Top of mind -
The big mini-budget
Liz Truss has been Prime Minister for less than a month, yet her administration has dramatically changed the course of the UK government’s economic policy.
In a mini-budget delivered in September, the Chancellor of the Exchequer, Kwasi Kwarteng announced a series of bold tax and policy reforms. The reversal of both National Insurance contribution increases and planned corporate tax increases was expected. What surprised markets were further tax cuts, including the bringing forward of a reduction of the basic rate of income tax from 20% to 19%; abolishing the 45% tax band cut; and a cut in stamp duty. The total package of tax cuts was estimated to be in the region of £45bn, the biggest as a percentage of GDP since the 1970s.
The market reacted quickly and poorly. UK 10-year gilt yields moved from 3.5% pre-budget to 4.5% in a matter of days. Higher yields mean it will be more expensive for the government to borrow money to fund the deficit. The sterling collapsed, falling to record lows versus the US dollar.
Within days, the plan to abolish the 45% tax band was scrapped. Almost immediately, the sterling rallied, reaching higher levels than before the mini-budget.
However, while the policy reversal offered some support to the sterling, crucially, the dollar weakened slightly, which has also helped boost sterling. The US Dollar index is down 3% since 26 September. Furthermore, while UK 10-year bonds have bounced back to pre-budget levels, global government bond yields have also decreased. So, while the policy reversal undoubtedly gave sterling and gilts a boost, they also benefited from a weaker dollar and government bond yields decreasing globally.
All said, the 45% tax band cut was the smallest part of the budget. Cancelling it only saves between £2 billion to £6 billion out of the £45 billion. Therefore, the fiscal deficit is still expected to rise substantially.
Why are we seeing such big moves?
These tax cuts, coupled with the UK government’s support to freeze energy bills for both consumers and businesses, have resulted in an extraordinary fiscal package. The Treasury dramatically needs to increase the amount it borrows for years to come, and the market is now challenging the sustainability of the UK’s finances and demanding a higher yield on the debt.
This stimulus comes when inflation is at its highest levels in decades and unemployment is at historic lows. This may send inflation even higher. The BoE’s priority is to maintain price stability. The collapsing sterling will no doubt spur the BoE to raise interest rates even quicker. Higher interest rates tend to keep capital from leaving the country.
Impact to UK economy
The government is making a huge bet that its fiscal plan will help jumpstart the economy. The hope is that tax cuts, along with further policies meant to deregulate the economy, will push UK growth back to 2.5%.
This is no easy task. GDP growth requires more people to enter the labour force. It also requires improved productivity of the labour force. The UK is an aging society, and unemployment is already low. Without immigration, growth in the labour force is expected to be muted. Productivity growth will be driven by business investment in the UK. While tax cuts can spur investment, it is one of many criteria businesses consider in boosting investments. Strong trading partners are also essential, as is an investment in higher education.
The tax cuts announced should support consumer spending short term. However, if the BoE raises rates further, increases in mortgage rates will curtail this. In addition, further declines in the sterling will likely increase the cost of imported goods and weaken consumer sentiment.
There is much to cheer from the mini-budget, but acute borrowing is a risky move. If there are further shocks in the global economy, or the price of gas climbs higher, fiscal borrowing could increase further still.
Investors should maintain a highly diversified portfolio to prepare for any possibilities.
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