September 26 2022
Late last week we saw the first what was meant to be a mini-Budget from Kwasi Kwarteng, the new UK Chancellor. Given the level and degree of announcements made however you could be mistaken for thinking that it was indeed a full budget. The tax cuts and levels of spending which the government have committed to are now very well publicised. All were with the intention of trying to put more money back into the hands of the public, giving them increased spending power to fight the cost of living crisis, and prop up the economy.
It would be something of an understatement however to say that the financial markets, UK and international investors have not taken to the news too kindly. In what is being perceived as a huge give away, there are significant concerns surrounding how all the announcements are going to be paid for. There can be no doubt that the government will need to borrow significantly in capital markets to do so, raising uncertainty as to the credibility to repay it.
We suspect that it is unlikely that the government would default, but that isn’t stopping investors demand a higher return from gilts to compensate for the additional perceived risk. At the time of writing we now see 2 year, 5 year, 10 year and 30 year gilt yields above 4%. On the 19 September the 10 year gilt yield closed at 3.1535% and even on the 22 September the yield was 3.489%, therefore a marked increase as been seen.
Another casualty of the Budget announcements has been sterling. It was already showing signs of weakness, in particular against the US dollar, on a deteriorating UK economic outlook. However, the pace of weakening against the latter has quickened over the last two trading sessions. Sterling currently trades around US$1.07, having been below $1.04 in Asian trading, and some now believe that the currency has every chance of trading at parity with the US dollar, if not below. Larry Summers, former US Secretary of the Treasury very much believes this is a possibility.
We would add however that it is not just Sterling which the US dollar is strong against. The US dollar currency index, which measures the strength of the currency against a basket of overseas currencies, is approaching one of the highest levels seen since 1986. This basket of currencies includes Sterling (11.9%), Euro (57.6%), Japanese Yen (13.6%), Canadian Dollar (9.1%), Swedish Krona (4.2%) and Swiss Franc (3.6%) (source: theice.com).
The Budget announcements are likely to sit uncomfortably with the Bank of England who, through previous interest rate hikes, have been battling to bring inflation under control. Extra spending power in the hands of the consumer has the potential to contra out some of the rate increases they have already imposed. There is another consequence of a weaker Sterling which they now also need to consider, in that the move is inflationary in its own right. Many imports, in particular commodities, which are brought into the economy, are priced and purchased in US dollars. Sterling based purchasers will therefore see an increase in their cost base which, you would expect, they will look to pass onto their end users.
As a result there are many market commentators, forecasters and now even MP’s who expect the Bank of England to react via an emergency meeting as early as this week. How much they could hike is at best an estimate, but some would not be surprised to see a full 1% increase to try and support the currency and tackle any future inflationary pressures.
Longer term a weaker currency against the US dollar is potentially a positive for UK listed equities with a high degree of overseas earnings, particularly if those are dollars. At an index level this particularly favours large cap companies within the FTSE 100. At the same time it could also be a positive for UK dividend payments. The Link UK Dividend Monitor for the second quarter of this year shows that two fifths of the total dividends paid were denominated in US dollars, with weakness in sterling boosting their sterling value by £1.4bn. The latest currency weakness, depending on the level of dollar payers left to declare in the third and fourth quarter of this year, could see a currency uplift of an even greater magnitude.
For now UK equities are reacting negatively to the Budget, with key indices having fallen on Friday and again today. It is not just here however and there is currently a sea of red across equity indices across Europe this morning and US indices are expected to open down later today. So it is not just here where we see negative sentiment but plans put in place by the Conservatives have certainly been unsettling.
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