What are we talking about? The situation in the UK remains…fluid. We wanted to take stock of events over the past two weeks.
What have we seen? Quite a lot! Here’s a quick selection
1. On September 28th, The Bank of England stepped in to back-stop the gilts market “on whatever scale is necessary to [restore orderly market conditions]” – and has introduced a new mechanism this morning
2. The Chancellor and Prime Minister announced that they wouldn’t abolish the 45% top tax rate, saying it had become a distraction.
3. Two ratings agencies have put the UK on a negative watch for a potential credit downgrade
4. The IMF came out to raise concerns over the direction of UK fiscal policy
5. The Conservative Party conference highlighted the divisions within the party over the direction of policy. Commentators are speculating whether the Prime Minister will survive in office.
6. According to opinion polls, the Labour party has opened a 30-point lead over the Conservatives.
What can we say about all of this? There are a few points worth making.
First, and most obviously, the Bank of Englands response highlights how much pressure some market participants are under. The challenges facing so-called “LDI” funds have been well-documented in the press in recent days – highlighting the challenges facing leveraged investors. While the Central Banks actions should help to calm the situation over time, it seems likely that the UK financial environment will remain volatile. The impact is reflected most clearly in the mortgage market – where rates have spiked and so far haven’t come down in the wake of Central Bank intervention. Given the structure of the UK mortgage market – with relatively short fixed-rate deals – a tighter monetary environment can be transmitted quite quickly into the real economy (a point well-made by Mike Harris at Cribstone).
Second, the government appears in disarray and you’d guess that we’ll see further U-turns on policy (for instance, will benefits rise by inflation or by earnings?). That might not be an insurmountable problem for financial markets, but in a challenging economic environment, it hardly inspires confidence, regardless of whether or not Liz Truss stays in office.
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Third, silence from the independent Office of Budgetary Responsibility was a highlight of the mini-budget. In the absence of data, market participants generally took the view that the OBR would have taken a negative view on the Chancellors plans. Apparently the OBR has now provided the government with a view and that should now be published at the end of October (brought forward by several weeks as of this morning). Again, you’d guess that the conclusion won’t favour the Chancellor.
Fourth, you might ask why the IMF felt the need to opine quite so quickly. Lots of governments are trying to manage the current economic challenges in various ways. Some might claim there’s a whiff of anti-Brexit sentiment, striking a blow for international organisations. Or maybe it reflects the current status of the UK in the global economy, not as relevant as large players like the US, the EU or China, but still sufficiently big and interconnected to make a mess.
Fifth, the General Election is probably still two years away – so thinking about the next government seems premature, but at some point investors will start to consider what a Labour government might look like. And despite their best efforts, the policy disagreements over the past few years haven’t gone away.
What does it mean for markets and portfolios? The global environment remains challenging, as the economy slows and Central Banks continue to wrestle with inflation. Even within that context, the Bank of England already had a difficult hand to play. Governments policy announcements and the reaction of financial markets have made that even more difficult. It raises the likelihood that we’ll see slower growth and higher inflation in the UK for longer than we would have done. Policy uncertainty remains very high, and we’ll probably see that reflected in continuing financial market volatility, both in equities and bonds.
From a portfolio perspective, we continue to favour a conservative approach, both in terms of our exposure to equities and to long duration bonds. Global diversification remains particularly relevant given UK domestic challenges. Valuations look better than they have done for a while, and that gives support for long-term returns, but over shorter time periods, we’d expect volatility to remain high.
In terms of key indicators, inflation remains a critical driver. As we’ve noted before, we think inflation will decelerate, especially in the US, and that’s most likely a precondition for seeing a sustained recovery in risky assets.