This column was first published on Netwealth – 20th October 2022.
This column is not going to comment on the political problems engulfing the UK. You will be able to draw your own conclusions from that ever-changing environment. But political uncertainty is hanging over the UK outlook, although the risk-premium that was attached by the markets to UK assets in the wake of the mini-Budget has all but gone. Instead, here, the focus is on the economic and policy environment.
My conclusion is that a UK recession is inevitable. In all likelihood, it will be deep. Inflation, though, is close to its peak and set to decelerate sharply. Fiscal policy – in terms of government spending and taxation – is set to tighten significantly, adding to the slowdown and poorer growth outlook over the next year. Meanwhile, monetary policy, which has been off the pace, may achieve the remarkable situation of showing that two wrongs do not make a right.
It is there that I think best to begin.
To echo a message that I have expressed before: the main story for now is the ending of cheap money. This has been an economic evil, accepted by the consensus as a necessary one. The alternative was always seen as far worse. That was indeed true in the aftermath of the 2008 global financial crisis, when we embarked upon this period of cheap money, but it has not been the case since, and certainly not in recent years.
Cheap money has had two components to it: low and close to zero policy rates; plus, the buying of financial assets by the Bank of England, as it threw caution to the wind and bought £875 billion of gilts, as well as £20 billion of corporate bonds. So much so, that the Bank of England owns close to one-third of the national debt. This is a truly remarkable statistic.
Cheap money has led to: financial markets to not price properly for risk as the price of money has been so low; an inefficient allocation of capital, with zombie firms remaining in business and younger start-ups sometimes finding it hard to access funds; rampant asset price inflation, not just in financial markets but also in property prices too (although, of course, the lack of housing supply has been a significant contributory factor); and it has contributed to the recent surge in inflation.
Although the trigger for the rise in inflation was supply-side because of bottlenecks arising from the pandemic, monetary policy accommodated this shock. Policy was not tightened. Not only that, in fact the opposite happened. Monetary policy was eased last year, through large-scale quantitative easing (QE).
Policy rates, instead of rising early last year, were kept at rock bottom levels. In fact, the Bank wrote to firms in the City to inform them to prepare for negative interest rates. So, not only was policy inaccurate, the messaging about the direction of travel was wrong. Last year, the UK economy could have coped with monetary tightening, as it rebounded post pandemic.
This year, it can’t.
The recent pension funds debacle alludes to Warren Buffet’s famous quote from the financial crisis: “it is only when the tide is out that you can see who is swimming naked”. It was a sign of how, after a prolonged period of low rates, different parts of the financial system and economy may become intertwined with cheap money and can’t cope with change – both as rates rise, and especially if expectations shift so quickly that the move up in rate expectations happens aggressively.
The two wrongs are that it was wrong to not tighten last year, but it may be wrong to tighten monetary policy too aggressively now. Monetary growth, which has accelerated ahead of the inflation spike, is now very sluggish. One doesn’t have to be a monetarist to recognise the importance of monetary aggregates on one’s economic dashboard. The Bank, though, does not appear to follow the monetary aggregates and these never figure in their quarterly Monetary Policy Reports.
The Bank has been slow to respond to the rise in inflation. Its communication, poor. Now the market expects UK policy rates to peak above 5% by next spring and then remain elevated through next year. Ahead of the mini-Budget, the expectation was above 4.5% and with a similar profile, although the global rate environment has deteriorated recently, too. The reversal of much of the policies of the ill-fated mini-Budget has removed the risk premium from UK assets that had been evident in recent weeks.
Despite this welcome development, though, rates and yields are far higher than earlier this year. Although off their recent peak, in the year to date the rise in yields has been around 3% for both two year and ten year gilts.
The fiscal stance has changed significantly. Earlier this year, markets were punishing sterling because of the domestic policy environment where the Bank was seen as behind the curve, and fiscal policy was tightening as taxes rose. There was a legitimate case to reverse the planned tax hikes, but the then Chancellor failed to allay market fears about economic policy and fiscal plans.
