Heraclitus, a Greek philosopher, once said “change is the only constant in life.” Sometimes those changes come gradually and sometimes they hit us like a torrent. Within 72 hours this month, we witnessed both a change of Prime Minister and a change of our Monarch. For most of us, Queen Elizabeth II has been the only Monarch we have known and she will be missed.
Prime Minister Truss has inherited something of a poisoned chalice with high inflation, falling economic growth, high government debt and the continued war in Ukraine. Immediate steps have been taken to prevent the cost-of-living crisis getting worse with a huge financial support package to cap energy costs for both consumers and businesses. Arguably, this was essential as without it people would face stark choices over the winter and the UK would be facing the potential of a severe recession with inflation estimated to peak at over 13%. However, the plan is not targeted (all consumers and businesses benefit) and is estimated by the Institute for Fiscal Studies to cost in excess of £100bn (although we won’t know for sure as the government has declined to have it assessed by the Office of Budget Responsibility). This will not be paid for by a windfall tax on energy companies but rather by additional borrowing, which means it will be paid for through our future taxes and those of our children and grandchildren.
In addition to the energy cap, the Government has announced a series of polices to increase investment in the UK and some eye-watering tax cuts through the ‘mini-budget’:
- Removal of 45p additional rate of income tax
- Reduction in income tax to 19% from April 2023
- Stamp duty cut
- reversal of National Insurance and corporation tax rises.
This is part of Truss’ philosophy of “trickle down” economics which proposes that lowering taxes and reducing red tape will create economic growth. Whether this works in practice remains to be seen but it will add to the indebtedness of the UK. Increased government borrowing (the package is expected to add £161bn over five years) at a time of rising interest rates, rising inflation and rising gilt yields is something of a gamble, especially when the Bank of England has suggested we may already be in recession, albeit a very small ‘technical’ recession (economic output fell -0.1% in Q2 and is expected to fall -0.1% in Q3). International markets are keenly aware of these issues and we have seen sterling fall against the dollar to levels we have not seen since 1985. The immediate reaction to the announcement was not favourable with the UK stockmarket, gilts and sterling all falling.
The general fall in sterling may not be all about weakness in the UK economy however. The Federal Reserve has been aggressively raising interest rates to combat inflation (which is now a global issue). Money tends to flow to where it can achieve a higher return which makes US Dollars a good place to park cash. The Dollar is also the worlds reserve currency so it tends to rise in uncertain times, while most commodities are priced in dollars which increases demand for the currency when prices are high.
It is likely we will witness continued interest rate rises until central banks are confident that inflation is falling. The Bank of England expects inflation to rise to around 11% (after the energy price cap) later this year before falling back relatively quickly in 2023, although the stimulative nature of the recent tax cuts could extend this. Over 50% of the current inflation rate is due to energy price rises but core inflation (goods and services) remains elevated at around 6%. The Fed expects to raise interest rates by another 1.5% to peak at around 4.5% early next year.
Central banks know there is little they can do to combat the current high rates of inflation from energy prices. The real concern is the secondary effects of inflation; those in goods, services and pay. If people get used to high inflation, they will demand higher wages and bring forward spending (in case things cost more in the future). This creates a virtuous circle of high inflation which can be very damaging. By raising interest rates, they reduce the supply of money and reduce consumer and business spending. This is likely to reduce employment, or at least the number of vacancies, which reduces the chances of high wage demands (people are happy to have a job). Whether they can do this successfully without creating a larger downturn remains to be seen. On a positive note, unemployment on both sides of the Atlantic remains low and vacancies, while falling, remain high by historic standards. It would be very unusual to have both low unemployment and a significant recession. The likelihood then, at this stage, is a small fall in economic output (probably a technical recession) and a period of stagnation until inflation rates fall and interest rates stop rising or potentially then start to drop. Unfortunately, it is impossible to tell how long this might take to work through.
So, what is the impact on markets?
Unsurprisingly, markets have remained volatile. Since the last update, end of June 2022, the global stockmarket (FTSE World index) is actually up by 5.65% but there was a strong recovery until mid-August followed by another fall. This is likely to remain the pattern of markets as investors try to figure out the impacts of inflation and interest rates. Sterling weakness against the dollar has benefitted holdings in the US particularly but also global investments. Large companies, oil and gas companies and economically insensitive companies (tobacco, staples etc) have general performed better than smaller companies and those exposed to falling consumer spending.
Bonds have fared less well, in particular UK gilts which have fallen by -10% in the last three months. Bonds are historically a low-risk asset class because they deliver a fixed income and a known return of capital. However, bond prices are affected by rising interest rates and inflation so the current situation has not been kind to bonds. As inflation and interest rate expectations start to peak bonds should start to perform better. In particular, they should revert to a hedge against stockmarket weakness should we enter recessionary conditions.
Cash-in to rising interest rates.
Following on from the last update on retaining cash for emergencies, one benefit of the current situation is rising interest rates. For the first time in over a decade, we are starting to see reasonable interest rates being offered on cash accounts. These rates are still a lot lower than inflation but it is worth making sure your cash allocation is working as hard for you as possible. Listed below are a few of the leading options from large, reputable institutions as an example*:
Skipton Building Society Easy Access ISA: 1.5%pa gross
Nationwide 1-year fixed rate bond: 2.75%pa gross
Santander 1-year fixed rate ISA: 3%pa gross
Yorkshire Building Society 2-year fixed rate bond: 3.25%pa gross
National Savings & Investments Green Savings Bond: 3.3%pa gross, fixed for 3 years