Insight

UK volatility and global spillover: the outlook for ‘Trussonomics’

UK volatility and global spillover: the outlook for ‘Trussonomics’
Key takeaways
1
The UK government’s unorthodox approach to fiscal policy has rattled investors. The sharpest reaction was seen in UK assets – especially sterling and gilts – but there was also spillover to major bond markets.
2
We believe the Bank of England may have stopped the immediate concerns in the UK financial system with its liquidity injection, and this may limit the extent of volatility in gilts and sterling in the short term.
3
The risk of a major financial accident has been reduced for now. Markets are likely to become less volatile in the short term, yet the focus will return to the macro challenges facing major economies.

What happened?

A new UK government took office on 5 September under the leadership of Prime Minister Liz Truss. The new Chancellor (finance minister) Kwasi Kwarteng wasted no time in undertaking radical policy changes in a bid to reboot UK growth and contain inflation. He announced a “mini” budget last Friday, 23 September, which was far from mini by the standards of previous interim budgets.

Most of the key changes in the budget had been trailed in the preceding weeks, but the market was hit by the size of the budget deficit and methods that ran against the canon of developed markets’ fiscal policy and practices.

The government’s key decisions based on what some commentators have dubbed ‘Trussonomics’ included:

  • Top-rate income tax scrapped and the reduction in basic rate brought forward one year
  • National Insurance Contributions for social security and healthcare increases scrapped
  • Residential Stamp Duty – property purchase tax – reduced

  • A host of measures to streamline planning restrictions and timeframes to spur investment
  • Financial sector deregulation including removal of an EU rule capping banking bonuses

  • Target 2.5% per year, a new “central economic mission” of government
  • 38 Investment Zones with looser regulatory constraints, labour protections and tax incentives

After Kwarteng suggested the market volatility was no reason to reconsider policy, matters escalated over the weekend as the Chancellor doubled down on his policies, hinting there was more to come.

Kwarteng’s new fiscal policy was almost universally criticised in the markets, and by academia and policymakers.

The International Monetary Fund issued an unprecedentedly blunt criticism, the sort usually reserved for emerging market countries that have gone off-track in an IMF program during a full-blown crisis.

We believe the delayed market and policy reactions to fiscal changes that were largely flagged up for weeks before their actual announcement reflect three main problems:

  1. The tax cuts were larger than expected1 and left a potentially open-ended fiscal gap, given the plan to cap energy bills with no offsetting plan to reduce the fiscal deficit or public debt.
  2. This loosening of fiscal policy runs against the grain of the Bank of England’s efforts to reduce inflation by hiking rates, since it would support consumer spending power and keep inflation high.
  3. The new government undermined UK institutions. The Chancellor had sacked the top UK Treasury civil servant and appears to have prevented a full fiscal costing of the plan by the UK government’s independent watchdog, the Office of Budget Responsibility2 (OBR). The new PM also appeared to challenge BoE independence during the leadership campaign. Though this has been rowed back since, the danger exists that continued high inflation undermines the BoE’s credibility as well as the UK’s overall strong institutional reputation in the markets.

Although the Chancellor’s actions have been seen as cavalier, it should be noted that they have been considered by the Prime Minister, reportedly, for years. The government’s economic advisers have been advocates for unorthodox policies to bring economic growth to the UK alongside higher interest rates, trying to revive ideas from the 1980s. However, the world has changed a lot since then and there are strong arguments for why these ideas are inappropriate in today’s context.
 

How have markets reacted?

Figure 1. British pound sterling to US dollar exchange rate

Data as at 28 September 2022. Source: Statista

 

The market shock for the UK was severe, drawing parallels with crises such as Black Wednesday, leaving markets anticipating an intervention. The sharpest reaction was seen in UK assets – especially sterling and gilts – but there was also spillover to major bond markets, especially in the eurozone, and risk aversion flows into the dollar.

Gilt yields sold off sharply, moving by 30-40 basis points a day – larger moves than recorded for decades. Sterling collapsed against the admittedly strong dollar, hitting all-time lows, but Monday’s fall against the euro was also breath-catching given the installation of a right-leaning Italian government over the weekend.

