Markets uneasy over new Truss-Kwarteng era

Financial markets assess the health of a country’s economy and its political stability in two ways. The fledgling Truss-Kwarteng government got off to a shaky start, at least as far as the government bond and currency markets are concerned.

Let’s start with the bond markets. UK government bond buyers express their satisfaction or concern through the demanded yield on government bonds. The worse the prospects and the less confidence investors lose, the higher the compensation they are asking for.

The bond markets don’t seem impressed. Granted, the 10-year Treasury yield bottomed in the summer of 2020 as the economy began to shake off Covid-19 and inflation picked up speed, but the benchmark Gilt yield has fallen since Liz Truss’ Conservative election victory on May 5. September skyrocketed – hardly a vote of confidence.

A jump of almost 40 basis points to an 11-year high Friday morning in mini-budget also looks like a thumbs down.

Sterling’s continued – and apparently accelerating – fall to new 47-year lows against the dollar suggests that FX markets have yet to be persuaded of the fiscal plan.

The government follows the playbook of tax cuts and supply-side deregulation dictated by the Thatcher and Reagan administrations in the early 1980s. Some call them the architects of an economic turnaround after the stagflationary chaos of the mid-to-late 1970s.

Stock and bond prices have risen steadily since these reforms, albeit with major stumbles along the way. From this perspective, Downing Street’s newcomers may be surprised that their program has been greeted with such indifference by currency, bond and even stock markets, where the FTSE 100 fell sharply on Friday.

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Perhaps one reason for this is that Kwarteng has less room for maneuver than his Conservative predecessor, Sir Geoffrey Howe, did in the early 1980s.

At that time, public debt was less than 40 percent of GDP, while interest rates peaked at 17 percent in late 1979 and began to fall in the second half of the 1980s. By contrast, the national debt of over £2 trillion is now almost 100 per cent of GDP and interest rates are likely to rise further as the Bank of England grapples with the legacy of its misperception that inflation would prove temporary.

This could explain why markets are nervous given that Kwarteng’s plans are currently uncalculated and the initial lack of involvement from the Office for Budget Responsibility.

But it may also be rising prices that worry them. The BoE is now trying to prevent inflation from taking hold in the service sector of the economy and then fueling the cycle of higher prices, higher wages, higher prices and higher wages that plagued the 1970s. Problems then arose from the end of the barber boom in Britain, the pro-spending presidencies of Johnson and Nixon in the US, and the aftermath of the oil price shocks of 1973 and 1979.

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Investors with a long memory will certainly feel uneasy at the thought of such parallels.

The 1970s was a terrible decade for UK gilt holders and even the current 3.78 per cent yield on 10 year gilts looks like a no return risk compared to the prevailing rate of inflation.

Stock investors are worried too. Although the FTSE All-Share quadrupled from its January 1975 low by the end of the decade, the previous collapse meant that the index’s 56 per cent rise over the entire 1970s was offset by the 290 per cent rise in the retail price index as an inflation benchmark in was eclipsed over the same period. Only gold bugs ended the 1970s with a smile on their faces as gold bullion rose from the Bretton Woods level of $35 an ounce to over $800 by the early 1980s, aided by Nixon’s withdrawal of the dollar from the gold standard in 1971.

With most gains coming from abroad, and between 40 and 50 percent of gains in 2022 and 2023 expected to come from miners and oil, consensus forecasts suggest the current FTSE 100 may be in better shape than the FTSE All-Share of the 1970s investors to protect against a sustained inflationary storm.

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But the boom in UK financial assets since the early 1980s has been fueled by disinflation, falling interest rates and easy money from the central bank. At first glance, the current environment offers none of these three.

Central bankers now seem to accept a downturn or even recession as a short-term price worth paying for the long-term gain of lower inflation. But politicians who think in terms of election cycles are likely to see the downturn and, as a result, unemployment as the greater enemy. Voters will be unhappy with inflation, but they will be far more desperate and likely to put a cross next to someone else’s name at the ballot box if they lose their jobs.

It was former Labor Chancellor Denis Healey who argued that good government is about “stable prices, jobs for those who want them and help for those who need it”. Investors, workers and voters alike will hope that the government’s supply-side reforms deliver a similar combination of disinflation and growth.

The author is an Investment Director at AJ Bell

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