Although the Growth Plan that accompanied the mini-Budget has many good points – and indeed was endorsed by the business groups, the CBI, IOD and FSB – this was overshadowed not only by the unaudited and un-costed tax cuts that appeared in the mini-Budget but, in my view, by the Chancellor’s announcement the following Sunday (two days later), that he would double down on future tax cuts. This destabilised markets.
The markets, which were in a febrile environment, were not convinced that the fiscal changes announced in the mini-Budget were not inflationary or affordable. I felt that the market’s concerns about the inflationary implications were overdone, but alongside that, without the OBR to mark the Chancellor’s homework, they were concerned that his fiscal sums did not add up.
It is within this context that has led the new Chancellor to put achieving stability at the centre of his policy focus. There have been U-turns on policies to not raise taxes, plus reversals of tax cuts. These have totalled around £32 billion per year. At the end of October there may be austerity, too, of a similar magnitude. Such a tough fiscal policy will weaken the economy.
UK debt to GDP is high. This makes the outlook very susceptible to changes in the relationship with economic growth. A weaker growth outlook can cause havoc with the debt outlook, as too can higher rates. With growth slowing and rates rising, this is not a good backdrop. The trouble is that to tighten fiscal policy further makes the economic outlook worse. Ideally one should avoid such a pro-cyclical policy response – it is akin to being in a hole and digging deeper.
In fact, a legitimately higher growth forecast could result in the so-called black hole in the public finances being far less, limiting the scale of spending cuts. Also, higher inflation will help the ratio of debt to GDP fall significantly, and this factor is often overlooked. The trouble is, it is the private sector’s finances that are vulnerable if growth slows and interest rates on servicing mortgages, loans and debts rise sharply.
How will the economy cope with a tighter monetary and fiscal stance? The expectation that the Bank needs to keep hiking to get on top of inflation may give sterling some support. How sustainable that is, if the economy slips into a deep recession, remains to be seen.
The good news is the jobs market is still healthy, with unemployment low. But in recent months, the jobs market has shown signs of softening. This could accelerate if the economic downturn gathers momentum.
Meanwhile, consumer price inflation reached 10.1% in September, up from 9.9% in August. I think inflation could decelerate to 9.6% in October. So, the double-digit rate seen in September may prove to be the peak in annual inflation. The challenge, though, is the rate at which it may decelerate.
Previously, I have said that there could be a significant fall, but that post this crisis inflation may settle around 3% or so, higher than the 1% to 2% witnessed before. If the Bank had acted sooner, it would have been able to cap the feedthrough of inflation. If it hikes too aggressively now, it will weaken the outlook.
To show that it was not subject to fiscal dominance, where fiscal policy dominates monetary policy (although this is very much what happened last year when it engaged in QE), the Bank is following through on Quantitative Tightening. This will involve selling gilts. And alongside other gilt issuance arising from fiscal policy, this will see longer-dated bond yields remain elevated. The housing market will suffer as a result.
Conclusion
Overall, in recent weeks UK markets have been impacted by a combination of factors, including: the tough global backdrop; market concerns about inflation; and by worries about economic policy and fiscal discipline, with the latter not just triggered by the mini-Budget, but more particularly by the comments the following Sunday about doubling down on tax cuts.
The previous concerns about the UK being the only G7 country to be tightening fiscal policy through higher taxes (going into a global downturn) raised the justified case for using fiscal policy to stabilise the economy – but this was poorly handled by not having the fiscal sums fully costed and through unnecessary tax cuts.
Thus, the policy reversal and the welcome moves to restore stability by outlining fiscal tightening have removed the risk-premium in UK assets. But now, the danger is this may go too far with the combination of a very tough fiscal and tougher monetary policy hitting the economy hard. Hence the immediate outlook is a challenging one for the economy, and in turn, for UK financial assets.