Governments around the world would do well to heed the lessons of recent chaotic events in Britain that concluded with Liz Truss becoming the country’s shortest-lived prime minister.
Read this article to understand:
- Why sterling-based markets reacted with such alarm to events in Whitehall
- Why markets could be set for further turbulence
- Why other countries are likely to heed lessons from events in the UK
In his now-infamous ‘mini budget’ of September 23, Chancellor Kwasi Kwarteng unveiled the biggest tax cuts in half a century, worth around £45 billion a year, equivalent to 2.1 per cent of GDP.1 At the same time, he gave details of a two-year package of energy subsidies expected to cost £60 billion over the following six months alone.2
“This is a new approach for a new era focused on growth,” Kwarteng told MPs. He claimed the tax cuts, together with other supply-side reforms he was hoping to announce, could lift trend economic growth to 2.5 per cent over the medium term, which he argued would in turn help reduce debt as a percentage of GDP.
However, few believed he could generate sufficient growth to make the numbers stack up. After all, the UK economy has grown just 1.25 per cent a year for the past two decades. Prior to the pandemic, the Bank of England (BoE) had pencilled in a medium-term potential growth rate of just 1.1 per cent. This is partly because of demographic trends as the population ages and immigration falls, but also because of the UK’s poor productivity record.
Financial markets reacted with alarm. Sterling plunged to a record low against the US dollar, and briefly became the worst-performing currency in the world. UK government bonds suffered heavy losses.
While the sell-off may have come in the context of rising yields across the globe, it largely reflected concern the UK government was taking a reckless, unnecessary, and unaffordable gamble with the country’s finances. After all, should the energy price cap have been in place for two years, that would have added another £180 billion to the bill.
Within three weeks, Kwarteng had been dismissed, replaced by Jeremy Hunt. He immediately set about ditching almost all his predecessor’s tax cuts, and indicated he was looking to pare back the cost of the energy support package, to try to restore stability. Less than a week later, and just 44 days after taking office, Truss resigned.
A safe pair of hands
Financial markets have responded positively to Hunt’s U-turn and the anointing of Rishi Sunak as Truss’s replacement. The former Chancellor, an ex-Goldman Sachs banker and hedge fund manager, is seen by many as a safe pair of hands.
On the campaign trail in the summer to replace Boris Johnson, he prophetically warned it would be “complacent and irresponsible” to ignore the risk of markets losing confidence in the British economy. He said confidence had been maintained through having an independent central bank, strong institutions and a credible fiscal trajectory.3
Hunt is reportedly considering a significant package of tax hikes and spending cuts to try to fill what has been described as a multi-billion ‘black hole’ in the nation’s finances.4
The degree of financial market unrest was explained by the fact Kwarteng was taking such a big risk at a time when the UK was already running large fiscal and current account deficits, had a low unemployment rate and the Bank of England was hiking interest rates aggressively to try to quell rampant inflation.
The rationale underpinning his strategy remains unclear. According to one line of reasoning, he may have concluded fiscal austerity combined with monetary largesse, the economic orthodoxy that has prevailed in the UK and much of the West since the global financial crisis (GFC), had failed to generate sufficient economic growth and it made sense to head in the opposite direction.
Not raising rates more aggressively post the recovery from the global financial crisis will be seen as a mistake
“When the economic history of the past 15 years comes to be written up, not raising rates more aggressively post the recovery from the GFC will be seen as a mistake,” says Aviva Investors senior economist Stewart Robertson.
However, even if there are sound reasons to believe a combination of looser fiscal policy and tighter monetary policy would have delivered better results, the timing of Kwarteng’s attempt to change direction was hard to fathom.
Whitehall may have been able to get away with such an about turn before the pandemic caused inflation pressures to start building. But trying to change course at a time when global bond markets were struggling to find a floor, and investors were flocking to the relative safety of the US dollar, was asking for trouble.
Until relatively recently, financial markets were prepared to fund almost any level of government borrowing, at least in countries able to print their own currency, aware central banks would keep a lid on yields by mopping up excess supply. Now the priority is to fight inflation and investors are on high alert for signs of economic distress.
“The lesson from the UK is there is no such thing as a free lunch. There are limits to what fiscal policy can do to soften the blow as monetary policy tightens in response to rising inflation,” Robertson says.
Brink of a financial crisis
The BoE, having only in August announced it wanted to cut its holdings of gilts by £80 billion in the year from September as it starts to trim its balance sheet, was forced to purchase bonds to try to restore order to the market and prevent fire sales by pension funds and other investors.
An emergency £65 billion bond-buying scheme launched on September 28 helped soothe nervous markets. Had it failed to act, the bank says there would have been a £50 billion fire sale that would have taken the UK to the brink of a financial crisis.
As for interest rates, the BoE’s chief economist Huw Pill warned Kwarteng’s debt-laden economic plan would have required a “significant monetary response”.5 Having stood at 2.25 per cent prior to the mini budget, the bank’s Base Rate was at one point expected to surge to around 6.25 per cent , although it is now projected to rise more modestly, peaking at around 4.65 per cent next September.6
The apparent inconsistency of monetary and fiscal policy undermined confidence in UK assets as rating agencies Standard & Poor’s and Fitch cut their outlook on the UK to “negative” from “stable”.
