Market Update: A bold move or a foolhardy one – who will be right about the UK economy? from Jilly Mann

Posted by melaniebond

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Last week the new Chancellor of the Exchequer, Kwasi Kwarteng, announced sweeping fiscal policy changes for the UK economy in his mini-Budget. As we know, the UK stock market did not react well to the announcements, but this update aims to explain why markets reacted in the way that they did and how the Bank of England managed to bury their own performance last week in the wake of the Tory proposals.

• Strategy update
• Bank of England interest rate announcement
• The lead up to the mini-Budget
• The mini-Budget itself
• What next for stock markets
• Should we still be investing?
• Economic recovery remains a global challenge

Strategy Update

Firstly, I want to provide some reassurance with regard to the Telford Mann investment strategies and how they are performing relative to global indices. You will likely be familiar with this graph now as I have used it in the last couple of updates, but in spite of the relentless news about stock market woes, the Pound and politics, our investment strategies have remained resilient. 

Year to date, the score 3 Moderately Cautious strategy is down 4.70%, score 4 Moderate is down 6.07% and score 5 Moderately Adventurous is down 7.04%. As we always say, no falls please us, but in the context of the FTSE All Share (pink line) dropping 5.86% from its previous positive territory, the S&P 500 (brown line) falling 21.88%, the DAX  (green line) being down 22.67% and the Nasdaq 100 (purple line) being down 30.26%, the defensive positioning of our strategies continues to have worked well relative to the falls experienced in the broader, developed markets.

As I explain towards the end of this update, we continue to make changes to our strategies and have plans in place as the economic news develops to hopefully maintain this resilience and benefit from an uplift in those areas which we believe have growth potential in spite of the headlines.

Bank of England interest rate announcement

Last Thursday saw the Bank of England announce the latest move for interest rates in the UK. Stock markets were expecting an increase of 0.75% to take the headline base rate up to 2.50%. What the Bank of England actually did though was to instigate an increase of only 0.50%, thus taking the base rate up to 2.25%.

At face value, increasing the base rate of interest by less than expected may be considered a positive for the economy. It could be seen as a reflection that the economy is more under control and that inflation is on the wane. The reality is that neither the economy nor inflation are yet under control and so stock markets reacted with a level of incredulity that the Bank of England had failed to act decisively.

What happens next is that quite apart from markets then thinking that a further 0.25% interest rate rise is now inevitable at the next Bank of England Policy Committee meeting, expectations escalate into thinking that the economic situation may deteriorate further between now and then, which in turn would cause the Bank of England to need to raise interest rates even further and for longer than previously factored in.

Markets can work in counterintuitive ways, but stronger, perhaps more painful short term action assuages markets into believing that such measures will prevent a full scale economic downturn, at which point markets then tend to lead the economy out of a recession. If markets lose faith in Central Bank messaging, uncertainty kicks in and investors will tend to err on the side of caution.

We have mentioned before that the Bank of England have been too late on their decision making post Covid, last week’s interest rate announcement has done nothing to alter that view. Without a strong Central Bank and a clear direction for interest rates and inflation rates, markets will express their displeasure.

The lead up to the mini-Budget

The other factor which made the Bank of England’s announcement even stranger was the imminent mini-Budget which was delivered the following day.

It was well documented that Prime Minister Liz Truss’ manifesto was built on cutting taxes. There were stories leaked all week about the reversal of the recent National Insurance tax rise and rumours abounded regarding stamp duty. We wrote a few months ago about the economic impact of a tax cutting regime versus Rishi Sunak’s proposed “maintain the tax status quo” approach. Tax cutting typically fuels inflation and forces Central Banks into harder, more prolonged action. Maintaining the tax status quo typically allows nature to take its course with less extreme measures required by Central Banks to counter Government policy.

With that in mind, at the very least markets expected the Bank of England to raise interest rates by the predicted 0.75%, having put a potential rise of 1% on the back burner some time before. That the Bank of England still proceeded to dampen down the interest rate rise, knowing that fiscal policy was about to be overhauled, served only to exacerbate the situation. No joined up thinking between the Treasury and the Bank of England it seems.

To an extent, all the focus over the weekend has been on Tory policy and so the ramifications of the Bank of England’s strategy have thus far been largely hidden, but this coming week will bring them sharply into focus. There are now rumours surrounding emergency interest rate rises and Bank of England policy committee meetings being called ad hoc to conjure a plan to offset some of the potentially inflationary impact of tax cuts.

It would now be out of character for the Bank of England to react swiftly and out of schedule given their reticence to do so for the last couple of years and if they do, it may not reflect well on their control on the economy. “A steady hand on the tiller” is not a saying that springs to mind at present and so Governor of the Bank of England, Andrew Bailey, needs to think carefully about his next move.

I do expect further interest rate rises and I do think we may see rate rises slightly higher and for slightly longer, but I would be surprised to see extreme reactions to the Government’s announcements immediately. I suspect that Mr Bailey will now be trying to work out what future proposals are mooted and align further interest rate rises commensurately with those.

It is important to keep in mind that the UK base rate isn’t unbearably high at the moment, it is just a jolt to the system given the sunken level of interest rates experienced in the UK over the past 10 years. If inflationary pressures weren’t hitting households so much with energy bills, then the movement in mortgage rates wouldn’t feel such a stretch for many people, but the compound effect will meet increasing criticism from the electorate if our Government and Central Bank remain so misaligned.

