The Garrulous Jay – Copulatory Lock

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Like two foxes in copulatory lock, the British economy now finds itself being pulled in two equal and opposite directions. While the Fiscal Dog of Downing Street pulls one way with tax cuts designed to drive growth, the Monetary Vixen in Threadneedle Street is ramping up interest rates to contain inflation.

The eventual outcome of this tussle is hard to predict but, without wishing to overstretch the analogy, it feels like the process of resolution could be drawn out and painful.

The Garrulous Jay is not a place for political comment, but when a ‘not-Budget’ is so overtly ideological in its underpinning, it is hard to avoid the politics. I shall, however, endeavour to stick to the economics.

No Magic Money Tree

If you cut taxes, you leave more money in people’s pockets which they can then spend on things. If more people spend more money on things that stimulates economic growth. If the economy grows then employment rises, businesses’ profits increase and the overall tax take goes up, elevating general prosperity and boosting the potential for public spending.

So far, so Kwasi.

But the challenge is finding the money to drive this virtuous cycle. As Theresa May famously said, “there’s no Magic Money Tree”, so for governments the choice here is simple: you have to spend less or borrow more. In the midst of a cost of living crisis and burdened by manifesto commitments, the former is politically unpalatable, so Truss & Co have gone for the latter…in spades.

The ‘C’ Word

And here’s the rub… The ability to drive economic growth by maxing out the country’s credit card is critically dependent on the ‘C’ word: confidence.

If financial markets worry about the sustainability of a country’s debt position confidence declines, and they charge more to lend to that country whilst also selling its currency. This makes servicing public debt more costly, reducing the funds available to spend on public services, whilst also making imports more expensive, potentially exacerbating inflationary pressures.

This is where the vixen of Threadneedle Street steps in, as tax cuts plus a weaker currency accentuate the pressure to increase interest rates, making borrowing more expensive. And if folks are worried about the cost of their mortgages and what it’ll cost to borrow for their businesses guess what? Confidence falls.

Judgement Days

We have seen this playing out over the last week… It now costs the Government 4.2% to borrow money for 10 years, compared to 3.3% last Thursday, and a pound will now buy about $1.11 compared to $1.13 a week ago (having dipped to $1.04 earlier in the week). That’s the judgment of the financial markets.

At the same time the Bank of England’s Chief Economist, Huw Pill, has said, “It’s hard not to draw the conclusion that this will require a significant monetary policy response”. Consequently mortgage lenders have withdrawn many of their current offers, further undermining already shaky consumer confidence, as expectations of ramping interest rates build.

Consensus expectations are that the Bank of England base rate will be north of 5% by the end of Spring 2023.

The world’s so-called “lender of last resort”, the International Monetary Fund, also entered the fray with openly critical remarks of last week’s not-Budget.

Diversification Benefit

The UK therefore finds itself at the epicentre of a self-generated economic earthquake: “economic fracking” if you like.

At such times it is inevitable that our outlook may be biased towards what’s going on close to home. But by being well-diversified by both geography and asset class, as appropriate, investors can protect themselves from some of the worst effects of any macroeconomic headwinds in a particular country, at a particular point in time.

This is a textbook lesson in the importance of diversification. It’s just a shame the learning of it has to be so painful. Yelp!