What does the mini-budget mean for UK investors?
What does the mini-budget mean for UK investors?
The market reaction to Chancellor Kwasi Kwarteng’s "mini" budget has been remarkable. On the day of the announcement, we saw the third-worst daily performance for sterling against the dollar since Black Wednesday in 1992. We also saw the largest move in yields on five-year UK government bonds (gilts) since 28 January 1985, when the UK policy rate was raised by 2%.
In the following days, the Chancellor re-emphasised the government’s intentions, pledging further tax cuts in pursuit of economic growth. The promise of "more to come" fuelled a further decline in UK assets, with sterling briefly falling to new all-time lows against the dollar. UK gilts have also continued to sell off, with the yield on the five-year bond moving through 4.5% – a level last seen in 2008.
The hope is that many of the announced measures will incentivise business investment, driving improved productivity and stronger economic growth. While this gamble may pay off, at this stage the market is not willing to give the new UK government the benefit of the doubt. Intervention by the Bank of England and a tax cut "u-turn" have undone some of the damage, but sterling and UK markets remain volatile.
UK mini-budget – still a big tax cut
James Gladstone, Head of Wealth Planning:
Most of the measures in the new Chancellor’s "mini" budget were anything but. Much was well signposted, but there were still some surprises. Scrapping the additional rate of income tax was the most headline-grabbing change, however the mood of the country was clearly misjudged with a speedy reversal to follow within days. Whilst this change did not survive, it is important not to lose sight of those that have. The reduction in the basic rate by 1% and cancellation of the National Insurance and corporation tax increases will create a combined tax "saving" of over £40bn; dwarfing the mere £2-3bn that the additional rate was due to save. These savings should be welcome at a time when everyone is feeling the impact of higher prices, but the irony is that they may prove even costlier once their impact is fully budgeted.
What has ensued in the last week is a complicated three-way "tug of war" between economic growth, inflation, and interest rates. The additional stimulus of tax cuts likely means that UK interest rates have to rise higher – and stay high – for longer than might otherwise be the case. This will mute the growth the Chancellor is hoping to stimulate, whilst also fueling inflation, which the Bank of England is desperate to control through rising interest rates. Bringing forward future expenditure, wherever possible, should be considered.
The consequences of the resulting weakness in sterling are also complex. Our UK client portfolios are generally "underweight" UK equities and have significant exposure to assets denominated in US dollars. This strategy has helped portfolios but the persistent weakening of sterling will result in the UK importing even more inflation.
It is widely accepted that holding debt through periods of higher inflation can be useful given the relative value of the debt decays more quickly. Those holding long-term debt, fixed at low rates, may want to reconsider any planned repayment strategies and instead remain alert to investment opportunities resulting from this fiscal stimulus.
Finally, the Chancellor was very keen to emphasize his unbridled support for entrepreneurial activity in the UK and it is expected that the existing tax reliefs to support UK venture capital will be both improved and extended. There has also been noise around pension reform and the removal of lifetime and annual allowances. Perhaps too optimistic given the change in the narrative since last Friday, but we will be watching with interest to assess the opportunities this may present for clients.
How will it impact inflation?
There are clear concerns around how the government will fund a fiscal support package worth close to £300 billion, an amount the government has never before borrowed in an environment of tightening monetary policy. Parallels have been drawn with the 1972 budget of Chancellor Anthony Barber – the failed "Barber Boom" which is widely blamed for the UK’s inflation and debt crises of the 1970s and ultimately ended in a bailout by the International Monetary Fund. In an attempt to reassure anxious bond markets, the Treasury announced that it will outline the detail of its fiscal plan and how it will manage debt levels on 23rd November.
The Energy Price Guarantee will help lower headline inflation next year. However, following the mini-budget, investors are concerned that the scale of fiscal stimulus could boost consumer demand, resulting in more persistent inflationary pressures becoming ingrained in the UK economy.
This will likely force the Bank of England (BoE) to raise interest rates by more than previously anticipated, for three reasons. Higher interest rates will reduce the risk of more persistent consumer-driven inflationary forces. They will also help to protect the value of the pound. Lastly, and importantly, they will help the BoE demonstrate its independence at a time of growing political scrutiny – and rebuild credibility. As BoE Governor Andrew Bailey stated, the Bank’s Monetary Policy Committee "will not hesitate to change interest rates by as much as needed to return inflation to the 2% target sustainably in the medium term."
The BoE has lagged behind the Federal Reserve in the speed and scale of interest rate rises this year. As we move into 2023, there is now a good chance that we see a more aggressive policy response, with UK rates moving meaningfully higher. Following recent events, the market is pricing in UK interest rates peaking at 5.9% in November 2023. Realistically, the BoE will not be able to raise interest rates to this level without significant implications for the housing market and the broader economy. Higher UK inflation for longer may prove to be the lesser evil. However, it is almost certain that rates will be higher in a year’s time than they are today.
Is it time to buy UK equities, gilts or the pound?
UK assets now look like good value relative to their own recent history, and there is the potential for a short-term bounce given the scale of the declines over the past few days. However, we struggle to see a clear catalyst for a longer-term rally. As we move into the final quarter of the year, we are happy to remain underweight both UK equity and gilts relative to our longer-term neutral allocation.
For sterling portfolios, we have remained overweight the US dollar and underweight sterling this year. This has been beneficial to headline returns in a challenging environment for asset prices. In an environment of growing concerns over economic growth, we continue to see the merit in maintaining an overweight dollar position. But, in light of the extent of recent currency market moves, we may consider moderating our position and taking some profit.
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This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
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