The mini-Budget itself

With stock markets already twitching about interest rates, the extent of Friday’s mini Budget further unsettled markets. Everything that they thought could be factored in from the Budget was factored in, but what mattered more were the additional measures which were also announced and which were unexpected.

History shows that when Governments have tried a pro-growth approach to stimulate the economy, they normally restructure some of the policies first and then cut. By that I mean as an example, changing the income rate tax bands for all and then applying cuts, the net result being that everyone is deemed to have benefitted. What Chancellor Kwarteng did was cut without changing. That has led to the accusation that this is far away from a levelling up Budget, because it looks like a Budget to help the wealthy, with little to help the vast majority of households.

The approach is not popular with many and perhaps the Government have been bold in sticking to a view that by encouraging growth and investment amongst those who have the power (rightly or wrongly) to initiate economic growth, everybody benefits in the end. There are no hiding places for this approach and the devil will be in the detail, but I think it is telling that they have already come out to announce further fiscal cuts that will have a more direct impact on households.

We could be entering a hugely exciting time for the UK economy that rewrites the global rules on recovering from the economic conditions we find ourselves in. But on the other hand, we could be about to witness a period of heightened uncertainty where the push and pull between the Government and the Bank of England becomes something of a soap opera.

What next for stock markets

The market falls at the end of last week were perhaps overdone. It was not constructive to have the Bank of England and the Government make such announcements on consecutive days, especially when they provided such contradictory messaging. As I write, the UK market is mixed, half of the FTSE 100 is shining positively blue and half is in the red, but my expectation is that after the shock of last week, the market will find reasons to claw back those falls and we are already seeing that today. In my view, last week was not Armageddon for markets and nor was it the pivotal economic indicator we have been waiting for to provide real guidance on future economic recovery. It just wasn’t what was expected and as the markets continually remind us, the Government and the Central Banks that they like certainty. Fail to provide certainty and the markets will judge you harshly.

It wasn’t just equities which passed judgement. UK Gilt prices fell over 5% last week with yields rising to new highs. Gilts are considered to be the most secure asset class in the UK beyond cash, Government backed debt essentially. If the price of a Gilt falls, the yield associated with that Gilt typically rises and this happens in times of economic worry.

At the same time, the Pound fell to £1.05 against the US Dollar this morning, almost to parity. The effect of this is to make imports into the UK more expensive.

This combined situation led some commentators to unhelpfully compare the UK economy to an emerging market. The nature of the announcements were such that as the Pound fell, concerns were raised about the UK’s ability to repay its debts, debts which increased with the fiscal cuts as tax receipts fell and borrowing increased. In reality however, the UK is still seen as a safe economy, it isn’t an emerging economy. The Pound has found a floor for now and has already recovered some of its losses.

One other factor that needs to be considered when looking at the travails of the Pound to maintain its value is the relative strength of the US Dollar. In fact a great deal of the perceived weakness of Sterling is in fact Dollar strength. The diagram below shows how various world currencies have performed against the greenback during the last 9 months.

The UK is neck and neck with Japan and Sweden and the Euro isn’t that far behind in terms of weakness either.

Should we still be investing?

We don’t think we are at the point where we are devoid of good investment opportunities. We made some changes last week to portfolios to remove some of our Property and emerging market debt exposure and divert that into US Treasuries and overseas corporate bonds, as an example. We are thinking ahead about the potential for a recession worsening, or sharp currency movements ensuing and we are exiting assets that we think may be negatively exposed, diverting instead into assets that we think provide greater insulation for the period we are entering.

The UK market is one that we have been planning ahead for. We suspected a fiscal cut Budget and we suspected that the Bank of England would be slow to act, albeit not as slow as they have been. We don’t envisage further unremitting falls from here in the near future. What we are looking at now is ensuring that our UK exposure remains the right exposure for the fiscal environment we are now entering and that may result in us making changes to our underlying UK holdings. We aren’t saying the UK doesn’t continue to offer investment merit and I think that is an important point.

Economic recovery remains a global challenge

Whilst this update has deliberately focused on the UK, we are continually monitoring the US, China and Europe. We are relatively positive on the US and are ready to go with strategy changes to increase our US exposure once we tick through the next few weeks. We think there are some really strong investment opportunities emerging in the US, particularly in smaller companies, when the timing comes right.

We aren’t diminishing the impact of events in the UK, but the UK isn’t alone in finding ways to boost economic growth. Sweden has tried more traditional methods of larger interest rises and that hasn’t had the desired effect either so there is no one way to work through this and perhaps we need to give the latest measures an opportunity to play out. I think the bigger issue is signposting from the Bank of England with regard to their next moves and I think that however big or fast those moves prove to be, once we all understand what they are likely to be, markets will settle and we will see the traditional winners and losers that we always see in all countries and in all conditions.

The key to managing portfolios at the moment is to not have a kneejerk reaction to developments on any one given day. The bear market rallies and falls continue and increasingly we see bigger single day falls, which are then recouped fully over the ensuing days. I realise infinite patience isn’t a commodity we can all afford to have, but change provides opportunity, however, uncomfortable it may feel and I am sensing some exciting investment opportunities for our strategies in the coming weeks and months, in spite of perhaps, rather than because of Government or Central Banks.