On 28 September, the BoE stepped into the gilt market, buying in size. For the time being, this appears to have put a line under the selling in UK bond markets, where lenders, pension funds and other liability-driven investors were facing margin calls and severe liquidity squeezes. The pound has stabilised and gilts have rallied sharply across the curve. What’s more, bond yields which had also risen outside of the UK (notably in the eurozone) have also fallen back.
 

What is our outlook on the situation?

We believe the BoE may have stopped the immediate concerns in the UK financial system with its liquidity injection, and this may limit the extent of volatility in gilts and sterling in the short term.

However, the UK is not out of danger yet. On 27 September, BoE Chief Economist Huw Pill indicated that a significant monetary policy response was required. The market is still pricing in a 150bps hike at the next BoE meeting on 3 November. This week’s shock as well as further rate hikes are likely to hit growth, confidence and household consumption as mortgage rates are expected higher, possibly significantly.

We hope the authorities take further action to improve confidence. Above all, the UK government still needs to offer a credible fiscal plan (preferably assessed by the OBR) to complement the BoE’s financial stabilisation in a way that supports long-term growth without boosting inflation expectations. There is also the mismatch of time horizons – a higher near-term spending requirement versus longer-term growth plans to boost investment and productivity.

There are expectations that the Chancellor might issue new policy guidelines. At the time of writing, there has been no advancement of the medium-term growth plans to be published 23 November.

We hope that this will be brought forward and that there will be a more consultative approach with the Treasury, the BoE and other advisors for a more conventional approach to supporting long-term UK growth while reducing inflation.
 

What is our resulting investment view?

In short, we believe the risk of a major financial accident has been reduced in the short term. Markets are likely to become less volatile in the short term, yet the focus will return to the still pressing macro challenges facing major economies.

The US: It probably remains in the best overall position of the major economies with the US Federal Reserve facing the cleanest hiking path, as US inflation is increasingly led by domestic prices and wages – which is dollar-supportive. The eurozone and UK still face an energy crisis, which will require diligent fiscal support 

The UK: We take heart from the BoE’s moves to stabilise the functioning of UK financial markets. In the short term, global markets are likely to stabilise and refocus on global and local fundamentals as the reduced risk of a financial incident in the UK reduces global risk aversion and the resulting dash for cash and dollars. The UK remains vulnerable because of the loss of policy credibility and reputation for prudent economic and financial management that had been built over the last quarter century of the BoE’s operational independence.

Europe: We remain concerned that these UK policy missteps and the dramatic market movements have highlighted the difficulties facing governments that need (or want) to increase budget deficits at a time of high inflation and tightening monetary policy. The pressure to support households and the overall economy through the energy crisis remains a major challenge throughout Western Europe. Russia’s gas supplies remain far lower than normal as gas supply pipelines reportedly have been sabotaged and gas prices remain elevated.

Heavily indebted economies with fiscal challenges elsewhere also deserve close scrutiny and possibly higher risk premiums, notably Italy. Energy importers the world over have enlarged funding needs. Public debt ratios have risen sharply in many countries as a result of the pandemic and may rise again further as the energy crisis continues. The risk cannot be dismissed that as the European Central Bank continues to tighten its Transmission Protection Instrument, intended to cap unwarranted divergences in sovereign spreads, could be tested.
 

What are the risks to our view?

Uncertainty remains high; there are two-sided risks to these views. It is still conceivable that the new UK government continues down its current path without addressing market concerns about its policy sufficiently. If so, another round of sterling and gilt volatility is likely.

More generally, an early end to the war in Ukraine and general fall in energy prices would reduce the risks considerably, as would any early deceleration in US domestic inflation, by reducing the upward pressure on US rates and the US dollar.

Footnotes

  • 1

    The tax cuts mainly reverse planned tax hikes and would leave the tax take near their pre-existing high levels around 35% of GDP, according to the Institute of Fiscal Studies.

  • 2

    OBR – Office for Budget Responsibility, the independent body which assesses the sustainability of the UK’s public finances.

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