On the face of it, Chancellor Kwasi Kwarteng’s Plan for Growth shouldn’t have taken markets by surprise. After all, he was simply following through on promises made during Prime Minister Liz Truss’s campaign for the leadership of the Conservative Party.
True, he did pull a few rabbits out of the hat. Every Chancellor likes to, and his were politically eye-popping, for sure. But measures like abolishing the 45p income tax rate will cost the Treasury tuppence compared to his well-telegraphed plans to reverse Rishi Sunak’s rises in national insurance contributions and corporation tax – not to mention the uncapped liability of the energy price ceiling, an enormously costly policy that was widely anticipated, broadly welcomed as anti-inflationary and mimicked across Europe in one flavour or another.
The shock of a politician honouring a promise?
So wherefore the market gasps? Were investors simply aghast that Truss and her team were governing with the same, unadulterated poetry with which she had campaigned? Had they expected a diluted budget of half-measures and been taken aback by the sheer honesty of her ploughing ahead?
It is certainly a possibility. Others point not so much at the plan itself but instead the mood music. During the weekend that followed his ‘mini’ Budget, Kwarteng seemed to give the impression that he was only just getting started: more tax cuts would follow.
In failing to pay so much as lip service to fiscal prudence, they argue, he rattled those who would lend to the government – who were seeking a repayment plan less reliant on the mere hope of growth.
Decoupling from depressive projections
By declining to share forecasts from the Office for Budget Responsibility (OBR) when presenting his growth plan, the Chancellor perhaps unwittingly signalled a disinterest in balancing the books – verging on insouciance.
Yet, to him and Truss, this omission was seemingly more intended as a statement of intent to pursue growth-orientated policies unconstrained by the OBR’s modelling, which – truth be told – has been consistently pessimistic.
Kwarteng’s belief is that the Treasury should no longer kowtow to dour technocrats. Unfortunately, investors didn’t see it that way.
It could so easily have been different. Not all of the Plan for Growth was so controversial – proposals for investment zones, for instance, and the reform of onerous regulations in order to unblock moribund supply chains were broadly welcomed.
Far less costly to implement (and arguably more urgently needed) than cuts to income tax, these simplifications and relaxations sounded all the sweeter to investors in government debt. We wonder what the market response would have been had these elements been fleshed out in more detail and taken pride of place in the Chancellor’s announcements, with the fiscal belt loosened more gently over time.
Indeed, the very fact that the UK remains quite so vulnerable to external shocks such as energy prices is a plausible explanation for why such slight differences come to matter so much. If you’re standing on the edge of a precipice, a single misstep can be disastrous.
And then there are the unforeseen, snowballing consequences: as UK government bonds (gilts) sold off, pension funds were forced to sell portions of their vast holdings, especially those linked to inflation. This was necessary in order to meet obligations to banks that had provided them with risk-mitigating insurance.
With miserable irony, this insurance – intended to guard against volatility – ended up forcing pension funds into a vicious cycle, as falling prices begat the need to sell more.
We can only hope that such dreadful feedback loops will be prevented in the future. For now, the Bank of England has stepped in to act as the buyer of last resort. Frankly, the Bank had little choice.
But this intervention marked a dizzying volte face – only the week before it had been selling the government debt it had accumulated throughout the preceding decade of quantitative easing.
Unfortunately, then, monetary policymakers find themselves exacerbating inflationary pressures, rather than relieving them. This contradiction further added to investor jitters.
Battle of ideas
Ultimately, what we are seeing is an ideological conflict on display between the government and the Bank of England. The latter is being press-ganged into the higher interest rates that the former sees as necessary to end the decade or so of productivity plateau.
The conflict has already wrought collateral damage in the form of withdrawn mortgage offers and considerable alarm among homeowners faced with the prospect of spiking interest rates.
In itself, this could be enough to outweigh any of the Chancellor’s giveaways and reforms. And after all, tax cuts funded by borrowing can only be successful if the (hard to quantify) gains outweigh the interest rates charged by lenders, which have soared.
In short, the very announcement of Kwarteng’s plan upended the assumptions upon which it had been founded.
Beware uniformity of opinion
And yet, there is still a route by which the government might succeed. In all of this near universal opprobrium, we should recall that, back in 1981, when inflation was also in double-digits and central bankers were hiking interest rates to tame it, 364 economists wrote a letter to The Times decrying the policies of the Thatcher government, insisting that Geoffrey Howe’s Budget would only exacerbate economic problems.
That confident consensus proved spectacularly wrong. Might history repeat itself?
If Truss and Kwarteng can somehow inspire investor confidence and put a lid on market volatility – especially in UK government debt – then it’s not completely beyond the realms of possibility that their Plan for Growth may bear fruit.
With natural gas and crude oil prices tumbling – particularly as a consequence of a relatively unnoticed economic slowdown in China – external inflationary pressures are subsiding.
Road to recovery
Domestic pressures remain, not least of which the labour market, which remains uncomfortably tight. Record low unemployment is not, unfortunately, an achievement to be touted, because it has arisen due to people leaving the workforce.
About half of this effect is attributable to sheer demographics: people are getting older and retiring in an entirely predictable way. But the other half seems to be down to a concerning rise in the numbers of long-term sick.
Is this long-COVID? Some studies have suggested that such a malaise may be, at least in part, in the mind. Perhaps instead we are seeing the debilitating effects of anxiety, as the mental health cost of lockdown. Or, maybe, the troubling side-effects of lengthy NHS backlogs, as minor complaints turn chronic.
Whatever its true cause, there’s good reason to believe the situation will ameliorate over time. And as it does, inflation should ease back down.
Bowing to demand
If this happens fast enough, the government’s ideological conflict with the Bank of England might come to a peaceful conclusion. Free of the need for punishing interest rates, the Plan for Growth would have a far better chance of working.
These are big ‘ifs’, however. There is a chance that market volatility – or indeed political pressure – becomes so great that the Chancellor’s tax cuts never see the light of day. Damage to the UK’s policymaking credibility would not be easily reversed, but gilt yields would then likely fall back down much of the way.
By way of good news, recent GDP figures have shown that the UK is not in recession – at least, not yet. The bad news is that the economy still hasn’t recovered ground lost during COVID – the only G7 economy yet to fully convalesce. The Chancellor’s 2.5% GDP growth target looks increasingly unrealistic.
What does this mean for investments?
Finally, some perspective. As deeply concerning and relevant as the UK’s economy is to us as citizens, it matters far less to a sensibly diversified investment portfolio. In fact, the depreciation of the pound has translated into a much needed offset for foreign equities, which have declined a fair bit in their own local currencies but barely at all in terms of sterling.
And as for fixed income? We are increasingly glad to have offloaded almost all the long-dated government debt in our Global Tracker Portfolios back in the summer. Since then, long duration UK gilts have shed over a quarter of their value.
It’s worth emphasising that we took that action not out of any conviction that we knew what the future would hold. Rather, our prudence is flattered by the look of prescience.
In other words, we stuck to our rigorously objective asset allocation methodology. The evidence pointed to the significant risks of holding on to highly interest rate-sensitive bonds. We sold them even though it meant locking in losses (the temptation might have been to hang on or even double down in the hope of a recovery).
It’s a great example of how following the science, not emotion, when investing leads to better long-term returns and lower risk.
More generally, with so many gloomy prognoses about, we are reminded that the most unhappy times to invest usually turn out, in hindsight, to have been the best.
Past performance is not a guide to future returns. Please note that the value of investments can go down as well as up, and you may get back less than you originally invested.