AJ Bell press comment – 17 October 2022
- Short-term success will not cancel out the medium and long-term challenges that remain for the government
- Fall in gilt yields a reprieve, but inflation and recession still loom
- £2.4 trillion national debt and weak pound pose significant longer-term difficulties for the UK as a whole
Russ Mould, investment director at AJ Bell, comments on the near-term, medium-term and long-term challenges that still face the UK government following Hunt’s statement today:
“New chancellor Jeremy Hunt will be pleased to see the FTSE 100 rising, the pound gaining against the dollar and the euro, and gilt yields falling in response to his new policy salvo. Achieving some degree of near-term calm is a good thing, but neither Mr Hunt nor prime minister Liz Truss can rest on their laurels. The medium-term challenge of navigating a path between recession and inflation remains and then come the long-term tasks of picking sterling off the floor and managing the nation’s £2.4 trillion national debt.”
Near-term: firm numbers may bring some calm
“A drop in the benchmark ten-year gilt, or government bond, yield will be welcomed with a sigh of relief in Downing Street, the City and the households of the UK, as this could bring some relief to stressed financial markets, pension fund managers and those who are worrying about the mortgage bills. The yield on 2-year and 30-year government debt is also falling today.
“However, the yield on all three is still above where it was before former chancellor Kwasi Kwarteng launched his fiscal event on 23 September, so markets will still be looking for some clear, well-costed tax and spending plans, as well as the Office for Budget Responsibility’s independent verdict on 31 October.”
Source: Refinitiv data
Medium-term: inflation versus recession
“Moreover, yields on government debt are still way higher than they were a year ago. This reflects the medium-term challenge which faces both the government and the Bank of England who, between them, have to try and steer the UK between the twin dangers of inflation on one hand and an economic slowdown or recession on the other.
“Inflation is running at 40-year highs. As a result of that, bond investors were already charging the UK government more to borrow. They are now demanding an even higher interest rate – or gilt yield – to compensate themselves for the perceived increase in risks, relating to political turbulence, a worsening economic outlook and a wobbly currency. Mr Hunt may be able to reassure on political stability, especially as he is already in active talks with the Bank of England, and governor Andrew Bailey will have his role to play, especially as the Monetary Policy Committee’s erroneous call that inflation would prove transitory has left it playing catch up.
“The base rate is 2.25%, yet inflation is 9.9%. Now that is based on the CPI, introduced in 1997 and with a backdated history to 1989. The retail price index, or RPI, is no longer an officially recognised statistic but we have data here to 1948. RPI inflation is currently 12.3% year-on-year and it last reached this point in early 1981 when the Bank of England base rate was 12%.
Source: Bank of England, Office for National Statistics, Refinitiv data for future interest rate trajectory estimates
“Markets are currently pricing in a Bank of England base rate of 5.25% next May and rapid increases could yet slow down an indebted economy and shackle the mortgage and housing markets.
“Mr Hunt’s scrapping of several planned tax cuts may ease inflationary pressure but could in turn raise the risk of lower consumer spending and corporate investment, especially as pockets and profit and loss accounts face a range of cost increases including energy, food, mortgages and, in the case of companies, wages.”
Long-term: soggy sterling and monster debt burden
“Although it can be argued that the short-lived Truss-Kwarteng axis badly misjudged September’s fiscal event, they did not necessarily create the long-term problems which prompted markets to react so violently.
“The pound trades near historic lows because the UK runs an annual budget deficit and an annual current account deficit, because we spend more than we earn, and we import more than we export respectively. As a result, pounds are always flowing out, not in, and a weak currency is a logical result of that. It remains to be seen how the OBR thinks both deficits will look in fiscal 2022-23, but anything north of 5% to 6% for both are figures that would embarrass an emerging market, not a purportedly developed once such as the UK, and ones that leave the UK reliant upon external funding for its needs.
“The UK needs to keep the debt and currency markets sweet because if they turn their backs, then an emerging-market style debt crisis, to match that of say East Asia in 1997 or Greece in the 2010s beckons and on each occasion the IMF swept in with austerity plans.
Source: Refinitiv data
“The final elephant in the room is the UK’s £2.4 trillion national debt. The prime minister and former chancellor Kwarteng could be forgiven for thinking that £45 billion to £60 billion of tax cuts (with the energy price support package on top) looked like small beer in comparison and would thus pass through easily. But rising interest rates and rising gilt yields – with the prospect of further advances to come if inflation stays sticky – mean that there is no free lunch here now. The government’s own interest bill is rising sharply, at a rate of some £25 billion for every one percentage point on gilt yields according to another former chancellor, Rishi Sunak, and it needs to try and find a solution.
“Mr Hunt must reassure lenders (gilt holders) that tax and spending plans do not involve more living on the never-never and airy-fairy promises of paying lenders back later, especially because the £2.4 trillion national debt already leaves the UK with interest bills so big that they are a burden on growth and investment.
“There are five ways out of such a debt dilemma: default and stop paying the interest; start a war; inflation; collapse the pound; or grow the economy. Growth is the best option, and that was the Truss-Kwarteng plan, but it is the hardest to achieve. The government seems to be going down the inflate and crush-the-currency routes, whether it means to or not, but that is a path fraught with danger as it risks a loss of confidence among, and support from, gilt holders.
“If gilt yields start to rise due to a fresh loss of confidence, then the Bank of England might have to step in once more and start buying to try and cap yields, in another UK policy U-turn, since Bailey and colleagues are now committing to Quantitative Tightening and a plan to sell £80 billion a year of gilts, rather than buying more.
Source: Bank of England
“Logic would suggest that benchmark gilt yields could still creep higher. Inflation is running way, way ahead of the ten-year gilt yield, the national debt is still growing and the Bank of England, the single biggest buyer of UK government paper over the last decade, is about to become a seller.
“If there is a saving grace for Mr Hunt in the short term it is that the gilt market may have been characterised of late by distressed selling by pension funds in search of liquidity to meet their Liability Driven Investment strategy-related liabilities. Distressed sellers usually depress prices in their panic to raise cash, so it could be that Mr Hunt gets a period of grace while he prepares for 31 October and the next challenge.”