Fitch said the lack of independent budget forecasts, as well as an apparent clash with the BoE’s inflation-fighting strategy, had “negatively impacted financial markets’ confidence and the credibility of the policy framework, a key longstanding rating strength”.7
As for former US Treasury Secretary Larry Summers, he said the UK was “behaving a bit like an emerging market turning itself into a submerging market”.8
The country was never in any imminent danger of defaulting. After all, it prints its own currency and net government debt as a percentage of GDP is not especially high relative to other advanced nations.
Figure 1: Net government debt (per cent of GDP)
Source: International Monetary Fund. Data as of January 2022
Rather, the question was how high would bond yields have risen, and how far sterling would have fallen, to enable the UK to fund such large twin deficits, especially with foreign investors holding approximately 25 per cent of outstanding gilts.
Gilts do not have the same safe-haven status as Treasuries among international investors
“The UK is not the US. It doesn’t have the dollar, and, among international investors, gilts do not have the same safe-haven status as Treasuries. The question was who was going to pay for such a big gamble.
“In an environment of extreme global uncertainty, overseas investors would have demanded a very high price. It was a toxic backdrop for gilts and UK assets more generally,” says Ed Hutchings, head of rates at Aviva Investors.
Having successfully calmed the market, the central bank has been able to press ahead with ‘quantitative tightening’. On November 1, it sold £750 million of shorter-dated gilts, part of the £838 billion of assets held on its balance sheet.
However, though the sale proceeded smoothly, Hutchings says gilt investors remain watchful ahead of Hunt’s revamped Autumn statement on November 17.
“The UK has got to issue a staggering amount of debt over the next few years. With investors still nervous about the credibility of the country, they need to show they have a plan to get debt under control or else the risk is yields will start to rise again and sterling start to fall,” he says.
A warning to others
Robertson says recent events in the UK will serve as a deterrent to other countries that may be tempted to tread a similar path.
“If they weren’t before, most governments around the world will now be painfully aware that, unlike in the decade that followed the GFC, and the initial aftermath of COVID-19, they have little room for manoeuvre. Financial markets are going to police them much more forcefully,” he says.
Italy could provide an early test case with Prime Minister Giorgia Meloni vowing to cut taxes to try to boost the economy
Italy could provide an early test case. In the run up to recent elections, Prime Minister Giorgia Meloni vowed to cut taxes to try to boost an economy that appears in danger of flirting with recession.
Italy is due to send its proposed 2023 budget for consideration by Brussels by mid-November. Given the scale of the fiscal challenge it faces, investors will look for any sign of budgetary divergence from the previous government.
Like Robertson, Hutchings believes other countries will have learned from recent events in the UK. “With finances under huge pressure, and bond market confidence brittle, most sensible politicians ought to know investors will take a dim view of any country perceived to be taking excessive risk with their finances,” he says.
The long road back to credibility
While Sunak and Hunt appear to have repaired much of the immediate damage brought about by their predecessors, confidence in the UK macroeconomic policymaking framework will not be restored overnight.
Chris Higham, credit portfolio manager at Aviva Investors, says ongoing market nervousness following recent events helps explain why the yield differential between sterling corporate debt and gilts remains close to a ten-year high, save for a brief period at the onset of the pandemic.
The market is pricing even more rate hikes... driving up borrowing costs for corporations
“The market is pricing even more rate hikes. This is driving up borrowing costs for corporations due to a classic crowding-out effect,” he says.
Despite this, and the fact that from a fundamental perspective balance sheet leverage is not that high and interest cover and profit margins look supportive, he remains cautious.
“We now expect a UK recession and struggle to see a catalyst to turn the economic situation around. Although valuations may look attractive, we are not sure you are getting compensated for that risk,” Higham says.
Gregor Bamert, head of real-estate debt at Aviva Investors, explains that UK assets and the UK economy have generally been viewed by international investors as stable and predictable, buttressed by a strong legal framework, respected public institutions, and a sophisticated professional services sector.
“We did not see international investors run for the hills due the political and economic situation. However, the turbulence had a reputational impact that will likely last a while,” he says.
Trevor Green, head of UK equities at Aviva Investors, says the sense of crisis that enveloped the UK, and the constant U-turns in various aspects of policy, means there is little prospect of UK stocks, which have already been materially de-rated since the 2016 vote to leave the European Union, being materially re-rated in a hurry.
“Global companies need certainty over the next ten to 20 years when making investment decisions. Yet if you take government energy policy for example, there have been so many changes it’s a recipe for almost total paralysis,” he says.
You can’t buck the markets
Truss and Kwarteng said they wanted to ditch ‘business as usual’ economic policy and challenge what they saw as ‘economic orthodoxy’. Kwarteng sacked Sir Tom Scholar, the Treasury permanent secretary, on his first day as chancellor and sidelined the UK’S independent fiscal watchdog ahead of his budget. As for Truss, she was a vocal critic of the BoE during the Tory leadership campaign, threatening to review its mandate.
Politicians should be careful what they wish for and heed the lessons of the recent market turmoil
While a degree of normality may have returned to British politics, some see a danger that attacks on the central bank intensify in the run up to the next UK general election, as the Conservative party attempts to deflect criticism of its handling of the economy. Politicians should be careful what they wish for and heed the lessons of the recent market turmoil.
“If the market gets as much as a sniff that BoE independence is in doubt, that would be taken extremely badly,” Hutchings says.
Truss made no secret of her admiration of one of her late predecessors, Margaret Thatcher. Ultimately confronted by economic reality, she was to learn the hard way that as Thatcher herself famously said in 1988: “You can’t buck the markets.”