When Kwasi Kwarteng stood up to present his “mini budget” (aka “Growth Plan”) on 23rd September, he was unlikely to have considered quite how dramatic the Financial markets response would be.
Pulling in opposite directions
Meanwhile, the Bank has continued to warn of higher inflation on a CPI (Consumer Prices Index) basis, raising its estimate for the peak from 10% to 11% for October. Inflation is then expected to fall back, although higher oil prices of late could mean it proves stickier. It is likely that the old measure of RPI (Retail Prices Index) will peak at around 13%.
There are a few reasons why investors found this mini-budget so unsettling. The government is focusing on economic growth at a time when the Bank of England is trying to slow the economy down – predominantly through interest rate increases. The Bank recognises that the economy is operating at full capacity and if it accelerates from here it will generate more inflation, rather than improve living standards. As a result, the Bank of England and the Treasury risk pulling in opposite directions. Because the economy is operating at full capacity, the government is unlikely to achieve its 2.5% growth target particularly soon – and that means lower tax revenues at a time when the government is already borrowing too much.
Another reason why markets reacted so poorly is that the government’s borrowing costs are likely to increase. Bond prices tend to fall when interest rates rise. When bond prices fall it means their yields rise, and these form the minimum long-term interest rates for borrowers in the UK. This raises the cost of borrowing over long periods of time.
The government is focusing on economic growth at a time when the Bank of England is trying to slow the economy down – predominantly through interest rate increases.
Increased Borrowing and Spending
In the days following the “mini budget” we witnessed the pound plummeting in value – particularly against the US Dollar, and Gilts (UK government bonds) falling at such a rate that the Bank of England were forced to step in, buying Gilts at “whatever scale is necessary” to help restore orderly market conditions.
For now, the actions taken by the Bank of England seem to have calmed the markets and we have seen a stabilisation in bond prices and an improved strengthening of the pound against the dollar. However, bond prices are likely to come under further pressure in the weeks and months ahead as the government will be borrowing more money and with increasing interest rates, this borrowing will cost more to service.
In the coming years, the sheer volume of new borrowing and the higher rate of interest on those loans could push yields up further still. This extra borrowing – made in a way which will not generate much growth, would need to be offset by higher interest rates, and is in pursuit of economic benefits which many are sceptical of – is why the markets were so rattled.
For now, the actions taken by the Bank of England seem to have calmed the markets and we have seen a stabilisation in bond prices and an improved strengthening of the pound against the dollar.
The Impact on Global Markets
Whilst the Chancellor’s speech caused an element of consternation, particularly in the UK, the real issue globally is inflation. Since the start 2022, we have seen almost every major global stock market falling. At the time of writing the S & P 500 & the German DAX are both down over 20%, the Shanghai Composite & CAC both down c17%, and the FTSE 100 & Nikkei 225 both “relatively” unscathed with a mere c-7%. The backdrop for this is Investors fear a recession as central bankers take a hard line against inflation, looking to cool the economy by raising interest rates. Stocks have whipsawed all year, tracking shifting forecasts for inflation, interest rates and growth. This, at a time when bond prices are falling (caused by increasing interest rates), has meant that client portfolios, that are largely made up of a combination of equities and bonds, have also fallen.
We were for some time concerned that inflation was coming, but the central banks around the world were too slow to increase interest rates believing that inflation was “transitory”. When it became apparent that it was not, the hiking of interest rates commenced. The hangover from the Covid supply chain issues, the War in Ukraine and China’s zero covid policy have all added fuel to the “inflationary fire.”
In America, the US Federal Reserve has been more aggressive, with larger interest rate increases than other central banks and we are hopeful that their actions could avoid a deep recession in the US. They are largely insulated from some of the inflationary factors that the UK and to a greater extent, Europe are exposed to, as they are almost entirely self-sufficient in oil. Those countries that do not have the same natural resources will be more exposed to the inflationary impact of increasing energy costs.
In general, we believe that high degrees of volatility will remain in Global markets until such time as the increase in interest rates by central banks has the desired effect, and they start to see inflation reduce. Until then, we would encourage investors to stay calm.
Markets by their very nature go up and down and it is very easy to panic and sell out at the wrong time. If history has taught us anything it is that, in time, markets do recover from downturns and in the long run, a well balanced and diversified portfolio provides better than cash / inflation returns – albeit it is necessary to tolerate periods of downturns along the way.