Will UK assets move on up after the mini-budget or hit the ground?

The immediate storm in the wake of Chancellor Kwarteng’s fiscal event (aka the ‘mini-budget’) appears to have calmed. The gilt market has stabilised following the Bank of England’s intervention in the UK bond market, sterling has recovered some ground versus the dollar and euro, and the UK Government has backed down on some of its more controversial measures. Nevertheless, investors are still digesting the longer-term impact of this change in direction.

In the bond markets, 10-year gilts are currently around 4%. However, pressures remain. Gilts face a supply and demand problem. On the one hand, there is increasingly huge supply. The Resolution Foundation estimates that the spending measures and tax cuts will drive up borrowing by £411 billion over the next five years.

On the other hand, it looks like there may be fewer buyers for UK government debt. The Bank of England has ended its bond-buying programme that was used to finance the Government’s stimulus programme during the pandemic and some international investors are worried about the UK’s precarious finances to invest. When investors can get a similar yield on US treasuries, and with it, exposure to the US dollar, it is difficult to make a compelling case for gilts.

Against this backdrop, yields could move higher still, with repercussions for mortgage rates. In the immediate aftermath of the mini-budget, lenders pulled almost 40% of mortgage deals[1]. Many have returned to the market today, but while uncertainty persists, rates are higher. The average two-year fixed rate mortgage has now tipped over 6%[2]. In the worst cases, borrowers who are re-mortgaging may be moving from a rate of 1-1.5% to 5-6%. HSBC estimates that this could see mortgage costs rise by £3,000 to £5,000 for the average household.

The recent popularity of longer-dated fixed-rate mortgage deals, in the UK, is cushioning the blow. HSBC says the average borrower is shielded from rate rises for over 3.5 years, more than three times longer than a decade ago. However, higher mortgage rates will push household incomes (after mortgage expenses) lower over the next two years and weigh on the housing market. This makes economic growth more difficult to achieve.

The corporate sector is also exposed to high interest rates. Higher borrowing costs could render corporate balance sheets more precarious and damage profitability. If the Bank of England base rate rose to 6%, corporates could come under significant pressure. This may temper the Bank of England’s plans for further rate rises. It is unlikely to hike so aggressively that it risks an economic slump and corporate defaults.

The turmoil in financial markets briefly looked and felt like a real financial crisis for the UK. Many economists have pointed out that this was not a purely mathematical phenomenon. The Government’s debt-to-GDP ratio is below many of the UK’s developed-market peers. The problem appears to be one of credibility – in sidelining the Office for Budget Responsibility, firing the Treasury’s most senior civil servant, Tom Scholar and criticising the Bank of England, the UK Government started to look as if it was undermining key institutions.

Any immediate crisis appears to have been averted. The Chancellor has brought forward the timing of his fiscal plan, which sets out how the Government will pay for the tax cuts and spending he has announced. Nevertheless, this is already controversial, with the Cabinet scrapping over proposed cuts to the welfare system. Equally, it will be hard to win back credibility with international financial markets.

Sterling has recovered a little, which lowers the risk of an upward spike in inflation due to higher import prices. Nevertheless, it is difficult to see a catalyst for it to rise significantly from here in the near term. In normal times, the combination of easier fiscal policy and higher interest rates should raise a currency higher, but this needs to be set against the general distaste for UK assets.

This is the million-dollar question. If the Government’s plans create growth, as it expects, the UK’s finances should right themselves... However, the jury is still out on whether the measures in the mini-budget will achieve that. Lower taxes may create the hoped-for trickle-down effect. On the other hand, higher interest rates could wipe out the effect of any tax cuts for many households. A rise in yields and decline in the pound could prompt higher savings and weaker investment into the UK. The UK already has one of the lowest investment rates in the Organisation for Economic Co-operation and Development (OECD), which appears to be a significant source of its low growth and productivity.

It is not original news to say that FTSE 100 companies generate the majority of their revenues overseas, and therefore tend to benefit from a weaker currency. The FTSE 100 has been relatively resilient through this period. The impact of UK economic weakness is likely to be felt more acutely among more domestically focused small and mid caps (though in practice, these companies tend to be more international than their reputation suggests).

The gilt market looks more difficult. Although yields are superficially appealing, lower bond prices could push yields higher still. The correlation between equity and bond markets is at historic highs and it is difficult to argue that gilts are fulfilling their role as a ballast for a portfolio in difficult times. We suggest caution and prefer shorter-dated gilts. Equally, we believe there is merit in diversifying into global bonds, with similar yields to be found elsewhere.

The greatest reassurance for investors holding UK assets should come from the low valuations. The risks taken by the UK Government are well-understood and are reflected in pricing. A piece of good news could reverse their fortunes: an easing of energy prices, a U-turn on some key policies, or an easing of inflationary pressures that encourages the Fed to scale back on its hawkishness to drive up global growth expectations. At that point sentiment could change quickly, and particularly for a cyclically sensitive currency, such as sterling.

If this article has raised any questions, please do speak to your usual Evelyn Partners adviser.

Sources

All data is from Refinitiv/ Evelyn Partners unless otherwise stated.

[1] 40% of mortgage deals pulled since mini-budget; financial markets in turmoil – as it happened, The Guardian, 29 September 2022

[2] UK mortgages: average rate on a two-year fixed deal soars to nearly 6%, The Guardian, 4 October 2022