It's been a busy and volatile time for markets... This week we look at the UK government's mini-budget and euro zone inflation.
UK government mini-budget spooks markets, forcing Bank of England intervention
The Bank of England (BoE) was forced to step in after the newly-installed Chancellor of the Exchequer’s mini-budget provoked severe reactions in markets. The devaluation of the pound was particularly pronounced, falling to 1.03 against the US dollar – a record low. However, it was the steep rise in gilt yields, pushing up borrowing costs for the government, which led to the intervention by the BoE in order to stabilise bond markets.
The new chancellor, Kwasi Kwarteng, announced a range of tax cuts which amounted to approximately 1.8% of GDP. This included scrapping the planned increase in corporation tax to 25% in favour of keeping it at 19%, and a cut in the basic rate of income tax from 20% to 19%. Surprise additional announcements came in the form of reducing the highest rate of tax from 45% to 40% and increases to stamp duty thresholds.
Whilst the new prime minister, Liz Truss, had run for office on a promise of lower taxes, markets were surprised by the speed at which they were implemented, the lack of a detailed fiscal plan setting out how they would be funded and the absence of economic forecasts from the independent Office of Budget Responsibility. Whilst removing the highest rate of tax was only expected to cost c.£2bn, it was the most controversial of the announcements politically and the move has subsequently been reversed.
Alongside the tax cuts, Kwarteng announced a huge support package for households, businesses and charities, capping average household energy prices at £2,500. This is expected to reduce peak headline inflation by around 3%. Opposition parties had argued that this move should be financed by extending the current windfall tax on energy companies. However, the government decided to fund this additional spending by increased borrowing.
The result of this enormous give-away, tax cuts and the manner in which they were delivered saw the highest rise in UK funding costs ever recorded in a single month, with 30-year yields rising by almost 1% on Tuesday alone. This, in turn, led to a spiral in UK pension funds, where their use of liability-driven investing (LDI) strategies forced them to sell gilts in order to cover margin calls, pushing gilt prices down even further.
As a result, the BoE had to change course from their quantitative tightening programme in order to announce a bond buying programme until 14 October, citing the possibility of a ‘material risk to UK financial stability’.
The announcement had its intended effect, with bond markets stabilising and sterling reversing some losses against the US dollar. However, the moves by the chancellor to stimulate growth have seemingly put the government at odds with the BoE’s attempt to tighten fiscal policy and tame surging inflation. Speculation of further policy reversals by the government is rife and attention is on the BoE’s next meeting in November, with markets pricing an unprecedented 100bps rate rise.
Euro zone inflation surprises to the upside as energy prices continue to inflict pain
Euro zone inflation hit 10.0% year-on-year in September vs consensus estimates of 9.7%, led by energy prices which rose 40.8% over the year. This represented an increase of 0.9% over the month, showing that inflation is not yet abating as the war in Ukraine continues to impact the euro zone acutely due to its proximity to Russia and reliance on Russian gas.
There was huge variation in numbers across the bloc, with the Baltic states being hardest hit with inflation above 20% year-on-year. Germany, the largest economy, saw inflation hit double digits as some government support packages rolled off.
Critics argue that the European Central Bank has been slow to react, only starting their rate hiking cycle in July. However, markets now expect another 0.75% rise at their meeting this month.
Market review
It was a negative week across all major equity markets as investors reacted to the prospects of rising rates and a global recession. The MSCI AC World Index ended the week down just under 3%. In the US, the S&P 500 saw a 3% decline whilst the MSCI Japan registered a drop of almost 4%. Within equities, energy was the only sector to rise (+1%), whilst utilities saw the biggest fall, at over 7%.
UK index-linked gilt prices rose dramatically on the back of the Chancellor’s announcement and the BoE’s intervention (+8%). However, UK corporate bonds universally declined as yields rose.
Currency markets saw dramatic moves, as sterling gained some of the its lost ground, ending the week up 2% against the US dollar in sterling terms. However, as at 30 September it is still down over 20% for the year to date against the US dollar.