Ill-fated mini-Budget sparks torrid couple of days for markets

September proved to be seismic month for the UK as the nation mourned the passing of its longest reigning head of state. During her Majesty Queen Elizabeth II’s reign, commerce progressively shifted from tangible to intangible assets, factories to offices, much improved labour flexibility and working conditions. This combined with the development of the relatively new National Health Service and improved nutrition saw life expectancy rise by seven years. All this was accompanied by an ever-expanding range of technology, entertainment and comfort. The modern Elizabethan age!

What is happening in the UK

Not only were there dark clouds of mourning, the economic situation deteriorated sufficiently to merit pause for reflection with the wrestle with inflation here in the UK and elsewhere, the major influencing factor. Topping off a period of many new headlines Liz Truss became Prime Minister but didn’t have the honeymoon period she would have hoped for following the new Chancellor, Kwasi Kwarteng’s, ill-fated mini-Budget and the uncertainly that this unleashed on the UK government bond market.

The reasons for the backlash to the government’s plans to both limit energy costs and stimulate growth are many and varied but can be simplified as this – when borrowings rise typically attention needs to turn to increasing tax takings not reducing it. The absence of a report from the Office of Budget Responsibility to accompany Kwarteng’s plans added to investor pessimism, culminating in a torrid couple of days for markets where the pound plunged to record lows against the dollar and gilts sold off.

To avoid systemic risk in the pensions sector (specifically the liability driven or matched pensions industry) as a result of the bond market moves, the Bank of England had to announce a significant bond buying programme in contrast to their general aim of owning less government bonds. The move, which bore many of the hallmarks of quantitative easing, could have been interpreted as a loosening of monetary policy which would reduce bond yields. Whether this reflects a period of greater pragmatism in monetary policy mid taming inflation remains to be seen.

Caught off guard by the market reaction and with the Tory conference looming, Kwarteng yielded to pressure and scrapped plans to cut the 45% income tax rate. He claimed the policy had become a distraction from other growth plans announced in the mini-Budget. These included reducing the basic rate of tax to 19%, reversing the National Insurance increases brought in under Rishi Sunak, and scrapping planned hikes to Corporation Tax.

With greater understanding of balance not only from a popularity point of view but also with tax collection in mind, the pound has since recovered, and the bond market has stabilised. However, in the round, mortgage rates remain at elevated levels, adding to pressures on households already struggling with the wider cost of living crisis.

Eyes will be on the Q4 corporate earnings and growth forecasts for clues

It is worth making the distinction between this sort of uncertainty and volatility and what we might generally see in stock markets. Of course, macroeconomic factors are inevitably an immediate headwind for all, but a meaningful driver for profitability of companies is investment, change and self-help all of which lies in the control of the company. Over the long term, the value of companies should gravitate around their ability to generate profits.

Changes in interest rates make the hurdle rate for buying that stream of profits more or less expensive depending on direction. The declines in prices we have seen this year have primarily been driven by macroeconomic factors and the immediate impact; the likes of Nike reported slowing sales in China (COVID lockdowns etc) and increased inventory levels as they struggle to sell their wares without increased markdowns. Meanwhile, FedEx – considered a bellwether of global growth – has seen shares plunge over 20% as shipping volumes fell with China and macroeconomic factors influenced. As we move into Q4, investors will once again be eyeing corporate earnings and growth forecasts for clues as to the trajectory of the global economy and future monetary policy from the Federal reserve and other central banks.

What is happening in Europe

Away from monetary policy change being implemented the most obvious source of instability remains the Russia/Ukraine conflict and the supply of energy to the European markets over the winter period. The sabotage of the Nord Stream pipeline underscores this and raises concerns that other pipelines could be targeted to further squeeze European states struggling with energy security as they head into what is likely to be a challenging winter. European countries have filled gas storage as much as possible and Germany has begun hastily constructing gas import terminals, but European member states are also being asked to each reduce gas consumption by 15% to try and balance the supply and demand.

One of the key energy suppliers will be the US, which has plentiful reserves of gas and oil. The European economy is more sensitive to gas prices, whereas the US is more sensitive to oil. Europe is reliant upon imports of energy, whereas the US has seen the value of its energy exports almost double from its pre-pandemic level. Access to cheaper energy gives US companies an advantage over their European counterparts. It is one of the factors driving the dollar higher against most other currencies.

What is happening in the US

The US economy is experiencing an acute shortage of labour, prompting the Federal Reserve to raise interest rates sharply. US consumers also benefitted from pandemic savings which were inflated by emergency payments and the Biden administration’s plans to relieve US students of a share of the debt burden that is built up through loans. Government generosity can help to boost growth, but when there are shortages of labour or materials, these giveaways are more likely to translate into higher inflation. These, in turn, must be offset by higher interest rates. Federal Reserve chairman Jay Powell came close at the central bank’s September meeting to conceding that a recession would be necessary to tame inflation.

The year has been a difficult one so far for investors. Higher interest rates weigh on the prices of company shares and, although the economy has performed well, interest rate expectations continue to rise. These episodes come at the end of economic cycles and can drag on frustratingly because interest rates are slow to shape consumer behaviour. But as these begin to take effect, it is hoped that a rebalancing of supply and demand will take shape and interest rates will hit their peak, shifting the focus back to company fundamentals as a driver of returns.

Written and prepared for Crowe Financial Planning UK Limited by John Moore (Senior Investment Manager at Brewin Dolphin)