In the United Kingdom, monetary and fiscal policy is no longer hand in hand. While the Bank of England was trying to slow down demand and inflation, Liz Truss' government lowered taxes to boost consumption, killing public accounts.
This is very unpopular with investors, precipitating the fall of the British pound, causing bond yields to rise and forcing the Bank of England to intervene. Do we still need to invest in the UK?
The Bank of England does what it can
In the current economic climate, which is marked by high inflation everywhere, the task of central banks is not apparent, and that of the Bank of England is no exception.
As the United Kingdom has been facing inflation rates of 9% since April, it had no choice but to increase its key interest rates seven times over the past year, raising the key policy rate by 0.1% until December 2021. At 2.25% today.
This policy aims to slow down an economy that is overheating in the aftermath of the pandemic and suffering from supply chain difficulties, as well as a shortage of labour, two phenomena that Brexit still amplifies.
Unfortunately, these seven increases were not enough for investors; the last one, by only 0.5% - while the US Federal Reserve had just increased its share by 0.75% - it went badly. With the primary US key interest rate now 3.0% to 3.25%, the interest rate differential between the two countries is increasing in favour of the US dollar, which is appreciating against the UK currency.
The fact that the Bank of England has begun to disengage from the debt markets does not help. Since March, it has allowed a portion of the debt it holds to mature, not reinvesting the amounts recovered. At the beginning of September, she began to get rid of the British debt she had actively.
Debt for which a buyer must be found. Investors do not rush; it is through the adjustment of asset prices that this balance must be found. Better returns, but also by the fall in the currency in which these assets are denominated, to make them more attractive. Naturally, interest rates were on an upward trend while the English pound was losing momentum.
Like an elephant in a china shop
The fact that the Bank of England gradually withdrew from debt markets does not help. Since March, it has allowed a portion of its debt to mature, not reinvesting the amounts recovered. In September, it had to start actively getting rid of its British debt. Investors would therefore be more likely to finance British debt.
However, it is in this delicate phase, where the latter had to be reassured about the credibility of the London authorities, that the mini-budget of the new Prime Minister Liz Truss and her Chancellor (Minister of Finance) arrived at Kwasi Kwarteng, determined to turn the economy around at all costs.
Removal of the top tier for income tax, lower tier tax rate from 20% to 19% in 2023, reduction of registration fees for real estate purchases, cancellation of the planned corporate tax increase, the shortfall in tax revenue is estimated at around £45 billion (around €50 billion). At the same time, households will see their energy bill capped at £2,500 per year (some €2,800) for two years, a measure that should cost the state coffers some £150 billion (€166 billion). All to be financed by additional debt, for which it will be necessary to find a buyer.
Impact of these measures on the public accounts? They will not be known in the immediate future. The OBR (Office for budget responsibility) has been muzzled, and its forecasts for both the economic impact and the deficit and debt have not been published.
The pound plummets, and interest rates soar
All this gives a very moderate degree of reassurance to investors who rarely see such a gap between monetary and fiscal policy objectives in a large Western economy. The English pound bore the brunt of this distrust, affecting, during the session, the 1.04USD while, on the whole of 2021, it traded at 1.38USD on average. As for the British 10-year rate, negotiated at the beginning of August at around 1.8%, it soared to approach 4.6%.
In the end, the Bank of England had no choice but to retrace its steps, buying £5 billion in long-term debt for 13 days for a total of £65 billion. This stabilising effect on the markets allowed the pound to rebound somewhat and interest rates to cool off, with the 10-year mark returning to 4.0%.
How can we end the crisis? Not so sure. The central bank’s margin is limited. If it intervenes on the front of debt buybacks, it is, among other things, because its foreign exchange reserves are minimal, not exceeding hardly 108 billion pounds at the end of August. And if market stabilisation is necessary, its intervention cannot absorb the consequences of a fiscal policy that is at least risky.
Variations of this magnitude have an impact on the real economy. The fact that the pound has lost some 20% of its value against the US dollar will inevitably contribute to increased imported products, especially energy. A few months ago, the Bank of England forecast inflation to peak at 13%. The fall of the pound strengthens the chances of such a scenario.
The sharp rise in interest rates is also very worrying because it directly impacts households (heavily indebted) and businesses. At this stage, the uncertainty is such that several mortgage lenders have temporarily chosen to suspend new loans. This could stop the housing market, on which the British economy relies. This is also likely to weigh on investment, one of the vectors through which the government intends to stimulate the economy.
British exceptionalism admits its limits. The London authorities are jeopardising their credibility by believing they will be entitled to preferential treatment from the investment world.
As a result of recent announcements, debt will increase, as will the amounts needed to finance and refinance it, for which a buyer will have to be found. The upward pressure on interest rates will remain in order, and any investment in British bonds is risky. We stay out of that market. By contrast, the London Stock Exchange – particularly its flagship index, the FTSE 100 – is primarily made up of multinational companies with a global footprint, active in defensive sectors (such as health) or natural resources.
Overall, the London market, mainly the FTSE 100, is an attractive diversification for any portfolio.
(Note: article updated on October 04th)