A ‘perfect storm’ hits the UK

Please note: The article does not constitute advice or any form of investment recommendation. All numbers quoted were sourced from Bloomberg data as at Tuesday 27 September. Past performance is never a guarantee of future performance.

The last 96 hours in the UK have seen a ‘perfect storm’ of political ideology and investor uncertainty unleashing itself across financial markets.

The catalyst was a sharp change of financial direction announced by the new chancellor, which consequently sees the Bank of England (BoE, where monetary policy sits) now charting a different course to the Treasury (where fiscal policy sits).

Crucially, it leaves a number of important questions unanswered about funding and timing, and the UK now needs to claw back investor confidence.

No one likes uncertainty

While the initial reaction to Chancellor Kwasi Kwarteng’s policy changes wasn’t bad, the flames appear to have been fanned over the weekend when he publicly declared that more tax cuts were imminent.

It was a significant announcement, coming so soon on the heels of the UK’s biggest tax cuts in 50 years and it left investors asking one big question – how will all of this be funded? (You can read our separate budget article here: UK mini budget: Brave new world?)

Realising that their messaging has big implications if misunderstood or misinterpreted, the government decided not to comment further as investors ran for the hills.

Ironically, issues with communication have troubled the Bank of England this year, and politicians and policymakers will need to address this quickly if they want to regain the confidence of weary investors.

Short-term shock

The additional measures, and the prospects of even further steps, will substantially worsen the UK fiscal situation and increase gilt supply from additional borrowing.

The Treasury has advised that Friday’s announced measures would cost an additional £161 billion over the next five years, and more details are expected by the end of November at the latest.

While the UK debt-to-GDP ratio is still lower than for most European Union countries, the measures may result in a jump to over 100% of GDP in 2024. Meanwhile, the budget deficits for 2023 and 2024 are likely to increase substantially just when the deficit was narrowing again after the pandemic.

Additional financing requirements come at a time when the BoE is scheduled to start selling gilts out of its asset-purchasing portfolio. The supply demand balance becomes even more precarious given the increased trade deficit. This results in the UK being more dependent on foreign direct investment and financial investments from overseas. Higher bond yields are usually the result.

A 75 basis point (bp) hike in November by the BoE has now become more likely, and together with further hikes, may lead to a base rate of minimum 3.5% by the end of year. Current market pricing points to a base rate as high as 6% by November.

While further interest rate rises and continued volatility are likely, it remains to be seen if the UK economy can withstand such a high level as suggested by the rate market. A situation as fluid as this one may not put all eggs into one basket, but current levels make selective engagement in bond yields appear more reasonable.

Sterling under pressure

Fears over the spiralling debt pile created by these aggressive tax cuts and the energy bill support package announced this month, have sent sterling tumbling to its lowest level against the US dollar since decimalisation in 1971. Over the past three days, the currency has fallen by 4% against the dollar and close to 2% versus the euro. 

Investors appear to be more cautious about the UK’s prospects after the sweeping changes in policy were not accompanied by details outlining the accompanying offsetting revenue and spending measures. Traders are also concerned that the fiscal boost will stoke inflation and increase pressure on the Bank of England to hike base rates into restrictive territory.

Sterling could remain under pressure until the government provides clarity on the measures that it intends to implement to return the nation’s finances to a sustainable path. Moreover, global foreign exchange markets in the short term remain driven by risk aversion, interest rate predictions, growth rate projections, and investment flows. All of these things point to further support for the dollar, despite the US currency starting to look overvalued on many metrics.

For more information about the UK’s new political environment, you can listen you our latest podcast here: Markets Weekly Podcast

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