As markets moved towards the end of last week various thresholds were breached that will have led passive investors and risk managers to take action that will likely feed the downturn. We are already seeing evidence of this, adding to selling pressures in the markets.
There are also considerable positions in sterling assets held by overseas investors that are unhedged against current risk, so as sterling weakens they become less valuable and the question is whether this forces selling which adds to the pressure. For longer-term investors they are unlikely to sell, but for many others they might.
The UK has a large current account deficit which leaves it vulnerable. Events on Friday led the market to worry about the Government’s budget deficit, too. Yet, it was not only this twin deficit issue that unnerved the markets. In recent weeks, as we noted, markets were in a febrile mood and their concerns about the overall stance of policy were not addressed. In particular, their concerns were about the possible scale of tax cuts and that these were unfunded.
The events in the preceding forty-eight hours to the mini-Budget had also exposed market concerns about monetary policy, too, following policy meetings at the US Federal Reserve and the Bank of England. The Bank did not hike rates as much as the Fed and also announced gilt sales as part of its quantitative tightening. Market risk positions were already building, and a sequence of events thus, in some respects, led the dam to burst following the mini-Budget.
Financial markets should never be under-estimated. Let’s take two different examples of how to address markets.
When he was president of the European Central Bank (ECB), Mario Draghi got the markets onside by saying he would do, “whatever it takes” to protect the euro. In the event he didn’t have to spend money convincing the markets, they knew he understood their concerns and they then trusted him.
In contrast, his successor, the present president, Christine Lagarde, in one of her initial speeches, said it was not the ECB’s job to worry about European bonds. The market disagreed. They felt she didn’t understand and it took her a considerable time to restore her credibility.
UK policy makers appear to have been insensitive to market concerns, or not appreciated the extent to which they might unfold.
In a column for the weekend’s press I wrote: “While the CBI and the Institute of Directors welcomed the Chancellor’s measures (in the mini-Budget) the financial markets didn’t. The Chancellor said he and the Governor of the Bank of England speak twice a week. If so, they might have anticipated and quelled in advance the fears of the financial markets. They didn’t.”
For a number of weeks the market had expected a “fiscal event”. The Government had indicated clearly that it would reverse two planned tax hikes: national insurance and corporation tax. In addition, further details of the energy price plan were to be unveiled.
The Chancellor announced the cost of the energy cap was £60 billion over the next six months. Expensive, but expected. Furthermore, the markets could cope with this permanent, one-off measure. Fixing the cap at £2,500 meant the government was removing the risk of energy prices going above this and away from people and firms and onto government borrowing. For firms, though, the cap was fixed for only six months, not helping longer-term planning, whereas for people it was fixed for 18 months.
Yet the worry for the market was the suite of other fiscal measures.
I have been supportive of the idea of fiscal policy being relaxed to address downside economic weakness. Indeed, the UK had been the only country going into a global downturn with a plan to raise taxes. That made no sense. The market should have coped with this, and with the full costing of the energy price cap. The cap also helps bring down inflation, with inflation now set to peak far lower than the market had expected.
The challenge was that the fiscal event had more in it than that, and hence became a mini-Budget and the markets were spooked by the additional tax changes, even though the scale of these was not sizeable. It also fed a narrative and perception, unfair as it was, that the UK was being belligerent with the public finances.
The Chancellor announced increased borrowing of over £160 billion over the next five years. The fiscal easing announced was: £19.2B (in 2022/23), £26.8B (in 2023/24), £31.4B (in 2024/25), £39.4B (in 2025/26) and £44.8B (in 2026/27).
Importantly, just over 82% of this (so 82 pence in each extra pound borrowed) was explained by the corporation tax increase reversal and the national insurance tax reversal. If this was all, the markets probably would have coped.
That is because reversing these tax hikes – alongside the energy cap – was seen as helping prevent a deep recession that would have blown the public finances out of the water. Of course, a slowdown is still happening and a recession (albeit shallower than it would otherwise have been) is still possible.
But it has been the ongoing talk of tax cuts that has led the market to associate the new fiscal policy with two things that it is not: a dash for growth (seen by the markets as adding to inflation) and trickle-down economics (which is a crazy concept).
