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

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.

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.

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"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.