Q3 Investment Update – Dark Carnival

This update strives to be apolitical. We do though, have a view on markets and it turns out that markets have a view on UK politics.

Quarter 3 of 2022 looked very much like a trapezium, with July showing a sharp rise, August a flat return and then a fall in September. For UK residents this was eclipsed on 23rd September by Truss and Kwarteng’s ‘mini-budget’.

The market wobbles started with Prime Minister Truss & Chancellor Kwarteng removing Tom Scholar as permanent secretary to the Treasury. He was widely seen as one of the most experienced civil servants at the Treasury having worked with Brown and Cameron followed by chancellors; Osbourne, Hammond, Javid, Sunak and Zahawi. This move was to appoint someone less likely to challenge their joint tax-cutting economic growth plan as outlined in their short 2012 tract Britannia Unchained, co-authored with Priti Patel, Dominic Raab and Chris Skidmore.

The decision was then made to ask the Office for Budget Responsibility not to publish the usual analysis of the economic impact of the ‘mini-budget’ alongside it (contrary to some reports, the OBR offered an analysis). The relatively new head of the OBR, Richard Hughes is another individual with an excellent economic CV.

With what was about to follow – one wonders if experts are the ones we ought to be turning to after all.

When it arrived the ‘mini-budget’ contained huge spending to cap household energy bills £72bn-£142bn and £22bn-£48bn to cap commercial energy bills (according to Cornwall Insight). This measure was not means tested, did nothing to encourage energy use reduction and was to be funded by government borrowing. If the cost ends up at the higher end of the estimate it will cost two Covid furloughs (the new unit measurement for huge unfunded government spending).

At the same time as increasing government borrowing through spending it did the same through cutting income (estimated bill of £45bn). It contained tax cuts (removing the 45p rate of tax on earnings over £150,000 and cutting stamp duty), acceleration of tax cuts (basic rate income tax from 20% to 19%), a series of reversals of previously announced tax increases (National Insurance increase of 1.25% and Corporation Tax increase from 19% to 25%) and a removal of the cap on bankers bonuses. The net effect was an estimated £10,000 boost to the richest households and £22 to the poorest.

The total cost was estimated at £160bn but with a wide range of possibilities. Partial funding of all of this by cuts to departmental spending were not included but trailed as coming at a later date. It was this uncertainty over the cost, combined with the lack of analysis that triggered a market sell-off in UK assets.

Sterling fell to nearly parity with the currently strong US Dollar and fell against nearly every other currency including the Mongolian Tugrik. The capital value of UK government loans (Gilts) fell sharply, leading to a rise in the yield and adding a further circa £12.5bn to the government’s debt interest bill. UK stockmarkets fell and UK house prices were predicted to do the same by the year end. The ratings agencies downgraded their growth forecasts and adjusted their assessment of the security of UK government debt downwards. In short the markets did not like the budget – they did not like it at all.

A strong tendency for long rates to go up as the currency goes down is a hallmark of situations where credibility has been lost.

Larry Summers, Harvard Professor & Ex-US Treasury Secretary

The fall in Sterling was good news for most of our clients who are globally invested and earn dividends in US dollars but was bad news for clients of the big UK fund managers who tend to be over allocated to the UK markets.

The really bad news was to come though.

Investors seem inclined to regard the UK Conservative Party as a doomsday cult.

Paul Donovan, Chief Economist UBS

With the UK crashing on all measures, the Bank of England was forced to step in and in effect counter-act some of the government’s own measures. They increased interest rates to try to dampen down soaring inflation. This led to 60% of mortgages being withdrawn by the market and replaced with much pricier deals. All of a sudden any gains from the budget were more than wiped out by rising inflation, mortgage interest payments and falling investments.

The Bank was due to start selling assets in its long-overdue unwinding of its post-Global Financial Crisis/Covid money printing operation (quantitative easing). It was forced into a reverse ferret and a £65bn bond (£5bn per day until 14th October – since doubled to £10bn) buying commitment to stablise markets.

The extraordinary thing about all of this is that we now have a situation in the UK where Monetary policy (central bank activities to control money supply) is in direct conflict with Fiscal policy (where a government controls tax and spending to influence the economy).

Given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture. It is important that fiscal policy does not work at cross purposes to monetary policy.

International Monetary Fund – IMF

The cause of this bond buying spree was an event that has been under-reported given its importance (probably because journalists have filed it under too opaque). Some of us will remember CDOs (collateralised debt obligations) triggering the Great Financial Crisis of 2008. These nasty packaged financial products nearly blew up the banking system when they went wrong and banks needed huge government bailouts to prevent bank runs. Well a similar event just happen in the defined benefit pension market.

