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Market update


By Thomas Griffin

Market sentiment: Uneasy. U.K economic policy is in turmoil after the market’s poor response to last Friday’s ‘fiscal event’. Cutting taxes, in order to boost demand and output, is an unorthodox approach when the economy is already running at full capacity, with unemployment at 3.6% (the lowest level since 1974). Bond investors fear ‘Trussonomics’ will add to inflation, and to an oversupply of gilts as the tax cuts and spending commitments are unfunded, and have demanded sharply higher yields in return for the increased risk of holding government debt. Sterling has fallen sharply, and may yet reach parity against the dollar, as foreign investors sell sterling-denominated assets.  

The market is currently pricing in UK interest rates to peak at around 6% by May of next year, they currently stand at 2.25%. The resulting increase in borrowing costs will hinder economic growth, possibly reversing any demand growth  arising from lower taxes.

The outlook is for continued volatility for U.K stocks, bonds and for sterling. The government is running a fiscal policy that appears to undermine the anti-inflation policies of the Bank of England, and one that creates the conditions of its own failure by pushing up inflation and interest rates higher, and for longer, than would otherwise have been the case.

The VIX index of implied volatility over the next month on the S&P500 has crept back up over the last month, from 20 in mid-August to 30 today. But this is a far cry from the 66 peak of March 2020.

Investing: some U.K stocks will do well from a weak pound. UK exporters, for instance, will have a boost to exports from a weak pound. Many FTSE100 multinationals are not only in defensive sectors such as energy, pharma and utilities, but make most of their earnings in foreign currency. This offer protection to sterling-based investors as sterling falls. But when the current global economic slowdown passes, we will need exposure to growth-sensitive assets, such as U.S tech and European luxury goods. It is very important that a mix of investments is maintained throughout this difficult period. Ugly ducklings can turn into swans very quickly.

The Fed and Bank of England: higher rates, for longer. Friday’s ‘fiscal event’ (the U.K government refuses to call it a budget) came at the end of an already eventful week for the markets, as they responded to central bank statements and interest rate hikes.

Investors were anticipating the Fed’s 75bp rate hike on Wednesday, but not the dramatic cut to U.S GDP forecasts that came with it, nor the more aggressive outlook for interest rates in 2023, as illustrated in the so-called ‘dot chart’. Fed policy members are now predicting increases in rates throughout next year, to curb stubborn core inflation. Markets had been pricing in rate cuts by late 2023.

Investors are bracing themselves for downward revisions to corporate earnings estimates in response to the weak growth, high borrowing costs, economic outlook.

Meanwhile, the Bank of England at first appeared to be going easy on rate hikes on Thursday, with a 50bp rate rise. But it made clear that it is reserving the right for a much more aggressive stance at future meetings, should circumstances -including fiscal policy – warrant it.

Those circumstances were more than delivered by Friday’s fiscal event. Delivered by new Prime Minister Liz Truss’ new Chancellor, Kwasi Kwarteng, they include £45bn of unfunded tax cuts, and energy subsidies worth £60bn over the next six months (and which may persist after April).

The response of the gilt market to Trussonomics has so far been withering. The U.K government deficit for the current fiscal year is now expected to be £234bn, from a forecast of £161bn in April. The bond market has made it clear thar is not going to happily absorb the massive increase in government borrowing without exacting a price. Gilt yields have risen sharply, the 10yr gilt traded with a yield of 2.8% at the start of September, the yield now stands at 4.2%.

Like in the U.S, it appears that inflation, and interest rates, will both be higher for longer than had been expected at the start of last week.

Pity the pound, parity beckons? Sterling is down to £1.08, a level not seen since the 1985. If the Bank of England does not step in to defend the currency, by aggressively raising interest rates, many analysts think the pound will fall further, perhaps to the politically explosive level of parity. Certainly, much of the fall in sterling this year reflects the strong dollar, pushed up by fears of high-for-longer U.S interest rates. This is the point being repeated by U.K government ministers and spokespeople today, as they answer questions on the government’s economic competence.

But there are home-grown issues that are dragging sterling down, which include weak export growth, low productivity growth, weak investment and now the pro-growth fiscal policy from the government. The specific dangers for the pound following Friday’s policy announcements are, first, that an impression of poor economic management deters foreign buying of U.K assets – whether it be gilts and other financial assets, or direct investment into the U.K. The second is that a boost in domestic demand, caused by expansionary fiscal policy, leads to a rise in imports and growth of the already large trade deficit.

The World Bank’s three policies to avoid a global recession. Last week the World Bank published a paper titled: ‘Is a global recession imminent?’ It notes that economic growth is decelerating in the three key economic regions: the U.S, eurozone and China. It is looking at fall in global GDP from 2.8% this year to just 0.5% in 2023, and a contraction next year of 0.4% in per capita GDP terms.

The paper’s three key proposals to support growth are sensible but none are easy to execute. First, liberalise labour markets to increase labour market participation, and so reduce wage growth. (Governments in the west have been trying to do this for more than thirty years!)

High energy prices should be used to stimulate energy saving measures, and non-fossil fuel alternatives. (Sadly many voters prefer price caps on energy).

Third, strengthen global trade networks in order to ensure limited disruption caused by bottlenecks, and enforce compliance of international trade law. (Geopolitics is currently pushing against globalisation as rules-based trade).

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