A conflict of economic opinions
‘Let us get the job done’ and ‘do whatever it takes to kill inflation’ are the key messages we have been hearing from central banks during this memorable September 2022.
At the same time, governments are trying to prevent the fallout of an inflationary bust. As always, they do this by spending more. As seen in the UK, some are ready to throw any household stability concerns overboard. So you have central bankers putting on the brakes and fiscal policymakers putting the pedal to the metal. How functional is that?
As a result, bond markets are tanking as rates rise and sovereign solvency wanes. Some currency markets have also collapsed (see ‘number of the week’ below), particularly against the USD, since US politics has the mixed blessing of approaching the mid-term elections. This usually curbs the spending spree in politics for a while and is not all that bad considering the USA’s significant fiscal choices last year.
Number of the week
Currencies in focus
So the USD is strong, while bonds, equities, and most other currencies are weak. So how can investors protect themselves from increasing recession risks? Gold is in the doldrums, since rates, the USD, and physical buying are all pushing it down. Yet by the time economic indicators begin to implode, gold might make a marvellous comeback.
We are just not there yet, and we will likely only get there if central banks seriously damage the economy while stomping out the inflation fire. In the meantime, the amount of panic we are seeing lately makes you feel that a bottom in stock markets must be imminent. The question is whether it will require a final bang or whether the start of a new quarter over the weekend will be good enough to get everybody out of the ‘risk-off’ mode.
As we cannot know the answer in advance, the best approach is a staggered one, taking a first position while keeping some powder dry for October. A number of profitable growth stocks are trading at historically low valuations these days.
Government actions’ impact on the pound
In the UK, Friday’s ‘mini budget’ turned out to be not so ‘mini’ but in fact a radical tax-cutting exercise that sent the pound plunging and decoupled it from surging yields. Chancellor Kwarteng’s short but momentous 30-minute speech presented broadly two elements. First, more details on the energy support plan, i.e. the energy price cap for households and corporations, and second, a surprising ‘Growth Plan 2022’, introducing a wide range of tax cuts to “turn the vicious cycle of stagnation into a virtuous cycle of growth” (including a lower basic income tax at 19%, a cut to the top income tax rate to 40%, and a cancellation of a planned corporate tax hike to 25%).
With this plan, the Truss government aims to ignite future growth (a higher potential GDP of 2.5% was praised), which in turn will make up for the tax income losses and the cost of the energy bill cap. However, financial markets reacted rather worriedly. The large fiscal spending impulse risks pushing up inflation pressures that could prompt the Bank of England to hike more and sooner (some debate even an emergency hike, also to stabilise the pound). We have revised our rate-hike expectations up by 50 bps to 125 bps (75 bps in Nov. and 50 in Dec.) and foresee a rate of 3.5% by year end, with a risk of more to come. Markets also see fiscal stability at risk.
Additional borrowing is required to finance this exercise, but 10-year gilt yields shot up beyond 4%, raising borrowing costs, while the BoE ended gilt purchases that kept yields low.
The risk markdown on the pound due to the monetary/fiscal policy mismatch and the large uncertainties is likely to stay and render the pound unable to benefit from higher UK rates.
We therefore cut our EUR/GBP forecast to 0.90 for +3m and 0.88 for +12m. Ultimately, ‘Trussonomics’ could become a burden for the Conservatives at the 2024 elections. Given the risky plan, and tax cuts that mainly benefit the rich, it would not surprise if the pendulum swung back to Labour.