Private sector Defined Benefit or Final Salary pension funds own something close to £2tr of assets and a substantial portion of these are held in UK government debt. This is a useful asset for these schemes to hold as they have very long-term income liabilities to current and future pensioners and UK government Gilts can have long-maturities and pay an income. In recent years, though, Gilt yields had started to fall and so funds were finding that they had shortfalls between their liabilities and the assets they had to fund those liabilities. Enter another three letter acronym LDI (liability driven insurance). LDIs were essentially a derivative based contract allowing pension funds to insure their liabilities by entering into an interest-rate swap (essentially swapping a fixed payment for a variable one at a later date). Some of these LDIs also included leverage which just means borrow to magnify your returns when the value of your assets goes up. Pension funds would commit their existing assets to these LDIs as collateral.

Unfortunately as the Gilts that the pension funds owned, tanked in value following the budget, the banks issuing the LDIs made margin calls on these assets to cover the liabilities (a useful reminder that leverage not only magnifies gains). This forced the pension funds to sell assets that were falling in price, exacerbating the price falls and their liability position.

Eventually the pleading of pension fund managers that they were facing very serious problems and that some would go bust, was acted on by the Bank of England who started to buy Gilts again to shore up the price. There have been mixed reports about the take up of the scheme but Bloomberg is reporting tens of billions of pounds of asset purchases and the Bank has broadened the scheme to buy other assets (all very reminiscent of the purchases made of bad assets from the banks post-2008).

The Bank of England’s purchase of £65 billion of gilts is only a temporary fix. LDI and a shift to illiquid assets — the solutions promoted by investment managers to help defined-benefit pension plans manage falling interest rates — may have helped solve one problem only to give rise to a deeper systemic risk.

Charles Graham & Kevin Ryan, Bloomberg Analysts

Of course some individuals did very well from this crisis, including a small group of Hedge fund managers (well known to Kwasi as he had met with them pre and post-budget) who shorted the pound and made huge profits. This sort of currency bet is not a victim-less trade. Money made by these managers for a handful of clients is money that has disappeared from the economy. Next time you buy some US dollars for that holiday, a Hedge fund manager somewhere warm might be toasting you.

Liz and Kwasi will tell you that all of this doesn’t matter because of growth. They will say that we can grow our way out of this mess by cutting government spending and reducing regulation. Essentially freeing up the private sector to become more efficient and profitable once it is unleashed. We often hear the refrain that the state is too big and needs cutting back but when you ask what public service the speaker wants to cut back the answer is never doctors, nurses, police, firefighters etc, it is only ever Civil Servants, as though there is some huge untapped pool of these individuals being paid for doing nothing. The same goes for deregulation, everyone is against red tape until you try to take away their employment rights, legal rights or environmental protections.

One way of driving growth would be to invest in companies and start exporting. If only our exports hadn’t dropped off a cliff in recent years.

Some commetators think that the mini-budget really was like taking a shotgun to both feet. There were easy wins to be had that could have enjoyed wider support and still achieved the chancellor’s aims. The FT economist Tim Harford outlined 5 excellent ideas here.

On tax cuts, instead of focussing on the 45p income tax rate, he could have binned the complex 60% income tax rate introduced by Alistair Darling on earnings between £100,000 and £125,140. Our tax system, much like policing’s Peel doctrine, depends on public consent. If everyone sees the tax system as simple and fair they are more likely not to avoid paying it. The 60% tax rate is complex and unfair as it charges 50% more tax to a small band of earnings before the rate reduces again. Many chancellors have baked these kind of complex tax rules into the system with other examples being the taper on the dual residence nil rate band, taper on pension contributions and limit on pension funds. All of these would have be less controversial than the 45p rate which had to be U-Turned on in the end anyway.

In fact it is worse, as the proposal on the table is to get rid of the well regarded Office for Tax Simplification set up by George Osbourne.

On investment, it would have been a well received patriotic message that announced huge investment in renewable energy infrastructure building, if packaged as the quickest way to become energy independent of Putin.

Instead we have a proposed ban on solar farms and a windfall tax on renewable energy providers rather than their dirtier cousins.

In conclusion, David Allen Green, the famous legal blogger has always said that constitutional law should not be exciting, and yet it has been for the last 6 years. We would say that the same goes for pensions and Gilts, they should not be exciting. They should certainly not be headline news.

Brace, brace.

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