UK mini budget: The closest thing to crazy?

We analyse potential consequences of new UK fiscal and monetary policy for UK bonds and the wider economy.

Key points

• With windfall taxes on energy companies ruled out, we had expected UK national debt to rise to over 100% of GDP in the near term as a result of revisions to fiscal policy, but the outcome of the ‘mini budget’ was higher than expected.
• The dramatic change in fiscal policy suggests the credit ratings agencies may lower their ratings on UK debt. 
• We anticipate that gilt-market volatility will remain high for some time.
• With sterling tanking and core inflation expectations increasing, pressure is on the Bank of England’s Monetary Policy Committee to move further and faster with interest-rate expectations.
• There must be considerable doubt that these policies (and by implication this prime minister and chancellor) will survive until the end of the fiscal year.

The appointment of Liz Truss as UK prime minister seemed destined to herald a reversal of the previous government’s plans to reduce the country’s budget deficit; instead of a five-year plan to see the national debt fall from about 96% of GDP to around 80%, we expected to see it exceed 100%, at least in the near term, with the total cost exceeding £100bn. What we did not expect were further regressive tax cuts for the highest earners and for companies, taking the estimated total bill over the next five years to £161bn, with precious little detail on if, how or when fiscal discipline would be restored.

Gilt-market reaction violent

Market reaction to the energy price-cap measures announced by the new prime minister about two weeks ago, along with expected reversal of tax and national insurance increases brought in by former Chancellor Rishi Sunak, was relatively muted, mainly because it came as no surprise. Arguably, the UK gilt market had been pricing in quite a degree of fiscal loosening over recent weeks; August was the worst month for gilt returns since at least 1986 after all, and gilts had been behaving more like Italian bonds.

However, the reaction to the 23 September ‘mini budget’ has been dramatic. The fiscal statement shocked the market, with further unfunded tax cuts for the highest earners, and steeper-than-expected cuts in corporation tax rates. Not only does it add to the debt burden with an uncertain growth payback – the main concern for markets – it also threatens already fragile social cohesion. The side-lining of the Office for Budget Responsibility, which would normally produce an independent assessment of the impact of these measures, and the recent removal of the most senior official in HM Treasury, has further dented investor confidence in UK institutions.

Gilt prospects remain unattractive for now

A few weeks ago, gilts looked exceptionally poor value to us, given the inflation backdrop, the likely need for extra spending, waning demand from liability-driven investors and overseas buyers, and the imminent start of gilt sales by the Bank of England. Therefore, our stance for flexible bond mandates had been to be broadly shorter in gilts than the respective benchmarks, preferring some overseas government bond exposure. With last week’s fiscal statement heralding even larger-than-expected twin deficits, and confirming even more unorthodox policy, and with a glut of gilt issuance in sight, we believe gilts still lack investment appeal, even at these much higher yields.

Stubborn core inflation

UK government measures announced to cap energy prices should reduce headline inflation (by up to 5%), but with the government supporting aggregate demand with its fiscal largesse, and the pound slumping, we could see core inflation remain high, and a more aggressive monetary response. We have also found with other government relief measures that it is easier to give them than to take them away, so we would caution against assuming the cost of capping energy bills will be a ‘one off’, even if recent energy price falls might reduce the cost.

UK credit rating under threat?

The stable outlook on the UK sovereign rating from the major rating agencies was predicated on a path of gradual debt reduction. This radical change of fiscal policy certainly suggests the outlooks will be revised to negative, as a minimum, or we could see the ratings lowered.

Furthermore, as the prime minister did not receive the backing of the majority of Conservative MPs in the leadership ballot, and her victory in the membership vote was not overwhelming, we expected the honeymoon period to be shorter than if she had been heavily endorsed by the party membership. The fiscal statement has just raised the stakes both internally and externally.

Authors

Howard Cunningham

Portfolio manager, Fixed Income team