Kwasi Kwarteng, the new Chancellor recently announced increased spending and tax cutting measures in a bid to boost growth.

The initial market reaction has been strongly negative, with falls in the value of Sterling, Fixed Interest and Equity markets. On the face of it, this reaction seems quite extreme, as the bulk of the revenue measures (via the energy support bill and cancelled corporation tax hike) were already known before this ‘mini budget’. It is true to say that the budget deficit is a little higher than expected, but not significantly so. Additionally, the UK’s National Debt (as a proportion of Gross Domestic Product) is the second lowest of the G7 nations.

So why are the markets so spooked by this news? There appear to be 2 main reasons.

Firstly, as the Chancellor’s statement was not officially a Budget Statement, Kwarteng had not felt compelled to show his workings regarding the costings of the package and future projections for economic growth and tax revenue. Without this information, the markets can’t review the government’s forecasts and assess how realistic they are. Is this a carefully costed package or just a shot in the dark? The Chancellor needs to explain and reassure the markets that he is in control. As I write this , news is coming through that Kwarteng will have discussions with City Bankers this afternoon, which is a positive sign.

Secondly, Kwarteng announced on Sunday that more tax cuts are coming soon. He now needs to demonstrate credibility and remove some of the uncertainty from the markets.

Interest Rates

The key question amongst investors is ‘How high will interest rates go?’

My answer, of course is that I don’t know. But I can speculate.

There are many complicated calculations, using data from numerous sources that can give us a guide as to where interest rates are going. My preferred forecast is derived from “overnight index swaps” (don’t ask!).

This data is used by the Bank of England as the basis of their forecasts of future interest rates. They produce a daily chart, showing yesterday’s forecast compared with the forecast from the date of the last meeting of the Monetary Policy Committee (MPC) who set the Bank’s interest rate.

The orange line on the chart is a proxy for Bank Rate climbing over the next few months to reach a peak rate in the region of 6.0%. This peak holds for a limited time before the rate falls off, presumably to some more neutral level.

Accordingly, I think it entirely reasonable to say that market prices, as they stand today, are consistent with a rapid increase in Bank Rate from 2.25% toward a peak of 6.0%. It’s likely that the peak will coincide with the MPC meeting scheduled for August 2023, and that the peak will not last for long at all.

A word of caution though, the 6.0% target is subject to a very large degree of uncertainty. A glance at the blue line on the chart above ought to give you pause for thought. Had I written this note last week, I might have concluded that peak rates would fail to reach 4.5%.

Where next for markets?

For what it’s worth, I will be a little surprised if the Bank rate does make it as high as 6.0%. I’m a little less concerned about inflation, and a little more concerned about the prospects for growth in the economy. A 6.0% interest rate may do little to supress persistent inflation, but it would present great headwinds to a recovering economy.

I am just hearing news that the Bank of England has started a program to buy back Government Bonds. This will hopefully ease some of the upward pressure on interest rates and ensure that financial markets continue to operate efficiently in turbulent times.

All other things being equal, this is not ideal news for UK equities, but the market was already looking cheap in comparison to history. As ever, a weak currency is a cloud with a silver lining. Exporters will undoubtedly benefit and companies with revenue in US Dollars should rise in sterling terms as the currency falls, just as we witnessed following the surprise Referendum result in 2016.

Our tactics

For medium to long term investors, we do not propose any changes to your portfolios. We see no reason to sell holdings currently and prefer to sit tight, closely monitor the conditions and be in place to benefit from the eventual recovery in prices.

This has been our strategy for many years, and we have yet to be proved wrong in times of market stress.

If we see any reason to alter your portfolio, we will take steps to do so and will keep you informed. In the meantime, please feel free to contact us to discuss matters further.

28th September 2022