Further reporting of the commitment to tax cuts over the weekend – while aimed at a domestic political audience – added to concerns in financial markets.
What was needed at the end of last week was to make clear that:
- (a) this is a pro-growth strategy, not a dash for growth strategy. A pro-growth strategy is focused on the supply-side, boosting investment and skills and thus raising productivity and productive potential. A dash for growth was seen under previous Chancellors like Maudling and Barber and led to a boom and bust.
- (b) to reinforce that tax cuts are just one part and not the overall focus of this policy. In fact, early in his speech the Chancellor articulated that as tax cuts, plus fiscal discipline and supply-side measures.
Critics of the Government have called its policy trickle-down economics. It is not. This is a stupid concept, where if you give more money to the rich it trickles down to the poor. It goes without saying that it is vital to look after those in need, and the best way to do this is through the overall tax, welfare and benefit system.
It’s also vital to have a progressive tax system as we do, where the more you earn the more you pay in tax. But that means if you cut taxes, those who have paid more tax get more back.
However, as the political narrative has focused on tax cuts the markets were left concerned – wrongly – about the idea of unfunded tax cuts.
Naturally, I was not aware of what was to be in the statement, apart from what could be garnered from the press. A removal of the cap on bankers’ bonuses was announced. This is understandable and needs to be seen in terms of improving the City’s competitiveness.
However, I was surprised to see the abolition of the very top rate of tax, which I felt was not necessary. Not only did it divert attention from other aspects of the package, but it fed the narrative of trickle-down and also of unfunded tax cuts. In my view, these tax changes such as abolishing the top rate of tax, which I was surprised by, should have waited until being fully costed in a Budget, alongside other measures.
- (c) a critical component of the new approach is that fiscal policy can be used to help stabilise the economy in the near term. And that allows monetary policy to be on top of tackling inflation.
There is no doubt the Government is committed to fiscal discipline. The Chancellor announced he will provide a medium-term fiscal plan (MTFP). The fact it is not available yet, though, has created a vacuum for those in the market worried about the finances.
As noted previously, the market has also been unnerved by worries about institutional independence. Although not grounded fully, these worries have been allowed to fester. The fact that the Office for Budget Responsibility (OBR) did not provide a forecast alongside this mini-Budget added to such concerns – although it is mandated by Parliament to produce two forecasts a year and so will provide one before year-end.
Given the absence of such an OBR forecast to accompany the statement, ideally the MTFP should have been released. That would have likely highlighted that fiscal discipline is enshrined in reducing the ratio of debt-to-GDP over time. But the focus on tax cuts and a lack of the other detail has fed unnecessary uncertainty.
Of course, the issue of public spending cannot be ignored, and that, too, has to be addressed in a full Budget or a Spending Review, given that higher inflation has both boosted tax revenues and also reduced the real value of government spending. But again, that did not figure, nor was it expected to, in this fiscal event.
The overall narrative that followed the mini-Budget was that this was the biggest tax cut for half a century. Not proceeding with tax hikes can hardly be a tax cut. Moreover, not proceeding with the corporation tax hike helps firms (and thus one might argue the supply-side of the economy) who are helped by reversing the employers’ national insurance hike.
Over recent decades the rate of corporation tax has fallen. The argument heard is that as business investment has not risen that means the tax can be increased without much impact. What this argument fails to note, though, is that as the tax rate fell, the tax base on which it applied has widened. Thus, the effective tax take has remained unchanged.
Therefore, to allow the rate of corporation tax to rise from 19% to 25% would have seen a higher tax take on this wider tax base. It would have been very damaging for business competitiveness in the UK. Hence not proceeding with this tax as well as extending other investment allowances alongside it (as was announced in the mini-Budget) makes sense.
While such actions remove some considerable downside economic pressures, the economy has already slowed, with consumer confidence low and demand squeezed by the cost-of-living squeeze as inflation has risen.
This leads onto the other aspect feeding market problems last week, and which is where attention may now focus: monetary policy.
Last Wednesday the US Federal Reserve hiked interest rates by 0.75%. They also signalled that there would be a further 1.25% hike by year-end. The Fed is clearly on the front foot to ensure their anti-inflationary credibility. Against this backdrop the dollar is strong across the board.
