Sam Benstead explains what a plummeting pound means for financial assets and why investors are spooked by the chancellor’s tax-cutting measures.
The pound has fallen to a record low against the dollar as traders bet against financial stability in Britain following chancellor Kwasi Kwarteng’s tax-cutting budget.
One pound now buys just 1.07 US dollars, but it fell to as low as 1.05 in early trading on Monday. The latest drop follows a 3.5% fall on Friday, taking sterling’s losses versus the dollar over the past 12 months to 22%.
Friday’s collapse was the third worst-ever day for sterling since Black Wednesday in 1992, according to Deutsche Bank, with the worst two others being the day after the Brexit vote (-8.1%) and following the initial Covid shock in 2020 (-3.71%), when there was a global flight to dollars.
Victoria Scholar, head of investment at interactive investor, says: “On first glance, one might expect that the chancellor would get support from the markets for his pro-growth, anti-red tape plans to cut taxes and stimulate the economy.
“However, there are major investor concerns about his lack of focus on fiscal prudence and sound money given that his strategy depends on alarming levels of government debt at a time when the cost of borrowing is sharply on the rise. On top of that, the chancellor has failed to focus on the inflationary implications of his agenda when price levels are already flirting with double digits.”
Here’s what the moves mean for bond and stock markets.
Bond investors are panicking, dumping UK government debt. Yields, which move inversely to price, have therefore shot up. The 10-year UK gilt now yields 4.1%, up from 3.5% before Kwarteng’s budget.
Nearly all UK bond maturities now yield more than 4%, pushing up the cost of issuing new debt for the government at a time when they are setting out to borrow on a huge scale to fund tax cuts.
The total cost of the various measures announced in Kwarteng’s mini-budget is expected to reach £161.5 billion over this financial year and the next four years, according to Schroders, the fund manager.
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Bonds are selling off because investors expect the Bank of England to increase interest rates more rapidly to control inflation and boost the value of the pound. Financial markets now point to interest rates of 5.5% in the spring, up from 2.25% today, according to some economists.
Schroders said: “The additional huge fiscal stimulus is likely to drive up inflation more than growth, which will be less useful for the Exchequer, leading to more borrowing and debt. This explains the dramatic reaction in gilt markets.
“Some investors are also concerned that sovereign rating agencies may now consider downgrading the UK’s rating, which could lead to some holders of government bonds being forced to sell some, or even all, their holdings.
“This may follow in time, and it will be up to the government to defend its new approach to taxation in the coming months. Importantly, if growth and increased tax revenues do not follow, the chancellor has to be ready to pivot, and prepare some austerity measures.”
Rising interest rates is bad news for nearly all bonds, as investor re-price assets because they can get a higher yield from buying newly issued bonds. However, longer-term higher yields increase total returns for investors.
Bonds that are “floating rate”, meaning their income rises when interest rates do, will increase their payouts to investors. TwentyFour Income Fund, an investment trust, invests in these types of bonds, for example.
A weak pound is generally good for companies that earn most of their profits from overseas, as it makes their goods and services cheaper for international buyers.
On the other hand, net importers, which is most companies in Britain as there is an overall trade deficit, will suffer as their input costs will rise. This will fuel inflation further as they have to pass on higher costs to consumers if they want to protect their profit margins.
Reflecting this, year-to-date the very international FTSE 100 index has only fallen 6.5% and the FTSE 250 (the next 250 largest companies) has fallen 25%.
However, inflation is not good for any company, so if the chancellor’s tax-cutting measures drive up prices higher still and interest rates are forced to go even higher, which will put the brakes on the economy, then the entire stock market is affected negatively.
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Schroders says Kwarteng’s tax cuts in the pursuit of economic growth are a gamble. It said: “Many of the measures announced that are designed to encourage businesses to invest and grow should be welcomed by investors. The UK’s productivity growth has been deteriorating for some time, along with its ability to attract foreign direct investment.
“The other tax cuts, especially for households, are designed to reverse the trend of rising tax revenues as a share of national income. Under previous plans, tax receipts as a share of GDP were forecast to rise to 35% by 2025-26 – the highest since the Second World War. This is seen as unacceptable for the majority of centre-right Conservative party members.”
Dzmitry Lipski, head of funds research at interactive investor, says the stimulus will benefit small and mid-sized firms as they will profit from a stronger economy.
Investors can benefit from this by buying a FTSE 250 tracker, he says, such as the Vanguard FTSE 250 UCITS ETF, which costs just 0.1% a year in fees, or an actively managed fund, such as Henderson Smaller Companies investment trust or the Amati UK Listed Smaller Companies fund – both funds are part of ii’s Super 60 Investment Ideas.
But Schroders adds that the timing of these tax cuts could not have been worse.
“With inflation near double digits, the Bank of England is raising interest rates in an attempt to slow demand in the economy and bring inflation back to its target of 2%. While the chancellor stated that the independence of the BoE was ‘sacrosanct’, his tax cuts conflict with the central bank’s objectives,” it said.
Investors who own international shares are profiting from a weak pound as their dollar-denominated assets, such as a global or US tracker fund, now buys more pounds.
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