- Last week the new UK Chancellor Kwasi Kwarteng announced a “mini-budget” package of tax cuts, subsidies and benefits, designed to ease consumer pain and less convincingly, to attempt to resuscitate UK growth;
- Markets didn’t take to the news well and reacted by pushing the Pound and gilt prices sharply lower, having taken a view that this new program will increase deficits, worsen inflation and drive further rate increases;
- In doing so, the sell off in UK government bonds exposed UK pension funds and caused them to sell investments to finance margin requirements needed for their derivative bond strategies, which have been extensively used to increase income generation to their liabilities to pensioners;
- During the Eurozone crisis, central bankers and government officials promised to do whatever it took to preserve the Euro – this time, with remarkable similarities, the Bank of England said it would arrest a bond market crash by purchasing government debt at “whatever scale is necessary.” History doesn’t rhyme but…..;
- As energy prices continue to hurt consumers, and variable rate mortgages are resetting at higher levels, many European governments will likely have to spend significant sums this winter in subsidising energy bills, which will not improve any of their precarious budgetary situations and likely keeps Sterling and the Euro under pressure in the medium term;
- One measure that would certainly improve the UK’s fortunes, although may well be an electorally unpopular strategy, would be for the UK to once more return to being an energy exporter, and dramatically reduce domestic inflationary pressures, improve export revenues and by extension Sterling’s fortunes too.
KAMIKAZE KWASI
Last week the new Chancellor Kwasi Kwarteng announced a “mini-budget” package with a variety of tax cuts, subsidies, and benefits designed to ease the current economic pain felt by consumers. Some of it has been rather breathlessly compared to Reagan and Thatcher policies, which is perhaps stretch of the imagination, although what has transpired in recent days certainly is historic. However, to put into some context, we now have onc more interest rates in the UK which mirror those of last seen in 2012.
CHART: Spike in UK government yields (compare to Italian bonds)–.
The market reaction was to push the Pound sharply lower, within a few percentage points of parity with the US Dollar. Investors globally took the view that the new program will drive government deficits much higher, worsening inflation and pushing interest rates up even more. That interpretation sparked a flight out of the Pound, meaning that investors have little faith that the planned tax cuts and other growth provisions will ultimately succeed. Traders are wont to shoot first, and ask questions later, particularly in an environment where any sense of ‘fiscal largesse’ on the part of governments, is judged harshly by global markets.
The Pound has staged a small recovery as at the time of going to press, particularly given the UK government was forced into a humbling volte face and walked back the cut to the top rate of tax. However, energy subsidies are a political must and remain in place. In relation to UK government bonds, they remain under pressure as highly leveraged pension funds are now scrambling to cover the derivative positions that were being employed to generate higher yields, undertaken whilst government bonds had offered such paltry income streams until very recently. The abrupt rise in interest rates caused significant losses in those positions, meaning pension funds were forced to shore up their exposures by selling their UK government bonds amongst other holdings. That put further pressure on Gilt prices, to the extent the Bank of England was compelled to step in as buyer of last resort.
A HANGOVER THAT’S BEEN LONG OVERDUE
Over a decade of quantitative easing, compounded by the zero interest rate policies (ZIRP) and even negative rates in some countries, has had a myriad of investment consequences – notably forcing pension funds to adopt derivative strategies to try to generate additional income in lieu of that which has historically been provided by traditional safe haven investments such as government bonds. Other consequences have been the pernicious ill effects of such policies, presented in the increase in wealth disparity and widening of the distance between upper- and lower-income groups.
CHART: Fall in UK real incomes since 2008
Whole economy total pay deflated by CPI
Source: ONS, FT calculations – October 2022.
Whilst many voters in the UK, and more broadly across the world, may not have been running the numbers, they have had an acute sense of how since the 2008 global financial crisis, their earnings have simply not caught up with the increase in living costs. As demonstrated by the chart, the recent market pyrotechnics may consign the UK population to another decade before they will see their incomes regain the purchasing power they had in the run up to the GFC.
Of course, before governments and central banks could gradually normalise monetary policy, and being to raise interest rates, COVID struck – ultimately reducing the work force by virtue of the ‘great resignation’. Thereafter, pent up consumer demand unleashed by lockdowns only served to exacerbate the inflationary burst. Supply chain disruptions further muddied the business cycle waters, before the increase in food and energy prices driven by the Ukraine Russia war. Given such a combustible mix of factors, and how far government finances have been stretched, a currency crisis being one symptom of the ‘morning after’ or the deterioration of public finances, is hardly surprising.
WHATEVER IT TAKES
‘Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough’. So went the immortal lines as delivered by Mario Draghi in 2012, the president of the ECB, which went some significant way to averting an even bigger eurozone crisis – notwithstanding the depression that the Greeks endured thereafter.
