And just like that, Liz Truss’ Premiership comes to an end.
Tory credibility as a steady pair of hands and the party of fiscal discipline has been brought into question. Yet, for all the political drama, it was not Tory infighting alone which caused Liz Truss and Kwasi Kwarteng’s downfall.
Not seen since for at least 14 years, a ‘bond vigilante’ is a ‘bond trader who threatens to sell, or actually sells, a large amount of bonds to protest or signal distaste with policies of the issuer. Selling bonds depresses their prices, pushing interest rates up and making it more costly for the issuer to borrow’[1]. A decade of benign monetary policy and artificially low interest rates forced the vigilantes to take a back seat. There was no fighting fiscal expenditure when central banks were buying bonds in such significant quantities and, with both inflation and the cost of capital low at extremely low levels, there were no concerns to be had. Yet, with higher inflation comes higher interest rates, which in turn means higher interest payments on government debt through higher yields.
On the day of the mini budget, gilt prices fell precipitously, causing bond yields and consequently debt-servicing costs to rise. Meanwhile, sterling also plummeted on the day of the budget with at one stage sterling reaching a low of 1.035 against the dollar. The market was frantic with gilts moving more in a day than had been seen for over 30 years. The pension fund market, impacted by this huge move in gilt prices, experienced a liquidity squeeze and the Bank of England (BoE) ultimately had to intervene to restore an orderly market and prevent contagion.
While the Archbishop of Canterbury and Joe Biden both chimed in to express their dismay at the inequity of the Budget, it is clear that markets did not appreciate the inconsistency of the recently departed duo’s belligerent messaging. On the one hand tightening monetary policy to slow inflation, yet on the other hand adding fuel to the fire by adding demand-side policy measures and unfunded tax cuts. As a result, we had monetary and fiscal policies moving in opposing directions.
Who was to pay for these unfunded tax cuts amounting to £50bn? Why not allow the Office for Budget Responsibility to produce a report on the impact of the spending plans? The fact that sterling and gilts have rallied since the reversal of the mini budget is therefore no surprise. Since the appointment of the new Chancellor, BoE Governor, Andrew Bailley, has commented that Jeremy Hunt and he “have a clear and immediate meeting of minds” and markets seem to have been comforted by this.
If the bond vigilantes have returned for good, then what does this mean for future spending plans of those governments and policy makers outside of the UK that intend to run large fiscal deficits? Does this signal the end of expansionary fiscal policy and a return to austerity or is it just a matter of delaying the inevitable for a period of lower inflation when interest payments will be more manageable? What does it mean for governments who had pledged to cap energy price rises throughout the winter?
The large moves in gilt prices have created some tactical buying opportunities. On the equity side, we apply a global approach and typically invest in high quality companies whose sizeable overseas earnings are not only steady, but also resilient. As a result, these companies tend not to be cyclical or dependent on the capital expenditure cycle. These types of companies also boast experienced and adaptable management teams, with low to no debt, strong balance sheets and whose return on capital are considerably above market. We have faith that this approach will stand us well through the next few weeks and months, regardless of what happens inside Number 10.
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