In contrast, on Thursday, the Bank of England disappointed the markets. The markets expected at least a half point increase in policy rates and thought there was a chance of 0.75%. The Bank hiked 0.5% to 2.25%.
They also said inflation would peak around 11%. Of course, a collapsing sterling will add to imported inflationary pressures now, as well as to a higher import energy bill. But even at 11% this leaves UK policy interest rates very low in real terms, that is, relative to inflation. Now, inflation is about to peak and will decelerate next year, so interest rates do not need to rise to anywhere near these levels, but monetary policy is loose. That, though, has been the case for some time.
Hence even ahead of Friday’s mini-Budget the market expected policy rates to rise sharply further. And after the mini-Budget rates are now expected to rise sooner, and peak higher. Before Truss became PM, the markets expected rates to peak around 4.5% next spring. Now, this level of rates is expected over the next three months, although market rates have risen globally, too, if not always to this extent. The market expects UK rates to reach 6% by the end of next year.
The worry in the markets has been that if UK policy rates didn’t rise then sterling looked vulnerable, but that if they did increase then the economy would suffer.
The direction of policy rates has to be set based on the underlying domestic economic fundamentals. Hiking rates to defend a weakening currency will do little to help the pound immediately. But the point is that UK monetary policy is seen by the market as lax – even if inflation is near its peak.
Even after last week’s hike, policy rates of 2.25% compare with current inflation of 9.9%.
The Bank of England also committed to proceeding with £80 billion of Quantitative Tightening (QT) over the next year. Given market conditions they have wanted to wait. The market was already worried about its ability to digest the combination of normal gilt issuance from the Debt Management Office, increased issuance because of QT and further issuance because of the fiscal measures unveiled on Friday.
Markets are unlikely to settle until they are sure inflation is peaking and/or that policy rates are near their peak.
Moreover, as stated before, they need to be convinced that the fiscal easing made sense, being necessary, not inflationary and affordable.
In this context, sterling is falling and UK assets imploding. But notwithstanding this immediate outlook, bear in mind the sterling selling trade has been in play now for months.
For instance, I wrote about a sterling devaluation back in February and some big risk takers have been short of the pound for some time. It may be a good time for them in coming weeks to get out of their large sterling short positions – as others in the market sell – as the pound is now moving to incredibly cheap levels.
The policy aim that was confirmed on Friday is to raise our economic growth rate to 2.5%. It’s ambitious but achievable. But it can’t happen overnight.
A decade ago, weak growth led Treasury orthodox thinking to urge austerity to get the public finances in shape. In recent years it led Rishi Sunak to hike taxes. Both approaches were wrong. Rather than accept we are destined to be a low growth, high tax country, the idea is to become a high growth one.
The aim of a pro-growth economic strategy makes sense. As I have stated it needs to be based upon the three arrows of: monetary and financial stability which delivers low inflation; fiscal discipline; and supply-side measures that deliver higher investment.
In contrast, currently the markets: see a central bank as being behind the curve with inflation high; need to be convinced about the direction of fiscal policy; have focused on tax cuts which are just part of the story, rather than on increased investment.
The notion of fiscal loosening, via certain tax cuts, to address downside risks should not be disregarded because of the market reaction – or the subsequent comment by the Chancellor. But there is a need to provide clarity about the public finances.
A statement is expected by the Bank and the Treasury about the pound. Unlike 1992, the UK is not defending an artificial currency peg. But the issue is about more than the pound, as can be seen from bond yields rising. The Chancellor needs to address the market concerns about fiscal policy and affirm that easing is necessary, not inflationary and affordable. The Bank, in my view, should not proceed with its planned QT, in order to ease worries about supply. Also, there is a need for the Bank to hike rates, in order to address worries about inflation and that it is behind the curve.
The situation the new PM and Chancellor inherited is not good. Despite a healthy jobs market, consumer confidence is low, inflation high and the economy slowing. The situation has just been made a lot worse with sterling collapsing and UK assets imploding.
While much depends upon events elsewhere, UK policy makers need to prove their credibility.
Please note, the value of your investments can go down as well as up.
