Turbulent geopolitics, soaring inflation and tightening central bank policies have caused investors to question whether, at some point in the not-too-distant future, certain major economies may experience real rates of economic growth that are not sufficient to cover long-term real rates of interest. In such a world, any government would need to run a surplus to stabilise its debt. On 23 September the UK’s new Conservative administration presented a ‘mini-budget’, which gave detail on just one side of the balance sheet – £45 billion in tax cuts were proposed, but there was no mention of offsetting changes to expenditure. Moreover, the UK’s independent Office for Budgetary Responsibility was denied the opportunity to present its own assessment. This sent investors into a panic, with market pricing briefly implying UK long-term real rates of interest that were materially above plausible estimates of long-term economic growth. In this note, we analyse some of the financial market movements to date.
There is no better summary of this eventful week than the movements on the 30-year UK government bond, or gilt. In the days between the Bank of England’s monetary policy meeting on Thursday 22 September and the following Wednesday morning, the price of the 30-year gilt fell by 24%, while its yield almost doubled. The Bank’s announcement on 28 September that it would buy as many bonds as necessary to restore stability cut the week’s losses substantially. This rollercoaster ride demonstrates the extent to which international markets called the fiscal policy of the three-week-old administration into question.
In line with the bond market, FX investors responded to last Friday’s mini-budget with a sell-off of British pounds, bringing the already weakening sterling almost to parity with the strong US dollar. The weakening of the pound has added to UK’s inflation woes. The Russian energy embargo has already led to an unprecedented transatlantic divergence between the US and the UK and euro area on expected inflation. The latest developments threaten to push the UK further apart, away from the other two. Any UK inflation surge would require higher policy rates, with rates likely to average between 4%-5% over the next two years, according to market expectations. Rates of that order haven’t been seen since the Global Financial Crisis (GFC), and that is alarming: they imply that the UK is potentially at a crossroads, and that taking a wrong turn at the moment could lead to a crisis that might resemble the GFC.
The credit-default-swap (CDS) market offers a clearer idea of how risky the UK economy is now perceived to be. Since Mr Kwarteng’s speech in the House of Commons, the spread of the UK’s CDS over France’s and Germany’s CDSs has doubled, and over the US’s CDS has quintupled. CDS investors are clearly worried about the fiscal soundness of the proposed measures — fortunately, not worried on the scale of the GFC, but worried enough to ask for a significant UK risk premium.
The risks of low growth, sticky inflation, and the increasing likelihood of higher policy rates to deal with it, have been familiar to investors since the start of 2022 and have mostly been priced in. But now the additional UK risk premium (prompted by the latest UK government policies) has intensified those concerns, and led to fears about the outlook for corporate earnings and the discount rate used to value them in present terms. Evidence that these fears might be justified comes from weakening earnings momentum, approximated by the proportion of upgraded earning-per-share (EPS) forecasts in the total Institutional Brokers’ Estimate System EPS forecast revisions. The latest UK read is at levels last seen before the GFC, among other periods. But what makes this weaker backdrop for corporate fundamentals more painful is the higher rates at which they are compounded. As ‘easy money’ is less available due to higher rates prompted by the mini-budget, the cost of capital for companies is increasing. In other words, UK corporate valuations are set for a UK-specific, double hit from lower earnings and higher rates.
A sector that is at the heart of the UK economy is real estate, and here the market reaction to the mini-budget was anything but favourable. With yields rising as a response to the budget, the servicing costs of business and personal mortgages and re-mortages became unsustainable. The threat to property prices is now tangible. That risk can be seen in the performance of the UK’s real estate investment trusts (REITs). Industrial- and storage-space REITs are now writing off the post-pandemic recovery, while office- and retail- and residential-space have collapsed, without any sign of rebounding. These are not prices we see in the streets now, but the price movements of REITs provide a glimpse of what could happen to property prices if money becomes too expensive for too long.
On 28 September, the Bank effectively restarted quantitative easing (QE), monetising some of the planned increase in borrowing in an attempt to avert a financial crisis. But the Bank has said clearly that this QE is time-limited and will end by 14 October. If it sticks to its word, then something else needs to happen before that date. Will there be monetary tightening? Or fiscal tightening, either in the form of spending cuts to fund the mini-budget’s tax giveaways, or a reversal of the proposed tax cuts? Watch this space for part two of this latest UK financial saga.
The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.
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