Markets uneasy over new Truss-Kwarteng era


Financial markets assess the health of a country’s economy and its political stability in two ways. The fledgling Truss-Kwarteng administration is off to a shaky start, at least as far as government bond and currency markets are concerned.

Let’s start with the bond markets. Buyers of UK government bonds express their satisfaction or concern in the yield demanded on government debt. The worse the outlook and the less confidence investors get, the higher the level of compensation they demand.

The fixed income markets seem unimpressed. Granted, 10-year government bond yields bottomed out in the summer of 2020 as the economy began to shake off Covid-19 and fuel inflation, but benchmark yields on government bonds have soared since Liz Truss’s victory as conservative leader over September 5 – hardly a vote of confidence.

A jump of nearly 40 basis points to an 11-year high on the morning of Friday’s mini-Budget also looks like a thumbs down.

Sterling’s continued – and apparently accelerating – decline to new 47-year lows against the dollar suggests that currency markets are not yet convinced by the fiscal plan either.

The government is following the roadmap of tax cuts and supply-side deregulation set by the Thatcher and Reagan administrations in the early 1980s. Some credit them as architects of an economic turnaround in the wake of the stagflationary chaos of the mid-to-late 1970s.

Stock and bond prices have risen relentlessly since those reforms, albeit with major stumbling blocks along the way. From that perspective, the new residents of Downing Street may be surprised that their program has been met with such indifference by the currency, bond and even stock markets, where the FTSE 100 fell sharply on Friday.

Part of the reason may be that Kwarteng has less room for maneuver than his conservative predecessor, Sir Geoffrey Howe, in the early 1980s.

At the time, government debt was less than 40 percent of GDP, while interest rates peaked at 17 percent in late 1979 and began to decline in the second half of the 1980s. By contrast, government debt of over £2 trillion today equals nearly 100 per cent of GDP and interest rates appear to be continuing to rise as the Bank of England grapples with the legacy of its misjudgment that inflation would be transient.

This could explain why markets are nervous about the currently unfunded nature of Kwarteng’s plans and the initial lack of involvement from the Office for Budget Responsibility.

But it could also be rising prices that are at the root of their concerns. The BoE is now trying to prevent inflation from becoming entrenched in the services part of the economy, then fueling the cycle of higher prices, higher wages, higher prices and higher wages that crisscrossed the 1970s. Then came the problems of the end of the Barber boom in the UK, the free spending presidents of Johnson and Nixon in the US, and the impact of the 1973 and 1979 oil price shocks.

Long-memory investors can be forgiven for feeling nauseous when they think of such parallels.

The 1970s were a terrible decade for UK government bond holders and even the current 3.78% yield on 10-year Treasuries seems like some sort of yield-free risk when measured against prevailing inflation.

Equity investors were also hit. Although the FTSE All-Share quadrupled from its low in January 1975 to the end of the decade, the previous collapse meant that the index’s 56 percent rise over the entire 1970s was dwarfed by the 290 percent rise in the index. inflation benchmark of the retail price index over the same time frame. Only gold beetles ended the 1970s with a smile on their faces as the precious metal rose from the Bretton Woods set level of $35 an ounce to over $800 in the early 1980s, aided by Nixon’s withdrawal of the dollar from the gold standard in the early 1980s. 1971.

Since most of the revenue comes from abroad and between 40 and 50 percent of profits in 2022 and 2023 are expected to come from miners and oils, the current FTSE 100 may be better placed than the FTSE All-Share from the 1970s to protect investors from an ongoing inflationary storm.

But the boom in British financial assets since the early 1980s has been based on disinflation, falling interest rates and easy money from the central bank. At first glance, the current environment offers none of those three.

Central bankers now seem to accept a downturn, or even a recession, as a short-term price worth paying for the long-term gains of lower inflation. But politicians, who think in electoral cycles, are likely to see downturns, and thus unemployment, as the bigger enemy. Voters won’t be happy about inflation, but they’ll be much more alarmed and likely put a cross next to someone else’s name at the ballot box if they lose their jobs.

It was former Labor Chancellor Denis Healey who argued that good governance means “stable prices, jobs for those who want them and aid for those who need it”. Investors, workers and voters alike will hope that supply-side government reforms deliver a similar combination of disinflation and growth.

The author is an investment director at AJ Bell