The past week has seen a number of significant changes for the global economy.
Firstly, interest rates have risen sharply. In the United States by 0.75% and in the UK by 0.5%. In general, rates rose by around this amount across the rich world.
Secondly, stock markets fell as investors began to internalize the reality that rates will stay high for a sustained period, in order for central banks to be sure that inflation has been driven from our door.
Finally, here on our misty isle we have had our own problems. The British pound fell sharply against the dollar and other strong currencies in the wake of the mini-budget announcements of Kwasi Kwarteng. He unveiled huge tax cuts alongside the energy cap and failed to produce any real plan for balancing the books.
Source: Bloomberg, 26/09/2022
In one sense these changes are no surprise. Our portfolios have been positioned for many months for the reality that central banks will, as the Americans say, ‘play hard ball’. We knew they would not tolerate any declarations of victory over inflation from stock markets until they were absolutely sure it had been accomplished.
We were also confident that in this environment, the US dollar would rise in value versus the pound and that owning overseas bonds issued principally by the United States government would be a better holding than our own UK gilts.
For this reason, we should reassure investors that whilst no portfolio can avoid falling stock markets altogether, we have fundamentally been positioned in the right way to cope with these changes.
Although, we must acknowledge that we could not have anticipated the pound would fall as fast as it has this past
However, what is a surprise is the actions taken by our new chancellor. The central thrust of Liz Truss’s leadership campaign was to argue that she was, to coin a phrase of Michael Gove, ‘sick of experts.’ She argued that HM Treasury was full of grey conventional wonks not capable of seeing the big picture and taking the radical action to get our economy growing.
In response to this she has put in place a range of changes that will certainly produce arrhythmias among these civil servants but has also caused frankly bafflement amongst almost every serious economist across the world.
The problem with the changes announced in the mini-budget is that it is hard for any economist, of whatever political persuasion, to put together any credible argument for why it might work.
Amongst those expressing horror we can count Harvard’s leading economist Jason Furman (“I’ve rarely seen an economic policy that is as uniformly panned by economic experts and markets”) former US Treasury secretary Lawrence Summers (“the UK is behaving a bit like an emerging market turning itself into a submerging market”) and the FT’s chief economist Willem Buiter (“totally, totally nuts”). Oh dear.
Secondly, stock markets fell as investors began to internalize the reality that rates will stay high for a sustained period, in order for central banks to be sure that inflation been driven from our door.
For a number of reasons.
1. Inflation is a deadly disease
There are few forces in the world as dangerous and damaging as inflation. It has been found at the scene of the crime for many of the darkest moments in human history. Once it becomes ingrained in the behaviour of ordinary people it can define the economic prospects of an entire generation.
Therefore defeating it has to be the first priority for everyone, something we have understood for more than 40 years. The only really proven way to defeat inflation is by raising interest rates and this can cause a recession. However, a temporary recession is a small price to pay for avoiding a long-term inflationary cycle.
At the current time there is good evidence that inflation is falling. Increases in oil prices, food prices and broad commodity prices have slowed. In time we can hope the price of services will fall too. However, most experts agree it is far too early to declare victory. If you are taking medication for a deadly disease and you have taken enough that your probability of survival has risen to 60%, but you know you can carry on and reduce that to 90%, few sane people would stop taking their pills.
Yet this is exactly what Liz Truss and Kwasi Kwarteng are doing. By hiking government spending in the face of sky-high inflation they are increasing the chance that we do not beat that inflation. Truss says her tax cuts are ‘not inflationary’. There is simply no reason why this would be true. It is one of many things she says that she wants to be true, despite no real reason to believe they are.
2. More demand does not solve the problem
Liz Truss is a person on a deadline. She has two years to recover the Conservative’s 10-point polls deficit to Labour and win her own electoral mandate. She is therefore looking for rapid ways to stimulate the economy. There is no doubt that these tax cuts may well do that.
Of course, if people are faced with a cost- of -living crisis, growing income inequality and real poverty growth it may not feel that way.
However, just temporarily stimulating the economy by borrowing vast amounts of money does not solve the problem. Truss’s hero Margaret Thatcher understood that demand-side reforms such as cutting taxes had to be accompanied with supply-side reforms. These are incentives to help people produce more, innovate and improve their efficiency and competitiveness.
The supply-side reforms of the 1980s were huge in scale. They included the wholesale de-regulation of finance with the Big Bang, the privatization of large swathes of industry and (inconveniently for Truss) the opening-up of far more trading with the European Union.
In comparison, the reforms proposed by this government are laughably small. We are promised ‘investment zones’ yet the evidence says that these generally produce little real growth and instead take money from places where we can tax it, to places we can’t. The end of the sugar tax is floated although quite how this is going to help the economy we do not know. Perhaps most strangely the de-regulation of childcare. This is presumably to encourage more people back into the workforce although one wonders who is going to do this at the expense of proper checks on their children’s carers? In reality these reforms are miniscule. Whilst more action can be taken to make life tougher for those claiming benefits in the hope they return to the workforce; the current regime is already tight by historical standards and the gains are likely to be small.
So could Truss and Kwarteng’s plan be saved in the long-term? It would undoubtedly entail the announcement of further significant supply-side reforms. These are things like de-regulation, opening up trade or privatization. We are open to suggestions about what these reforms could be (although presumably if they existed, they would already have announced them). Indeed, an informal poll of fund managers last night to ask this question on WhatsApp only produces one serious answer: re-joining the EU. That we suspect is not considered an option for Truss.
In the immediate term the issue this plan creates is the credibility of the UK in international markets. A loss of credibility leads to a falling pound and rising borrowing costs on the UK gilts market.
The last time the credibility of government bond markets was tested was in the early 2010s. Then it was countries like Italy and Spain that saw their borrowing costs soar. However, they were backed by the implicit support of Northern Europe as members of the Euro. Britain at the time adopted policies of austerity to reassure markets.
Today in the face of rising borrowing costs and a real risk of this breakdown in credibility we have a government that has responded to the sharp fall in the pound by doing the rounds of Sunday morning television shows announcing that ‘you haven’t seen anything yet.’
The risks then to the UK are real. Our response is to continue positioning portfolios in the way we have done for many months. We will maintain less exposure to the UK domestic economy, the UK gilts markets and the pound. Instead, we will lean into our dollar-denominated assets such as US shares and prepare to benefit from the much higher fixed returns that are now on offer in the bond market following the sharp sell-off.
Our objective is clear. When markets fall, we want portfolios to take as little of the pain as possible. This enables us to be well-positioned for the fact that as prices fall, the long-term expected returns looking forwards look much better.
In the coming days we will be publishing new data on how far expected returns have risen in this crisis. We believe it will serve to reassure investors that every bear market leaves an investment world abundant with fresh promise, however bleak it is whilst it transpires.
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