investment insights
The UK’s new government goes for broke
Lombard Odier Private Bank
Key takeaways
- Liz Truss’ government has pledged to cap energy prices, financed by new state borrowing, while cutting taxes
- Higher borrowing raises the likelihood of the Bank of England raising interest rates more aggressively in an environment of high inflation
- Investors questioned the government’s fiscal discipline. Sterling fell against the USD and EUR, and Gilt yields rose
- We took profit on UK equities and invested the proceeds by increasing exposure to Swiss stocks.
The UK’s new government emerged from ten days of royal mourning with an energy price ceiling and tax cuts to boost the economy. Paid for by state borrowing, the spending programme reduces some short-term uncertainty over inflation by shielding consumers and businesses from the worst effects of the energy shock. At this stage, it is hard to see the spending offering a lasting path to economic growth.
Faced with a deepening energy crisis, Prime Minister Liz Truss’ administration, in office since 6 September, wants to boost stagnating UK growth and poor productivity. Specifically, the government plans to freeze energy bills for two years from 1 October at an average of GBP 2,500 per household, per year, and cap prices for businesses for six months. Government borrowing will finance the programme, compensating energy suppliers for the difference with market prices. While the cap is more than double the average household energy bill since 2018, it compares with an expected threshold set by the country’s energy regulator of GBP 3,549, which would have risen even further in 2023.
The government claims that the tax cuts and energy spending will pay for themselves by increasing growth. A 1% increase in gross domestic product, the Treasury said, would be worth GBP 47 billion. We estimate that the spending will add around 4 or 5 percentage points to economic growth, which may be enough to keep the British economy from falling into recession in 2023. Simultaneously, the Truss administration plans to scrap the highest rate of income tax, reduce corporate taxes, removed a ceiling on bankers’ bonuses, halt a ‘green levy’ on households and reverse an April rise in National Insurance, a social security tax.
Heating and eating, how much?
The energy crisis is only one significant element in a broader cost-of-living crisis. Politically, the government had to act to prevent many British residents from having to make a choice between ‘heating or eating’ as the weather turns cooler. Food prices have risen too as the economy sees a shortage of workers, and rising wages and material costs. At the same time, imports have become more expensive as a weaker sterling has offset a fall in the price of imported commodities in recent months.
We do not yet know how much the policy will cost, in part because it depends on the evolution of gas prices. In addition, unlike past budgets, the government has not instructed the Office for Budget Responsibility to prepare cost calculations. UK gas hit a record of more than 600 pence per therm in August, more than six-times higher than historical averages, and currently trades at 294 pence/therm.
The Institute for Fiscal Studies (IFS), an independent researcher, estimates the plan would cost more than GBP 60 billion over 12 months, and total around GBP 100 bn including the six-month programme for businesses, based on 2019’s energy consumption. Other estimates put the cost as high as GBP 150 bn, with tax cuts costing as much as a further GBP 50 bn.
The IFS also points out that high gas prices over the next two years mean not only a higher cost to the government, but also increases the likelihood that the support will have to be extended for longer. The government has not detailed what it plans to do once the two-year and six-month programmes expire.
Price signals and monetary policy
The policy must also balance cushioning the energy price shock with the effect of spurring inflation by putting more money in consumers’ pockets. By insulating consumers from energy market prices, the package undermines the market impact of prices to drive lower consumption. That runs counter to the long-term need to cut gas consumption and may eventually require some form of rationing.
The state’s planned borrowing therefore increases the challenge for the Bank of England to cool the economy with interest rate hikes. The BoE responded last week by raising the UK’s benchmark rate by 50 bps to 2.25%, its seventh consecutive increase since December 2021. The central bank also indicated that it would start selling bonds on 3 October to reduce its stock of Gilts by GBP 80 billion over the 12 months ahead, to GBP 758 bn. The yield on 10-year Gilts, UK government sovereign bonds, has risen through 2022 as interest rates have increased to slow the economy, reaching 3.83%, their highest level since 2008.
If spending funded by borrowing rather than higher government tax revenues is the model that the Truss administration plans, the BoE will need to raise rates both further and faster in an environment of historically high inflation. And if the economic growth that the government is expecting fails to materialise, it would then have to cut spending. From both humanitarian and political perspectives, it is easy for a government to justify a cut to energy prices to consumers and businesses. However, cutting taxes in an overheating economy with record levels of employment looks more questionable.
No other European state has yet offered such an open-ended guarantee on gas prices, nor tax cuts. The EU will discuss energy prices and subsidies for low-income households at meetings in October. So far, European governments appear to prefer more gradual and targeted subsidies, focussed on lowering consumption, funded by windfall taxes on energy firms’ exceptional profits.
Fiscal credibility
Much has been made of the risk to the UK’s fiscal health from the government’s spending. We believe that the logic for capping energy prices looks justifiable, but coupled with tax cuts, the fiscal policy has been poorly received by investors. Before the pandemic, such state spending would probably have been unthinkable. It is worth remembering that the energy cap equates to 4% or 5% of the UK’s GDP, far lower than the total costs of the country’s pandemic measures that amounted to between 15% and 20% of GDP.
However, the tax cuts announced last week add up to another 0.5% of GDP, and the government has said that it may announce further measures ahead of the annual budget, scheduled for November.
Importantly, the government cannot borrow now at the same costs as during the pandemic, when interest rates were still at multi-decade lows. The spending increases UK’s public sector borrowing. The UK’s Debt Management Office calculated last week that the country will need to borrow an extra GBP 72.4 bn, for a total GBP 234.1 bn in 2022.
Investors reacted quickly to the budget. The FTSE 100 index, which has outperformed global equities through 2022 in local currency terms, declined 2%, in line with other European indices at the end of the week. More tellingly, yield on 10-year Gilts surged by as much as 50 basis points and the pound fell as low as USD 1.04, its weakest level against the US currency in at least five decades. Against the euro, EURGBP surged above 0.90, exceeding the 0.83 – 0.87 range seen for most of 2022. While we had a cautious view on sterling based on the large current account deficit, markets have responded nervously to the government’s plans to finance the deficit. The currency is likely to remain increasingly volatile with a range of 0.87 – 0.95 on EURGBP. Amidst a broadly stronger US dollar, the pound may test parity.
With the UK particularly reliant on fixed income financing flows, measures to improve fiscal credibility, or a faster pace of tightening from the BoE at its next meeting on 3 November would be required to stabilise markets.
In December 2020, we initiated a UK-equity overweight portfolio position in a search for more exposure to value stocks. Given the macroeconomic headwinds facing the UK economy, two weeks ago we took profit and invested the proceeds by increasing our exposure to Swiss equities.
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