04/10/2022

Jeremy Batstone-Carr, European Strategist, Raymond James Investment Services Ltd*

Key Takeaways

The UK “mini Budget” is a high-risk plan to reinvent the UK as a high growth/high wage economy. An uncosted and aggressive borrowing plan to generate sufficient growth in the future has impacted on the gilt-edged market and sterling.

“Buying” growth by adding debt does not solve the UK’s long-term productivity problem.

Persistent high inflation has imparted a significant affordability problem for the average UK household. Energy costs, although rising, have been capped by the new administration.

The Bank of England has stepped in both to rescue the pension fund sector and restore the UK’s economic credibility, essential to avoid a debt servicing crisis and to “cover” the widening current account deficit.

The combination of a temporary return to bond purchases and likely yet higher interest rates has averted a sterling crisis and bought time, but more may need to be done.

In October 1973, the British progressive rock band Genesis released an album, the title of which has gone down in popular music legend as one of the all-time greats, “Selling England By The Pound”. The album was the band’s response to the disastrous Anthony Barber Budget of the previous year, which played a substantial part in the eventual unseating of the then Prime Minister, Mr Edward Heath. Fast forward fifty years and the newly installed British premier, Ms Mary Elizabeth Truss, “Liz” and her Chancellor of the exchequer, Mr Kwasi Kwarteng have an equally grand and ultra-high risk plan to reinvent the United Kingdom as a high-growth/high wage economy.

If the plan works, it will surprise all those who question the effectiveness of “trickle-down” economics. If it fails, confidence in the UK’s political economy, sovereign bond market and currency will be called into doubt. A “sterling crisis”, if that is what it comes to, would have disastrous consequences as import costs would rise yet further against a backdrop of an already severe terms of trade crisis brought about by sky high energy and food prices, that and the escalating cost associated with servicing debts denominated in overseas currencies.

The Truss-led administration has nailed its colours to the mast; it will pursue growth at all costs. The first of what amounts to a two-pronged approach, as identified by the embattled Chan-cellor Kwarteng in his mini-Budget, is to borrow aggressively now in the hope that the economy can generate sufficient growth to pay off its debts in the future. The second prong, with electioneering written all over it, is that providing generous hand-outs to the wealthy will ultimately percolate to the less well-off over time. However, this policy has partially backfired, the 45% top marginal tax rate cut now abandoned. It is indeed ironic that US President Biden, doing his bit for the Democratic Party cause ahead of Congressional midterm elections in November, has recently stated that he is “sick and tired of trickle-down economics. It has never worked”.

On the subject of the United States, Ms Truss, like her prede-cessor before her, seems hell-bent on antagonising the UK’s allies and trading partners whilst standing unswervingly together with regard to Russia and its military (and now political) adventurism in Ukraine. Mr Biden has made clear that a much-vaunted, post-Brexit trade deal with the United States is not going to happen, while simultaneously, the UK adminis-tration clearly believes that there are votes to be gained through antagonising Europe by reneging on the trade treaty regarding Northern Ireland. At a time when nations need to stand together in the face of profound geopolitical and economic stress, the newly installed Ms Truss is quickly learning how her own, admittedly heavily disguised, political weakness is swiftly evolving into an even more profound economic and financial market fragility.

From the viewpoint of economics, the nub of the problem affecting the UK (and developed Western economies more widely) is that one simply cannot “buy” growth by adding mountains of debt. Indeed, between 1999 and 2019, the year prior to Covid’s onset, the UK economy expanded by £0.72tr whilst adding debt of £2.9tr. Put differently, every £1 of borrowing yielded just 0.25p of growth. Within the growth reported over that period, as much as 69% of it was derived from the cosmetic impact of pouring vast amounts of addi-tional credit into the system. Whilst reported growth may have averaged an annualised 1.8%, borrowing averaged an annual-ised 7.2% of GDP over the same period. In essence, pretty much all the “growth” achieved by the UK economy since the dawn of the new century has been a mirage. Taking the view that the future will be different is to push back against recent historical experience.

Beyond this, the relentless downward pressure on real household disposable incomes has resulted in a profound affordability compression for the average household. This, if unaddressed, will inevitably lead to an undermined ability to not only make discretionary purchases but increasingly force the paring back of items hitherto deemed essential, including staged payments and subscriptions. This has equally profound consequences for an economy hugely leveraged on the global financial system. The latest available data pertaining to 2020 reveals that the UK has aggregated financial assets – the counterpoint to liabilities (relating to the household, business and government sectors), amounting to an eye-watering 1262% of GDP. For comparison, the equivalent figure in Japan is 871%, Europe 795% and the United States 588%. This is not to say that other regions of the developed world are in rude health, just that the UK is, on this metric, comfortably the most vulnerable to the vicissitudes of the financial markets.

An uncosted exercise in bluster, which is what Mr Kwarteng’s mini-Budget turned out to be, risks severely damaging the UK’s credibility at a time when, to borrow a phrase from the former Bank of England governor, Mr Mark Carney, the country needs all the kindness of strangers it can possibly muster. The UK needs cash from overseas to prevent debt servicing costs from spiralling out of control and to “cover” the sharp widening in the current account deficit. But kindness is not to be confused with charity; there is a price for everything, and financial assets will reprice until such point as the UK’s allure becomes irresistible. The Bank of England, already in the midst of raising the country’s base interest rate in an attempt to bear down on elevated and “sticky” inflation, may have to redouble its commitment, and fast, if credibility is to be restored and a fully-fledged sterling crisis avoided. It has already been forced into a high-profile U-turn, temporarily returning to purchase even more government bonds instead of selling them as scheduled, to head-off what had threatened to become a disorderly melt-down.

Amidst all the apparent doom and gloom, the hardened investor knows only too well the age-old mantra, “markets stop panicking when officials start panicking!” When all around are losing their cool, then that is the time to look for opportunities. Perverse as it may sound, the more distorted UK financial asset prices appear, the greater the longer-term opportunity. For now, holding the line and being courageous in the teeth of adversity will surely be rewarded in the future.