As this is being written, the UK’s Conservative Party is in the final stage of selecting a new leader, who will then be the next Prime Minister, following the resignation of Liz Truss after only 45 days on the job. Her libertarian economic policies and politics plunged the country and financial markets into chaos at a time when the country faced a grim winter, 10 percent inflation, soaring energy costs, strikes, and a hospital crisis. Fiscal austerity and tax rises appear inevitable under the next Prime Minister.
Promising to fight “Treasury orthodoxy,” Truss and her like-minded friend Kwasi Kwarteng, whom she chose as the Chancellor of the Exchequer, announced a massive 45 billion pounds in tax cuts with no indication of how the cuts would be paid for. Apparently formulated without the advice of the Office for Budget Responsibility, other civil service institutions, or the Bank of England (which was raising interest rates and reducing its holding of bonds), the announced “mini-budget” all but destroyed the Conservative Party’s reputation for fiscal responsibility. The response of the market for Britain’s government bonds, or gilts, was immediate and dramatic. The market plunged, and at times there were no buyers for long-dated gilts. By September 27th prices for longer-dated gilts were down some 26%, and the yield on 30-year debt reached 5%. Also, the pound crashed, though it later stabilized.
The havoc in the bond market had a severe impact on Britain’s pension funds. These funds have used so-called liability-driven investment (LDI) funds to help them match cash-flow liabilities with income, using derivatives. When gilts plunged, some LDI funds were forced to sell gilts at any price to put up more collateral, which in turn depressed gilt prices further — a negative feedback loop. This development forced the Bank of England to temporarily reverse its policy of reducing its holdings of gilts on September 28 and to announce a 65-billion pound bond-purchasing program with bond purchases of up to 5 billion pounds a day for 13 weekdays. The bond market recovered, but the pound declined in response. Subsequently, to ease liquidity pressures for pension funds, the BOE announced a new short-term lending facility that will allow a broad range of collateral to be used in a new repo facility. The mortgage market is another victim of the bond market chaos. Mortgages in the UK are tied to gilts. When gilts fall, mortgage rates rise. Now many cannot afford the payments.
Despite the Bank of England’s intervention, bond yields started rising again. Kwarteng’s position as chancellor became untenable, and Truss replaced him with Jeremy Hunt. Hunt radically reversed about two thirds of the permanent tax cuts in the mini-budget, reassuring markets that the government is recommitting to fiscal responsibility. Hunt also indicated plans to review the structure of the energy price guarantee for households and business and broadly promised Britain a future of fiscal austerity. Finally, Truss also was forced to resign.
Rishi Sunak, the former Chancellor will become Britain’s next prime minister. He is a moderate from the center/right part of the party and will be welcomed by financial markets. Former Prime Minister Boris Johnson, who was forced by party members to resign less than 100 days ago, has withdrawn from the race. He still faces a parliamentary probe for reportedly lying to Parliament. A third candidate, cabinet minister Penny Mordaunt, dropped out of the race in a move to unite the party behind Sunak.
As prime minister, Sunak will confront the difficult task of commanding sufficient support among Conservative MPs to implement the tighter fiscal policy measures that will be needed with the economy expected to be tipping into recession. There are sharp divisions within the Party. This continued political uncertainty will not help market sentiment. Despite pressures from opposition parties for a new general election, one doesn’t have to be held until January 2025. With the Conservative Party currently some 30 points behind in the polls, it will not wish to hold an earlier national vote.
Markets have reacted positively to the political news with gilts soaring. The gains are despite negative economic news that the flash Composite Purchasing Managers’ Index for October dropped to a 21month low. The troubled state of the economy was also reflected in a big drop reported in retail sales. Because of the process of choosing a new Prime Minister, markets may now face a delay in the expected October 31 fiscal plan from the UK Treasury. The Bank of England has been expected to return to its plan of bond sales (quantitative tightening) and aggressive raising of interest rates to counter inflation rates of 10+%. This would happen at a time when the government will face very large borrowing requirements. In view of the political developments together with the weaker economic outlook the Bank of England may now decide to raise rates at a more measured pace than had been expected.
The iShares MSCI United Kingdom ETF, EWU, is down just 2.2% over the past four weeks and 18% year-to-date October 21. In view of the turmoil in the government bond market, the weakness of the currency and of the economy, UK equities have done better than one might have expected. In comparison, the iShares MSCI Eurozone ETF rose just 0.9% over the past four weeks and is down over 30% year-to-date. At Cumberland Advisors we currently do not hold a UK-specific position and are underweight the Eurozone in our International and Global Equity ETF portfolios.
Neither Cumberland Advisors nor the writer hold the mentioned securities in their investments.
William H. Witherell, Ph.D.
Vice Chairman & Chief Global Economist
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Sources: Financial Times, Wall Street Journal, Oxford Economics, CNBC.com, BBC.com, barclays.com, The Economist, spglobal.com
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