UK Equities: Mini-Budget, Maxi-Consequences

Engulfed by panic, UK investors are reacting to the extraordinary degree of debt-funded fiscal loosening announced by the treasury. Ben Russon reflects on the Chancellor’s ‘mini’ budget and assesses the opportunities arising for UK equity income investors.

The UK has been subjected to a flurry of emotion in recent weeks. The conservative leadership race culminated in a broadly predicted victory for Liz Truss, which came just days before the sad news broke confirming the death of Her Majesty the Queen. Before the nation reflected on her reign during a sombre period of mourning, the newly elected PM shared details of her energy support plan to protect consumers vulnerable to the soaring cost of living. A core component of this plan was the “energy price guarantee” which will temporarily replace the existing Ofgem price cap, freezing consumer energy bills at an average of £2,500 a year. Businesses were afforded an equivalent level of support to provide stability amongst soaring wholesale gas prices.

Crucially, this was not the end of the support announced by the nascent prime minister and her cabinet. The Commons statement from Kwasi Kwarteng - which was broadly pre-branded a ‘mini-budget’ - has triggered record-breaking consequences for the UK economy. Deeply divisive tax cuts were unveiled in the form of income, corporation, national insurance, and stamp duty land tax, prompting a cloud of turmoil to engulf the UK amid intensifying inflationary pressures. The ‘pro-growth’ measures adopted appeared at odds with the mandate of the Bank of England, tasked with asserting financial stability amongst market participants and moderating inflation. After all, the mini budget was announced just 24 hours after the latest base rate hike. Ironically named, the budget will need to claw back around £45bn of unfunded capital in order to execute the measures pledged, at the expense of higher borrowing costs for the government, businesses and consumers.

The ensuing events were considered extraordinary across a number of dimensions. Investors - spooked by the perception of compromised financial credibility within the cabinet - fled UK assets, which saw sterling trading at all-time lows vs the US dollar. The actions of the government prompted the International Monetary Fund to urge the chancellor to reconsider the tax measures on the grounds of an expanding equality gap. Bond yields spiked to heights not reached in decades as defined benefit pension schemes were forced into liquidity mode amid margin calls to remain hedged in broadly adopted liability driven investment strategies. Major mortgage lenders began to pull their products from the market amid rumours of knee-jerk rate hikes. Unsurprisingly, the assurance from the chancellor that more tax cuts were on the way exacerbated an already spiralling state of affairs.

Inevitable intervention from the Bank of England came in the form of quantitative easing, pledging to inject £5bn a month into financial markets through the purchase of long-dated gilts. This stabilisation technique was a remarkable U-turn from the central bank’s plan to conduct opposing gilt disposals in the open market to combat rapid inflation. Evidently, the central bank was quick to react to this significant fiscal pivot. Forced into pro-inflationary policy action which directly contradicts the recent efforts of the Monetary Policy Committee, the Bank of England intervention was deemed imperative in order to circumnavigate a catastrophic and systemic financial meltdown. The market initially reacted well to this news as 30-year gilt yields plummeted over 1% - their biggest retraction on record – and sterling has since clawed back its earlier losses vs the US dollar.
 

Kwasi Kwarteng and Liz Truss have followed through on their widely-trailed ‘pro-growth’ mini budget, gambling on debt-funded fiscal loosening in an attempt to boost the underlying growth trajectory of the UK economy. The three main criticisms of this approach are the timing, the impact it will have upon the national debt and the regressive bias of the policies, often described as ‘trickle-down’ economics. The timing criticism is predicated on the notion that it is too soon to implement inflation-stoking policies before the existing inflation problem has been resolved. There is an inherent conflict of enacting fiscal loosening whilst simultaneously the Bank of England is undertaking monetary tightening, with the inference that the latter will be forced to tighten harder and longer than otherwise would be the case. The new leadership team have only got a couple of years before the next General Election and hence do not have the luxury of time afforded to the Thatcher Government of 1979, a popular political and economic comparison. 

With regards the impact on the national debt, comparisons have been drawn to Anthony Barber’s 1972 ‘Dash for Growth’ where tax cuts alongside significant public borrowing resulted in an unprecedented wage-inflationary spiral. With UK gilt yields rising to their highest levels in over a decade and sterling plumbing new depths against the dollar, the prospect of a sovereign credit rating downgrade is increasingly considered.

The equity market has not taken much comfort from the proposals, reflective of the challenges and risks in the period ahead. The prime minister appears to have taken the central bank intervention in her stride, defending the mini budget and initially offering no indication that the measures announced may be reversed. Concern is mounting surrounding the perceived lack of communication between the central bank and the treasury. If indeed the treasury informed the Bank of England of the extent of radical fiscal loosening ahead, a case for a rate hike exceeding the 50bps recently implemented would be well considered. A worrying alternative conclusion is that the ‘pro-growth’ fiscal measures were executed without consultation to the Bank of England, an eventuality that suggests the government may have publicly undermined the vital UK financial institution.

The input, or lack thereof, from the Office for Budget Responsibility (OBR) has been of particular significance to investors. Sidelining the official forecaster throughout the fiscal planning process is considered to have exacerbated the chaotic market response. The confirmation that the Chancellor will not unveil the OBR forecast until 23rd November has generated anxiety amongst investors, considering that the treasury will be in receipt of its first iteration as early as 7th October.

There is a pressing demand for clarity amongst UK investors. Uncertainty is consuming the market, and this will only be eliminated if the Chancellor pledges to accelerate the leisurely timetable preceding the release of the OBR forecast. Whilst the controversial abolition of the additional 45% tax rate has already been reversed - rebounding sterling to its pre-budget levels - further clarity will be necessary to curtail the intensifying pressure mounting upon the newly elected prime minster and her cabinet, who are already losing significant ground vs labour according to latest polling data.