What a Carry On

‘Infamy, Infamy they’ve all got it in for me’

The classic line by Kenneth Williams as Julius Caesar in ‘Carry on Cleo’, but no doubt how Kwasi Kwarteng is also feeling today.

Given their calamitous start, the pressure is building on Kwasi and PM Liz Truss. However, it is not ‘Carry on Kwasi’ as he has been forced into making an embarrassing U-turn and is abandoning the plan to abolish the top rate of tax for the highest earners.

The mini budget mayhem is already being compared to the 1972 ‘dash for growth’ budget and the 1992 ‘Black Wednesday’ Sterling crisis, when the government was forced to withdraw from the European Exchange Rate Mechanism!

Confirming a cap on energy costs and a tax cutting budget, the good news message was lost in the market’s reaction.  The government received a rebuke from the IMF, something more akin to a developing country and not a leading member of the G7 while the Bank of England was forced to launch an emergency rescue Gilt purchase package to protect some UK pension funds.

The mini-budget led to a spike in bond yields and an initial collapse in Sterling, relative to the Dollar, as global investors became concerned about the level of government borrowing. Interest rate expectations have been revised upwards as the Bank of England is expected to have to be more aggressive with rate hikes. As a result of the bond market volatility and a spike in long-term Gilt yields above 5%, UK mortgage lenders quickly withdrew 40% of their products.

The average UK household will not fully understand the intricate workings of the global financial system. With prime-time news dramatically pointing to a financial meltdown, it was an unnerving 48-hours.

What a start for Liz Truss! Some opinion polls have put Labour as much as 33 points ahead of the Conservatives implying a Labour landslide if there was a general election. However, it is worth remembering that it is not just the UK suffering from the cost-of-living crisis and higher interest rates, as reflected by election results from Sweden and Italy with a shift to the far-right.

Huge pressure is now on Kwasi Kwarteng and by default, the Government.  Kwasi has to come up with sensible spending plans that show debt will not balloon under his watch. The key date now is 23rd November, when markets may pay more attention to the positive elements of ‘Truss-economics’ – such as supply-side reform and pro-growth tax adjustments. However, that seems a long time off and global investors are not that patient. In the meantime, higher borrowing costs, falling house prices and public spending cuts don’t sound like great vote winners.

What a right ‘carry-on’, except nobody is laughing.

What have we been watching?

What a week! One that will go down in history! The financial headlines just got worse and worse for Liz Truss and Kwasi Kwarteng with a rebuke from the IMF and emergency action in the gilt market required from the Bank of England!

While Sterling and UK interest rates dominated domestic news headlines it is worth bearing in mind that it is not just the UK facing a cost- of-living or currency crisis and there has been a global sell-off.  Italy shifted towards the far-right while China also saw its currency weaken. Dollar strength has been most noticeable and reflects a shift to safer havens as interest rate hikes trigger recession although the hope is that this is still mild and shallow. The market mood was not helped by sabotage attacks on the Nordstream 1 and 2 gas pipelines and news that Gazprom is to sanction Naftogaz, the remaining gas pipeline from Russia to Eastern Europe. European and UK gas prices jumped on the news but have since drifted back.

President Putin announced the annexation of four more occupied regions of Ukraine as a means of vindicating its special military operation and consolidating patriotic support for the conflict. The key question now is what will he do if the Ukrainian offensive carries over into this region? Would he resort to tactical nuclear weapons? Hopefully he will not but, another source of angst for global investors nonetheless as Putin is backed into a corner.

Read our latest UK investment insights from Alpha PM

 

The Bank of England (BoE) and Treasury rushed to calm market turbulence after Sterling hit an all-time low against the Dollar. The BoE issued a statement saying it would ‘not hesitate to change interest rates’ to keep inflation under control. Huw Pile, BoE Chief Economist said ‘it is hard not to draw the conclusion that recent market uncertainty will require a significant monetary response.’ Meanwhile, the new Chancellor Kwasi Kwarteng said he will now set out a new fiscal strategy on November 23rd, with the Office of Budget Responsibility (OBR) announcing an independent set of forecasts on the same day. In a move which felt akin to an emerging economy the IMF said it was closely monitoring the situation in the UK and does ‘not recommend large and untargeted fiscal packages given elevated inflationary pressures.’ Credit rating agency Moody’s stoked the fire by lowering the UK’s economic growth rate for 2023 from 0.9% to 0.3% suggesting large unfunded tax cuts are a credit negative event.

Having hit an all-time low of $1.035, Sterling rallied off this low to $1.12 on the expectation of a bigger hike in interest rates. Short Sterling futures have interest rates at 4.88% by the end of 2022. At one point, futures were indicating 6.7% peak rates by May 2023 but this has since eased to 5.9%. UK gilts also suffered with yields leaping with the 30-year at one point hitting 5% as the risk premium to hold UK assets continued to rise, along with concern about debt issuance given tax cuts. This forced the Bank of England to take action given the repricing affecting long-dated UK government debt. This was also required to support the $1.5trillion Liability Driven Investment market, where derivatives are used to hedge long term pension liabilities and enhance returns. To restore orderly market conditions, it is carrying out temporary purchases of up to £65bn of long-dated UK government bonds from 28th September until the 14th October. So, after a mini-budget we have mini-QE! Isn’t QE inflationary? The previously intended £80bn QT programme has been postponed until 31st October. The 30-year Treasury yield had eased back to 3.81% by the end of last week from 5% on the BoE action but what will happen between the 31st October and 23rd November remains to be seen -will further support be required?

 

In Europe, the cost-of-living crisis continues to be reflected in voter action. Following the recent election result in Sweden, it appears Italy has also shifted towards the far-right. Giorgia Meloni will have to form a coalition but her victory looks to be a challenge for the EU and could be problematic alongside Hungary and Poland, particularly when it comes to migration, let alone Russia and sanctions. Meanwhile, inflation in the eurozone touched a new high of 10%, with Germany at 10.9% and the Netherlands at 17.1%. This reflects higher energy costs with inflation in France at 6.2%, helped by subsidies. The inflation data will keep the pressure on the European Central Bank to maintain its ‘hawkish’ rhetoric.

 

One of the reasons for Dollar strength relative to Sterling has been the Federal Reserve’s (Fed) more aggressive pace of interest rate hikes. Interestingly, US interest rate futures have rolled over from indicating a peak interest rate of almost 4.7% to under 4.5%.

Read our latest Chinese investment insights from Alpha PM

 

China is also suffering from currency weakness with the renminbi is on for its largest annual drop since it switched to a floating exchange rate in 2005. The World Bank has cut its economic growth forecasts for China suggesting the pace of expansion in the economy will lag behind the rest of Asia for the first time since 1990.

Read our latest investment insights from Alpha PM

 

Brent oil held edged up to $89 despite the deteriorating global economic outlook.

Finally, following our previous Alpha Bites on global supply chain security an interesting example of the shift now underway. Apple has started making its iPhone14 in India as it diversifies its supply chains away from China. Xi Jinping’s zero tolerance Covid-19 policy and ongoing regional lockdowns have probably not helped. Good news for India but perhaps even more pressure on China to stimulate its own domestic consumer sector and reduce the economy’s reliance upon manufacturing?

 

Read Last Week’s Alpha Bites – The Bear and Trident

 

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