Andrew Pyle
September 30, 2022
Untied Kingdom
Before I begin this week’s commentary, I wanted to take this opportunity on behalf of the entire Pyle Group team to extend our condolences to those lost during Hurricane Ian in Florida and to express our hope for a quick recovery for homes and businesses.
For those of you that have had the pleasure of taking economics, you may have been frustrated in the fact that the discipline was both art and science in one. There are often competing theories and methodologies in testing those theories. There are, however, some ideas that are more consistent across various schools of economic thought – like supply and demand will generally determine price and it is typically a bad idea to run a tight monetary policy and easy fiscal policy. Unfortunately, the current UK government looks to have missed some classes.
While not all of the sharp losses in global equities and fixed income this week can be laid at the feet of the UK government, much can. Essentially, one week ago, the freshly minted Prime Minister and Chancellor of the Exchequer delivered a mini budget, aimed at supporting citizens in in the face of higher energy costs and a worsening economic climate across the entire European region. On the surface, this budget may have been seen as a bold and well thought out attempt to strengthen the economy. Unfortunately, the thinking in the plan did not match the boldness of it.
Market reaction was swift, sending 10yr UK government bond (gilt) yields up a third of a percent to over 3.85% before last Friday’s close and then on a mind-blowing 4.6% this past Wednesday. To put this into perspective, the 10yr yield was trading below 2% at the start of August. Pound sterling tumbled to a record low of 1.03 US dollars. Since the currency peaked at above 2 US dollars back before the 2008-09 financial crisis (which drove the pound down more than 30%), sterling has basically been cut in half. That is on par with the 57% drop from the 1980 peak of over 2.4 US dollars to the previous record low before now.
What could have created such a market implosion which, mind you, has also flowed over into markets on this side of the pond? To answer that question, we need to look at what this budget contained. For one, this plan was built on broad tax cuts, not targeted ones (like what Ontario introduced with respect to gasoline taxes). The basic rate will drop by 1% to 19% in April of next year and the 45% high rate will be abolished at the same time in favour of a single higher rate of 40%. Corporations in the UK were set to see their tax rate rise to 25% next April from the current 19%. That increase has been cancelled. There was also a reduction in the so-called stamp duty, which is the amount you pay when you buy property in England and Northern Ireland. Instead of 250,000 pounds, the minimum value at which the stamp duty kicks in is now 450,000 pounds.
Indeed, the only targeted areas were in energy and excise taxes. Energy bills will be frozen, which we knew they were going to propose before the mini budget. It is expected to lower inflation by 5% and will cost 60 billion pounds. On top of that, foreigners will be allowed to show in the UK VAT-free and the higher excise taxes that been planned on liquor are now rescinded.
In normal times, these measures would not have been considered reckless or even misguided. The problem is that the UK, like many other countries, is not operating in a normal environment. Inflation has skyrocketed over the past year – made worse by the dilemma facing the energy sector thanks to Russia’s invasion of Ukraine. Headline consumer price inflation hit 15% this summer and core (ex food and energy) inflation is tracking above 6%. This has forced the Bank of England (BoE) to lift its policy rate two full percentage points since the start of the year, with the last two moves being half a percentage point each. The BoE’s rate still lags behind the Federal Reserve and Bank of Canada, but the despair facing the UK economy is arguably worse than over here.
And that is the problem. The UK central bank is earnestly trying to get inflation under control and because central banks cannot affect supply chains, they have to use the blunt instrument of monetary policy tightening to cool demand. Cuts to income and consumption taxes stimulate demand such that the supply-demand gap is made worse. Bottom line, instead of cooling inflation pressures, this budget will potentially make them worse. Given that the BoE still has a mandate to get inflation under control, this means even more rate hikes.
The other problem is that these tax cuts are not being funded by cuts to spending, so you end up with probably another 170 billion pounds being added to government debt, which is already on a disturbing upward trend. With yields rising, this means that the cost of servicing old and new debt will increase, thus putting more constraints on fiscal policy going forward. The only thing the government can cite in their defense is that consumer debt is not as problematic. Back at the start of the financial crisis, households were carrying debt that amounted to almost 160% of disposable income. We saw this ratio pick up at the start of the pandemic, but strong employment and lower borrowing costs have enabled that ratio to retreat back to the 132% area as of the first quarter. With higher rates and the UK economy cooling, this ratio could start to climb; but the government will dismiss this as a minor development.
Yet, like a couple of teenagers that take the parents’ Aston Martin Vanquish out for a spin without permission, they may not know all the things that might happen when they hit the gas pedal. For one, UK pensions are holders of a ton of government bonds. In normal times, when yields are low this puts pressure on pensions since their returns will fall short of their pension payouts. When they are higher, this pressure is relaxed. As a way to hedge their risks, pensions turn to something called Liability Driven Investment (LDI), where you purchase a bond with a particular yield that matches your liability over the same timeframe. The problem is that when yields plunged after the financial crisis, pensions could not obtain the returns needed over like maturities to meet their payout liabilities. As such, they turned to the derivatives market to boost returns which essentially meant they used leverage to magnify low-yielding bonds.
This was an okay strategy had rates stayed low, or even just ventured higher in a steady fashion. Thanks to high inflation and the government’s untied approach to fiscal policy, yields have spiked. This has put a number of leveraged positions offside, meaning pensions need to boost collateral. The potential for financial market instability from this development was so high this week, that the Bank of England had to step in and buy gilts on the open market.
For now, this has capped the spike in yields; however, with the government’s insistence that it will not back away from its recent budgetary stance, investors are not confident that further damage to the UK bond market can be averted. Investors in Canada may or may not have exposure to that country’s bond market and, most likely, this will be through a mutual fund or ETF. In our portfolio, Ally and I have used a combination of a couple of baskets to gain non-Canadian exposure to bonds, but these involve no more than about 2% to the UK overall. The thing that investors need to keep in mind though is that even if someone has no exposure to the UK bond market, the spillover weakness into other markets can still be significant. This is why institutional investors and the International Monetary Fund have (justifiably) knocked on the UK government’s door for explanations behind their recent policy.
Have a great weekend everyone
Andrew Pyle
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