In what has been one of the most uncertain periods for the United Kingdom for decades, volatility and uncertainty has taken a significant step up in the last few weeks.
Over the past 12 months the country has been dealing with a war 2500 km’s from it’s shores, supply chain issues, a 10 fold rise in gas prices and a new Prime Minster. This has all combined to create some of the highest inflation of any major economy in the world. Now to add to this, the newly elected Prime Minister (Liz Truss) and Chancellor of the Exchequer (Kwasi Kwarteng) are doing their best to stimulate the economy when the Bank of England and the majority of other central banks globally are trying to stamp out inflation. These competing factors have seen the UK bond market and the Great British Pound weaken significantly.
Post the departure of Boris Johnson as the Prime Minister of the UK, newly elected Prime Minister Liz Truss knew she had to think outside of the box, to win the Conservative Party vote to become the newly elected Prime Minister. Her big policy push was to repair the economy post Covid Pandemic. With the next general election having to be called no later than January 2025, there was no time to waste. But when the new UK Chancellor Kwasi Kwarteng’s announced his Mini Budget on Thursday 29th October the fiscal announcement went above and beyond expectations.
So what was announced:
- Income tax cut: The additional rate of income tax, currently 45%, is to be abolished. The basic rate, currently 20%, will be cut to 19% in April 2023, a year earlier than planned.
- Stamp duty cut. The threshold at which first-time buyers pay stamp duty increased from £300,000 to £425,000. The value of the property on which first time buyers can claim relief has been increased from £500,000 to £625,000.
- The planned corporation tax increase to 25% has been scrapped, and will see it remain at 19%.
- Gilt sales to increase. The total gilt remit for this fiscal year is GBP193.9bn vs 192bn estimated.
- “New investment centres”. Low-tax investment zones could be set up in almost 40 areas. They will reduce taxes for businesses in designated tax sites for 10 years as well as many other measures such as various tax reliefs.
- Other changes include and are not limited to planned increases in the duty rates for beer, cider, wine and spirits will all be cancelled
The market impact was brutal, Gilts (UK Government Bonds) sold off aggressively given potential inflationary impacts and prospects of greatly increased issuance. The pound plunged more than 8.5% against the USD to a record low. The release of the government’s “Growth Plan” was the biggest tax giveaway in half a century. This sharp move in Gilts saw many mortgage lenders cancel product offerings and some to even reprice mortgages to circa 10% for first home buyers. The plunge in the pound also had growing fears for inflation in the UK a country which imports a large amount of food and basic grocery items.
Many market commentators were saying the announcements were an un-funded gamble for the UK economy. While cuts to stamp duty, national insurance and corporation tax were expected, the further large measures on income tax were not expected. With funding costs well above trend nominal GDP growth, this left the UK in an unsustainable fiscal position. The market quickly jumped to the conclusion that the Bank of England will now likely have raise rates further and sooner in order to offset the demand effects of what is a relatively untargeted package.
The current Bank of England base rate is 2.25%, with the market currently forecasting a huge rate hike of just over 1% in November with the interest rates peaking at 5.7% in the middle of 2023. These rate hikes do seem quite aggressive, but there is no doubt the market is now thinking that the monetary policy now likely has to be more aggressive to counteract the recent policy announcement made by the government.
Collectively, the contrasting fiscal and monetary policy decisions amounted to a massive vote of no confidence in the chancellor’s proposals. If markets are right about interest rates, it would be almost bound to tip the economy into a deep recession, notwithstanding the countervailing fiscal loosening.
After relentless pressure from the media, inside their own party and even the Bank of England stepping in to buy long dated bonds, UK PM Truss & Chancellor Kwasi Kwarteng tried to hold strong on their policy decisions. But after days of pressure they were forced into an embarrassing retreat on their plans to reduce the 45% tax rate for the top income earners in the UK (people earning over £150,000 a year). This came after a number of their own party members threatened to vote against it, seeing it as a widening of the inequality gap between the high-paid and low-paid in the UK.
Markets reacted favourably with Gilts falling across the curve, UK 10 year yield back down to below 4% having peaked at 4.5% the prior week.
Surprisingly the UK equity market has performed well through this period. For many that don’t follow this market, with so many global firms listed on the FTSE, close to 80% of earnings are international, therefore the FTSE generally outperforms generally if sterling falls.
It certainly will be interesting to see how this all plays out. One would have to think Prime Minister Truss and Chancellor Kwarteng won’t be making any bold policy announcements for some time. And any announcements one would suspect be critiqued by a larger range of party members going forward.
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