Financial Update from Brewin Dolphin - 21 October 2022

October 2022

The Weekly Round-up

Friday 21 October 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses Liz Truss’s resignation as UK prime minister, and US third quarter earnings.

UK politics moved from market driver to market distraction this week. The bond market was settled by the reversal of many mini-budget features that had proven so toxic to market confidence. This time last week, Jeremy Hunt was appointed chancellor of the exchequer and he has been successful in lowering borrowing costs and restoring calm to the markets. That does not seem to have been too challenging so far, as it has involved reversing most of the measures at the last infamous mini-budget.

The job now will become more challenging as it seems likely that he will need to find further savings to put the UK’s finances on solid ground and meet the fiscal mandate of ensuring that debt as a share of gross domestic product (GDP) is falling by 2024/25. To do that, spending cuts will be required. The difficulty in enacting those cuts is that big commitments have been made to health and defence already, and there can be little doubt about the need for spending in those departments, which bodes ill for other departments.

Hard decisions are needed, which is difficult for a politically weak prime minister, but the job is made incrementally easier if you can persuade the Office for Budget Responsibility (OBR) to be more generous with its growth and cost assumptions. We have discussed how effective the suddenly austere tone was in bringing down borrowing costs. We also understand that the prime minister was keen to state that government policy favoured an increase in skills-based immigration, as alluded to in the plan for growth, as this should allow the OBR to forecast a higher rate of growth. It is speculated by some that this may have ultimately led to the home secretary’s resignation.

As we now know, after a few more procedural setbacks, the prime minister ultimately resigned. There will now be an abridged leadership selection process and the most obvious investment implication is that the new leader will have less time to take action that might influence the OBR’s judgement.

Who’s next?

To accelerate the process, only candidates with 100 backers from within the parliamentary party can advance. Mathematics dictates that this is a maximum of three. If required, eligible candidates will be reduced to two by ballot and, assuming there are two, these will be separated by a poll of party members.

We know that during the summer contest only Penny Mordaunt, Rishi Sunak and Liz Truss eventually amassed over 100 votes from within the parliamentary party. Liz Truss will obviously be absent this time, just as Boris Johnson was before.

The appeal of Boris Johnson is probably where the intrigue lies about this contest. If enough MPs are prepared to back him to make the second round, then polling suggests he is slight favourite to Rishi Sunak amongst the members. Sunak’s Cassandra-like predictions about the market reception to Trussonomics seem to have elevated him in the members’ eyes.

One final point to note is that there will be an indicative ballot of MPs signalling to the members who the MPs prefer. If the runner up is lagging, they will come under significant pressure to drop out to avoid a repeat of the situation in which the members choose a winner with very low support within the parliamentary party.

Boris Johnson’s stated preference for both having and eating cake would likely make him the least appealing of the front runners for the markets, although in reality it is highly unlikely that any candidate will run on anything other than an austere policy after the UK’s bruising brush with fiscal extravagance.

No, Mr Bond, I expect you to LDI!

It is easy to become too absorbed with the Westminster drama. The reality is that Truss’s policies had left office well before she did. But for a moment the UK government was at the centre of a global sell off in a wide variety of assets. Pension schemes were forced by rising bond yields to sell stocks, bonds and other assets because they had insufficient cash to meet margin calls on derivative contracts.

That concern seems to have ebbed away with bonds expressing relief at the resignation of Kwasi Kwarteng and the reversal of the economic agenda. The Bank of England has indicated that it will resume gilts sales as part of its quantitative tightening programme (despite rumours that it was going to delay). The discount ascribed to UK government bonds has been traded away and Britain’s role as a government credit of strong repute is well on its way to repair.

This episode has emphasised how a brief flirtation with unorthodox policy can be reversed rapidly if it doesn’t serve the interests of political and economic stakeholders. This is a reflection of the strong institutional protections that the UK political economic system boasts (independent central bank, free press, parliamentary democracy, to name but a few).

We should not take these strengths for granted as investors are sometimes prone to. Turkey spent 15 years with inflation averaging less than 10% until its president Tayyip Erdogan dispensed with orthodox economic policy and prices spiked. Inflation is currently running at 80% even as Erdogan prepares a fiscal stimulus worth 3% of GDP to boost support ahead of elections. Good sovereign borrowers are not necessarily ones that don’t suffer mishaps, but they are ones that can recover from them.

Away from the UK

Stocks made little progress this week as earnings season rumbled on. As is customary, around three quarters of US companies posted third quarter profits above their estimates, while about half of companies produced higher sales than expected. Experiences differ, but the average company that has reported so far did not manage to grow profits. Sales were up as you would expect given that inflation has remained high.

The tone from companies remains cautious about the future even though consumers continue to spend for now. This remains a difficult environment for the markets as we anticipate weakening profits but face rising bond yields (and lower valuations) in the meantime.

Economic data showed how sentiment amongst housebuilders remains subdued and housing transactions continue to slow. There has been a slowdown in new house building activity too, but it has been less marked. That’s bad news in terms of suggesting that demand for labour and materials will remain tight, but too much of a slowdown in housebuilding intensifies the long-term imbalance between demand and supply.

Next week the European Central Bank and Bank of Japan will be setting monetary policy. The latter had to embark on a further unscheduled bond buying programme in order to prevent the ten-year Japanese government bond yield from escaping the top end of its 50 basis point acceptable range. Although there is no indication of a willingness to relax this policy, the market continues to test policymakers’ resolve.