At the end of the quarter, I would usually focus my efforts on writing to reflect on the movements over the past three months. However, given the bout of volatility the "mini budget" ignited, a re-write would have been required, highlighting just how extraordinary the events of the past week have been.
Although the previous week was a pivotal moment for central banks (for more see last week’s Brief), something that would be front and centre in investors’ minds, it was completely overshadowed by the Chancellor’s announcement. On this island, this budget would have always caused a splash, however the fact the ripples spread globally given the UK share of global GDP is remarkable. The waves that it caused were so large that it was met with critique from not just the International Monetary Fund (IMF), but also messages of concern from the Biden administration and others. The sharp and swift upward movement in gilts raised concerns of pension funds failing and resulting in a much higher degree of forced selling, prompting intervention by the Bank of England (BoE) from a financial stability perspective.
The most pressing issue facing the UK and its population is the cost of living crisis given nearly double digit levels of inflation. Although a great deal of the impact is caused by spiralling energy costs, exacerbated by the Russian invasion of Ukraine and sanctions that were put in place, it is not the only cause. The pandemic has led to enormous disruption across global supply chains, and given the ongoing zero COVID-19 policy adopted by the Chinese authorities, this continues. This has curtailed car manufacturing at a time when public transport was broadly shunned resulting in significant increases in second hand car prices.
Furthermore, the reassessment of life priorities after a global health emergency has resulted in a vastly different labour market, one that is now much tighter and characterised by shortages. The common thread of these issues is that the "supply" side of the economy has faced enormous upheaval over the past two and a half years. On the demand side, people were paid to stay home and abandon social interaction. Given the broad loosening over the past 12 months or so, this has released pent up demand for the likes of travel at a time when airports and airlines were unable to cope resulting in higher prices. In order to try to restore balance, central banks are raising the cost of financing to curtail demand to better match the current level of output and quell rising prices.
While capping energy costs can be easier understood by investors, despite its potential eyewatering bill, cutting taxes without a proper assessment from the independent Office for Budget Responsibility raises several concerns. Firstly, by cutting taxes further without a clear sense of funding and the ultimate state of overall borrowing, would ultimately lead to higher borrowing costs. I don’t think any of us would expect to get a good rate on a loan, either personal or business, without a clear plan on how to reduce or pay the money back. Secondly, the tax cuts aim to boost demand in the economy at a time of high inflation, risking elevated price pressures for longer. If the government sought to borrow to alleviate some of the supply side issues this would have been much better received. For now, the policies appear to be a short-term sugar rush. Thirdly, this raises the risk of further political turmoil.
Over the summer, and more so in the coming weeks, we have seen a great deal of industrial strike action across a wide array of sectors. Given the fact the latest budget removed the top rate of tax, removing the cap on bankers’ bonuses and cutting corporation tax while ruling out a windfall tax on energy profits, has only reinforced the view of some that the conservative government seeks to enrich the wealthiest in society. As living standards fall due to rising food prices and a weak pound, this may fuel more resentment over the coming winter. The YouGov poll published yesterday illustrated this most acutely and showed the Labour party surged in the polls to its highest ranking since the late 90’s.
The most immediate impact for UK households is the cost of mortgages and its potential ramification to the housing market. Adopting a looser fiscal policy is usually met with tighter monetary policy. Huw Pill, the Chief Economist of the BoE, gave the clearest indication of what may have to follow yesterday at the annual dinner of the Institute of Directors. He said “on the basis of the fiscal easing announced last week, the macroeconomic policy environment looks set to rebalance. Taken in conjunction with the macroeconomic impact of ensuing market developments, it is hard to avoid the conclusion that the fiscal easing announced last week will prompt a significant and necessary monetary policy response in November." As such, the additional income from the tax cuts may be offset and more for households having to re-mortgage over the coming months and years.
Given the confluence of factors, the net benefits from this package are difficult to assess and its impact on growth remains ambiguous. That is why a lot of pressure has been building to reverse course and build back some credibility. The events of the last week, when the thirty-year gilt yield rose quickly from around 3.6% to above 5% before the BoE intervened, driving bond yields back below 4% remind me of a famous quote. In the nineties, when concerns arose about US Federal spending, the Clinton political adviser, James Carville, famously said at the time, "I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody."
The big question remains whether the UK government or other conservative party members force a U-turn after the bond market reared its head. For now, the majority of the electorate seems focussed on the bitter pill of rising mortgage costs and more expensive foreign holidays.
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