emphasized the need for lowering consumption and increasing supply, both of which would improve fundamentals over the medium term. Furthermore, the high public debt ratios have come into further focus following the previous UK government’s decision to omit the Office for Budget Responsibility (OBR) report. It seems like the current UK government is very much committed to improve those. Indeed, in the first speech Rishi gave as Prime Minister, he stated "The government I lead will not leave the next generation – your children and grandchildren – with a debt to settle that we were too weak to pay ourselves."

In a period of high inflation across most developed markets, making large and rash policy decision is costly. In the US, we have midterms elections coming up in less than two weeks’ time. Following on from large COVID relief bills, passing large tax increases has been politically challenging, especially given these upcoming elections. The Inflation Reduction Act that finally passed over the summer, while bold in name, was less bold in numbers than its initial Build Back Better Act proposition that was rejected. While the positives from act are that it reduces the budget deficit and promotes clean energy investments, it goes to highlight just how politically difficult it is to make meaningful changes.

Central banks have all stepped away from providing forward guidance, as the ECB reiterated yesterday. The interplay between fiscal and monetary at a time when consumers are feeling the pinch on several fronts, will determine just how far rates will need to go to in order to restore medium term inflation expectations. Following the scary October in the UK, it seems that more governments are heeding the warning. As such, they are now more likely to proceed cautiously when considering providing more broad unfunded help to households. While this may be painful to some households, following a period potential "trick" rather than "treat" when looking at mortgage fixes, central banks may not need to raise rates quite as high given budget caution. Politically, providing relief may initially be popular, but if it comes at the expense of people not being to afford their houses, this may turn out to be a worse outcome.

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