A decade on, (Super Mario’s protestations did buy time), and confidence once more is shaken in the Eurozone, with Italian government bonds trading very poorly and the ECB caught between rate hikes in response to inflationary pressures, and attempting to cap those rising yields from damaging the recovery in the peripheral eurozone economies. Ultimately, much of the financial system reduces to confidence or faith in the ability of institutions to survive.
These past few days have seen the Bank of England engaged in a similar exhortations, claiming that it would stand firm as the buyer of last resort, ‘at whatever scale necessary’. That has bought a few days respite in bond markets, but investors will ultimately need more comfort than this – comfort that will need to come from a governmental response, not a monetary one from the UK’s MPC. The BoE is caught in an impossible position – by seeking to keep financial stability, and intervening, it was then accused of an embarrassing U turn, as their support was seen as re-initiating new monetary stimulus or quantitative easing programs, days after having announced these programs were to be run to ground. Ultimately, a long standing solution will require much greater collaboration between the UK government and the Bank of England that has been the case hitherto, a more coherent approach and measures that will be credible in the eyes of global investors.
THE SUN DID SET ON THE BRITISH EMPIRE
The UK is an order of magnitude bigger than the peripheral Eurozone economies that were the epicentre of the 2012 Euro crisis. It runs large fiscal deficits (as a country it spends beyond it means), just like the US does, but Sterling, unlike the US Dollar, is not a global reserve currency – not since the US Dollar took that mantle after the Second World War. That means that whilst the US can spend more than it earns, with relative impunity, given the ‘exorbitant privilege’ of the US Dollar being the lingua franca of the global monetary order, clearly the UK does not have the same luxury as has been seen in the loss of confidence in the currency and its sovereign debt.
Higher interest rates in UK government bonds matter because it causes a repricing in credit generally – more expensive credit cards, car loans and notably mortgages – at one point several large lenders in the UK withdrew mortgage products from the UK housing market last week. Mortgage lenders need to borrow from wholesale money markets and/or use deposits, in order to lend for home purchases, and funding sources simply became prohibitively expensive. Public frustration is quite understandable – higher living costs (energy, food prices and borrowing costs), impact those lower income groups the most. Conversely, years of quantitative easing which boosted stock markets benefit the higher income groups the most. This is a highly politicised issue, and Liz Truss’ government will have to walk a fine line between providing further economic support and not causing further market turbulence. Whilst the Tories simply can’t afford another leadership battle, it’s likely that the Chancellor is on borrowed time.
POLICY PREDICAMENT
The commercialisation of shale oil in the US ushered in cheaper energy prices, improved economic fortunes, jobs and energy independence. It was one of the pillars of the bull market in equities during the ‘teenies’ – being 2014 onwards. Moreover, energy independence continues to deliver competitive advantages of its peers – it has been relatively less impacted by Russia’s aggression and the subsequent hike in European energy prices. (Europe pays nearly 8x what the US does for its natural gas, which powers much of industrial economy and renders many of its companies simply unviable when faced with such input costs).
CHART: Comparison of US versus EU natural gas prices paid
Until 2004, for the previous 25 years, the UK was actually a net export producer on account of North Sea oil and gas production. Growing domestic demand, trade restrictions and environmental policy mean that is no longer the case. However, proven reserves are still significant – if policy could be changed to increase energy production, it would go some way to structurally addressing some of the economic issues that it is currently beset by. Energy independence, high paying jobs and a currency backed by real assets, rather than simply the palliative words of a central banker could all result.
STERLING SILVER LININGS
For all the grave headlines, a sterling US Dollar exchange rate at 1.00 or parity, we feel would probably have priced in most of the bad news, and we would be surprised to see any weakness beyond that. In fact, it would likely offer an interesting buying opportunity in the British Pound. By the same reasoning, after a decade of unappealing yields, UK Gilts offering a return of over 4% per annum, are beginning to look very attractive. Investors, (in particular savers), have been forced to take on equity risk for much of a decade for lack of a better alternative, and whilst tumultuous, the recent ructions in the gilt markets do have a silver lining – finally government bonds are priced to more accurately reflect the investment risks they entail.
Moreover, perhaps current geo political and economic circumstances are such that certain changes to environmental policies may now be socially or electorally acceptable, meaning that the UK’s energy resources prove to be an asset, a national balance sheet item to lean on rather than seek to trade away, which would not only support Gilt prices, national security concerns, but would likely reframe global investors’ view of the Pound too. We wonder if amid the gloom the tide is already turning – a study conducted by Drax and Imperial College, earlier this summer showed that for the first time in over a decade the UK became a net exporter of electricity (to Europe). The electricity exports generated £1.5bn in earnings – transported via sub sea connectors. In our humble opinion, UK Government announcements which detail investments into new generation of pumped storage hydro plants, allowing Britain to become the battery to Europe, would be better received from investors than ‘kwamikase’ right wing Tory tax cuts.
