This time last year, things were looking good for the UK.
Inflation was rising but was still deemed “transitory” by a complacent Bank of England. Growth was recovering. The labour market was strong, and the pandemic (with hindsight) was well past its peak.
A year on, and while the labour market remains strong and Covid is firmly in the rear view mirror, things look a lot gloomier…
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No wonder the chancellor decided to act
The Bank of England has been very clear (perhaps rather too clear) that things are no longer rosy on the UK economy front.
Indeed, Bank boss Andrew Bailey agreed when asked by MPs last month that he feels “helpless” in the fight against inflation and also warned of the “very real income shock” facing consumers, as higher food and energy prices eat into disposable incomes.
Suddenly all the talk is of “stagflation” – the toxic combination of rising prices and slowing or non-existent growth most associated with one of the most painful decades for investors, the 1970s.
While Bailey’s slightly hopeless tone is hardly helpful (after all, whether he likes it or not, tackling inflation is his job), there’s no doubt that consumer incomes are under serious pressure.
Energy regulator Ofgem added insult to injury by warning that the energy price cap will shoot up again to £2,800 in October, meaning that energy bills will have more than doubled in a year.
The UK is a consumer-driven economy. If consumers feel the squeeze and stop spending, the economy slows down. That in turn would mean fewer new jobs being available, followed by higher unemployment, leading to a further squeeze on spending, and perhaps even a recession.
That’s bad news for a government already beleaguered by scandalous house parties, so it’s little wonder that chancellor Rishi Sunak suddenly felt the need last week to drop his stern tone on the public finances, and rush back to stick his arm down the back of the Number 11 sofa to see what he could find there.
As it turns out, what he found there was pretty significant. The chancellor handed money to every household to help cope with rising energy bills, with the poorest households getting the most (see here for more details).
Meanwhile, he planned to fund this with a windfall tax on the profits of North Sea oil and gas producers.
As is usually the case, the cost of the spending is a good bit clearer than the amount that will be raised from the taxing. But in all, says Paul Dales of Capital Economics, the chancellor has pumped the equivalent of about £10.3bn into the UK economy with this move, made up of £15.3bn being given to households, and £5bn taxed away from oil and gas producers.
The spender of last resort
What does this mean in practice? For a start, it makes a consumption-driven recession less likely, which is good news. As economist Julian Jessop of the Institute of Economic Affairs think tank points out on Reaction, the decision even makes fiscal sense, given that “a recession would have been an even worse outcome for the public finances”.
Secondly, this makes it easier for the Bank of England to narrow its focus to inflation (rather than flailing about in a panic, worrying about triggering a recession).
“Most economists agree that fiscal policy has been tightened prematurely, but also that monetary policy is still too loose. Sunak’s announcements may help to correct that imbalance,” says Jessop.
But perhaps the most important point here is that “austerity” is no longer an option. Voters are not in the mood to tighten their belts and it’s hard to blame them.
Companies may end up plugging that hole with rising wages as long as the labour market remains strong, but the government is also setting a precedent whereby it will step in to relieve consumer pain where necessary.
Put more simply, in recent decades, markets have grown very used to the Bank of England being the “lender of last resort”, stepping in to put a floor under markets any time they fell. That’s changed.
Today, the government is the “spender of last resort”, insulating consumers from painful price changes, while the Bank’s role will be to leaven the impact of that spending by tightening monetary policy accordingly.
This implies that we’re likely to remain in a very different investment environment to that which prevailed right up until last year. Inflation will remain a force to be reckoned with, which means that markets cannot rely on interest rates remaining low.
For example, Capital Economics reckons that the Bank of England will raise interest rates to 3% next year, and that it might even raise by half a percentage point at the next meeting on June 16th.
Central banks will still step in as and when something in financial markets threatens to “break” or if declines in markets become “disorderly”. But investors can no longer assume that the Federal Reserve (which tends to lead the charge on these things) will step in once the S&P 500 drops below a certain level.
Nor can homeowners take it for granted that the Bank of England will act to suppress mortgage rates (although I suspect that government intervention in case of severe mortgage pain cannot be ruled out).
What does all of this imply for the investment outlook? For a start, it suggests that “value” (which can survive and even thrive in a rising interest rate environment) will continue to outperform “growth” (which struggles in the face of a rising discount rate).
Meanwhile, if more fiscal largesse allows the Bank of England to raise interest rates a little more than would otherwise have been the case, you’d expect sterling to be stronger than it would have been.
Of course, all of that said, the chancellor is making the tax system even more complicated, which is hardly good news. For more on that, you should tune in to tomorrow’s Money Morning for a contrarian view from Max – on why the UK’s political turbulence might mean it actually deserves to trade at a discount.
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