Financial Update from Brewin Dolphin - 9 September 2022

September 2022

The Weekly Round-up

Friday 09 September 2022

In his latest weekly round-up, Guy Foster, our Chief Strategist, reflects on the UK’s economic transformation during Her Majesty Queen Elizabeth II’s reign and discusses the impact of the new prime minister’s energy cap.

The week began with the UK welcoming a new head of government and ended with it bidding farewell to our longest-ever serving head of state. This marked a sombre moment that was shared throughout the commonwealth and will prompt much reflection on a remarkable history. Her Majesty’s reign ends at a time when economic orthodoxy is being challenged after a remarkable period of prosperity. During her reign, commerce progressively shifted from factories to offices, which together with the development of the National Health Service and improved nutrition saw life expectancy rise by seven years. All this was accompanied by an ever-expanding range of entertainment and comfort.

The present and future, however, is in the hands of a new government which faces many challenges – a point underlined as the weather marks the transition between seasons.

Queen Elizabeth II came to the throne when butter and meat were still being rationed. Since then, we have become accustomed to believing that life’s necessities will always be available. Perhaps complacency has led us to a time when, following last week’s round-up, Russia disappointed Europeans by not restarting gas flows through the Nord Stream 1 pipeline – raising the prospect of gas rationing. Gas flows will not resume until the western states end sanctions.

Prices initially leapt on the news but subsequently sank back. They are incredibly volatile and nobody wants to count on the steep declines experienced over the last week enduring, particularly with their dependence on the notoriously unpredictable weather.

Energy cap

The first action point on the prime minister’s agenda was always going to be formulating a plan to avoid the shock stemming from soaring energy bills. Russia’s announcement was timed to be as unhelpful as possible in that regard.

The average household will see energy bills capped at £2,500 per annum over the next two years. Green levies costing £150 will be temporarily removed and consumers will keep the £400 energy bill discount that had already been promised to them. The cap is on standing charges and unit rates, not the total bill, so using less energy will save households a lot of money.

For businesses and public bodies, there will be an equivalent guarantee for six months. After that, only yet-to-be-established “vulnerable industries” will continue to receive support, which leaves enough ambiguity to keep business owners worried.

The UK plans to ramp up domestic production, with the goal for it to be a net energy exporter by 2040. To do that, the ban on fracking for shale gas will be lifted, and there will be greater investment in nuclear and renewables. The challenge here will be around how new energy developments can overcome local opposition.

Inflation

One implication of this plan is that inflation will rise less, peak sooner, and start to fall earlier. The aspect of inflation that was driven by energy bills will be reduced. However, as a consequence, the recession which the Bank of England had been forecasting will be shallower. So, as a fiscal impulse, it should require an offsetting monetary contraction – interest rates ought to rise more than they would have otherwise done.

Huw Pill, a member of the Monetary Policy Committee, confirmed that the Bank would expect this to be the case. It must, however, depend upon whether fuel bill increases are still enough to push the UK into a recession.

The primary channel for interest rates to affect the economy right now would be through their impact on longer-term interest rates, causing mortgage rates to rise, which act like a tax on consumers when they come to refinance their mortgages. The rise in mortgage rates has not yet taken effect, but will do so over the next 12 months.

Issuance

The measures are expected to cost around £150bn, although the true cost will be determined by the trajectory of natural gas prices over the next two years. The scale of new bond issuance is a concern. Previously, when the UK issued a lot of debt to cover the cost of the furlough scheme and other pandemic responses, the Bank of England took the view that lockdowns were deflationary and needed to be combatted by aggressive quantitative easing. This resulted in the purchase of bonds being of a similar volume to new issuance, causing some to question exactly how independent the Bank was. For the forthcoming year, the opposite will be true. The debt management office will be trying to issue a lot of bonds to fund the energy bill cap, at a time when the Bank of England is planning to start unloading around £80bn of bonds bought under previous programmes.

The incoming government has also begun to shake up the institutions charged with ensuring the UK’s economic stability. Sir Tom Scholar, who as permanent undersecretary to the Treasury was the most senior civil servant in the department since 2016, was dismissed. A search is underway for a replacement who will share the prime minister and chancellor’s desire to challenge economic orthodoxy.

Europe

In Europe, the European Central Bank raised interest rates by 0.75%, bringing the deposit interest rate into positive territory for the first time in over a decade. It also updated its macroeconomic projections, revising its expectations for inflation higher and real growth lower.

With all the doom and gloom at the moment, it is easy to forget that the European economy is heading into this energy crisis in reasonably good shape. The gross domestic product (GDP) numbers for Q2 were revised higher this week and the EU, like the UK, is seeking to roll out strategies to deal with the energy crisis. But the outlook is still very challenging. Eurozone money supply growth has been a very reliable leading indicator of real eurozone GDP, and it has plunged to its lowest annual growth rate since the euro crisis, signalling hard times ahead for the currency area.

Looking ahead

Next week may offer some optimism for markets as the latest inflation data land. US consumer prices are expected to have fallen during August, meaning that the annual rate of price increases should continue to decline. This is mainly a function of lower gasoline prices though (and the stronger dollar). The more important core inflation measure, which strips out food and energy costs, is expected to have risen once more at a pace that is uncomfortable for the Federal Reserve.