UK Investors face a 'tug of war' as a result of mini-Budget

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UK Investors face a 'tug of war' as a result of mini-Budget
Chancellor Kwasi Kwarteng speaks in the House of Commons to deliver his 'mini-Budget' (Jessica Taylor/UK Parliament)

The “unfunded” nature of the tax cuts and spending plans announced by chancellor Kwasi Kwarteng means investors are likely to face a “tug of war” between the Bank of England and the Treasury in the coming years.

This would mire markets in uncertainty, according to Trevor Greetham, head of multi-asset at Royal London Asset Management. 

In addition to the previously announced energy subsidy package, which the chancellor estimates will cost £10bn a month for the next six months, and an uncertain amount thereafter, a range of tax cuts were announced.

In normal circumstances, such fiscal loosening would be expected to be inflationary, but it is happening at the same time as the Bank of England is lifting interest rates to combat inflation, creating the scenario Greetham describes as a “tug of war.”

He said: “Action to help struggling households and businesses pay their heating bills this winter was essential, but the scale of the tax cuts and spending increases in this announcement is breath-taking.

"Arguably, a significant, unfunded fiscal stimulus package like this would have made economic sense after the deflationary Global Financial Crisis, when borrowing costs were low and private sector balance sheets were deleveraging."

Greetham added: "Now with spare capacity non-existent, inflation at a forty year high and the Bank of England trying to cool things down, we are likely to see a policy tug of war reminiscent of the stop-go 1970s. Investors should be prepared for a bumpy ride.”

I suspect markets will worry that these tax cuts will keep demand for goods high.Emma Mugford, Premier Miton

Gerard Lyons is both chief economic strategist at wealth manager Netwealth and an informal adviser to Liz Truss.

He estimated the cost of the measures announced today, excluding the energy subsidy, at a net £77bn over the next three years.

His view was that it is not a tug of war, as the higher inflation caused by the stimulus is offset by the higher interest rates and the government energy scheme.

Instead, he believed the actual increase in spending is much lower than many commentators believe, as some of the measures announced are offset by other, previously announced plans. 

The inflation question

Essentially, measures such as tax cuts, which might increase the level of aggregate demand in the economy, create demand side inflation, that is, inflation caused by a faster increase in demand for goods and services than the growth in the supply of goods and services.

The inflation we have experienced in the UK this year is supply side inflation, that is, caused by an increase in the cost of supplying goods and services, such as energy, that is not the result of increased demand.

The Bank of England has acknowledged that higher interest rates do not directly reduce supply side inflation, they put rates up to try to prevent longer-term inflationary trends taking hold. 

Increasing the level of demand in the economy may mean longer term inflation takes hold, causing the bank to lift rates to a higher level than may previously have been the case, though if the inflation moves from the supply, to the demand side, it could be that higher interest rates are more effective at addressing this type of inflation. 

Oliver Jones, an asset allocation strategist at Rathbones said the measures announced on September 23 “should reduce the likelihood of a very deep and long recession – something that had previously seemed very possible.

"Together, they amount to a loosening of fiscal policy worth perhaps 6 per cent of GDP.

"But opting for broad-brush fiscal loosening over targeted support for those most vulnerable to rising energy costs also increases the chances of high inflation sticking around for longer,”

The most recent UK GDP number was growth of 0.2 per cent in the second quarter of 2022, better than the US achieved. 

He said this placed greater emphasis on the Bank of England to deal with any consequent rise in inflation, implying higher interest rates are on the way. 

Emma Mogford, who jointly runs the Premier Miton Monthly Income fund, said: “I suspect markets will worry these tax cuts will keep demand for goods high, boosting inflation and hence putting upward pressure on interest rates.

"That is bad news for companies with lots of debt.”

A spoke in that particular wheel is the performance of sterling since Kwarteng announced his plans, with the pound falling by more than 1 per cent against the dollar. 

Because commodities are priced in dollars, weak sterling makes them more expensive, effectively importing supply side inflation into the economy. 

The other issue is that the price of government debt has also risen sharply, with gilt yields rising. This makes it more expensive for the government to fund its plans, and requires a greater volume of tax revenue to go to debt repayments. 

Gilt yields rising happens when investors expect currency weakness.

Numbers crunched

Ian Mills, a partner at Barnett Waddingham, said: “So far, the gilt market has reacted with what could best be described as an allergic reaction. 

"Twenty-year gilt yields were up 0.4 per cent shortly after the Chancellor’s announcement, reflecting increasing expected future supply of gilts, combined with fears that the tax cuts will add further fuel to the inflationary fire. 

"This adds to rises in yields yesterday (September 22) caused by the Bank of England’s policy announcements.” 

One factor which is not helping the markets adjust their pricing of UK assets is the absence of a published economic forecast from the Office for Budget Responsibility. 

That forecast will now be published in November.

The mini-Budget, which the government calls a “growth plan” contains a defence of the increased borrowing.

The report stated: “The UK has the second lowest gross debt as a proportion of GDP in the G7, although debt is currently high by historical standards as a result of a series of significant crises.

Global investors failed to be impressed by Kwarteng’s 'great growth gamble'.Garry White, Charles Stanley

"From the start of the financial year to the end of August, public sector net borrowing reached £58.2bn."

This is £21.4bn lower than the same point last year but broadly in line with the OBR's March forecast to date. Higher government spending has largely been offset by lower borrowing in other parts of the public sector.

Garry White, chief investment commentator at Charles Stanley, said markets were taking quite a pessimistic view of the government’s plans.

He said: “Global investors failed to be impressed by Kwarteng’s 'great growth gamble'. British shares fell, UK gilt yields surged to almost 4 per cent, and the pound hit a 37-year low against the dollar.

"Chancellor Kwarteng’s announced a series of tax cuts – the largest since 1972 – while also boosting spending, measures that will turbocharge the country’s national debt.

"Gilt yields surged as the UK Debt Management Office laid out plans for additional issuance to fund this planned spending."

He said a rise in the pound would have meant that the UK’s growth outlook would have materially improved.

White added: "Investors believe that tax cuts and increased public spending could make the UK's economic situation even worse – and see this gamble as risky.

"Simply putting money into the economy does not result in sustainable long-term growth. We need more entrepreneurship and an upskilled workforce – moves that should help resolve Britain’s lacklustre productivity.”

david.thorpe@ft.com