Markets 1, Truss nil

This brief episode has unquestionably damaged the UK’s reputation for financial prudence and sound economic management. The 30-year gilt yield became an important barometer for confidence in UK assets: it peaked at 5%, as investors demanded a larger premium for financing increased spending on tax cuts, but has since fallen back to under 4% as incoming Chancellor Jeremy Hunt shelved most of the measures in the mini-budget and restored some level of economic stability.¹

The political uncertainty that has weighed on the UK since Brexit is unlikely to be resolved in the short term. It is not yet clear who will succeed Liz Truss and it is possible that it could be an equally divisive candidate. Boris Johnson, for example, has not ruled out another attempt at the leadership. Outgoing home secretary Suella Braverman is also thought to be preparing a bid. The Conservative party’s internal squabbles have not been laid to rest with Truss’s departure.

Nevertheless, any successor is unlikely to attempt a reintroduction of Truss’s ‘dash for growth’ agenda having seen the market’s reaction to unfunded tax cuts and other spending promises. The new leader is set to be announced within a week, so the shape of the incoming government should be decided relatively quickly. At the moment, it seems more likely that it will be from the moderate wing of the party – Rishi Sunak with Jeremy Hunt continuing as Chancellor would ease market fears – but this is not inevitable.

A firmer grip on spending and taxation from the Treasury would mean that the Bank of England could potentially relax its stance a little on future interest-rate rises, in spite of continued high inflation. This would reduce the risk of a spike in gilt yields and further sharp falls in sterling, which is currently the main risk to owning UK financial assets.

In our view, bond markets are still pricing in some uncertainty for UK assets. The spread between 10-year UK government bond yields and those on US treasuries remain some way above where they were prior to the mini-budget, reflecting an ‘insecurity premium’. Sterling has made up some ground over the last week, but both currency and bond markets have scope to recover further if there is greater certainty about the UK’s political direction.

That said, the outlook for the UK economy remains difficult whoever is in charge. Inflation remains elevated, interest rates are rising and household incomes are being squeezed. The corporate sector is facing higher input costs and falling margins. Against this backdrop, large-cap UK companies, where more earnings are derived internationally rather than domestically, appear less vulnerable. Pricing power is important, as is low debt. Investors may need to bear in mind the potential for a windfall tax on energy companies, a dominant sector in the UK market. This was ruled out by Truss, but remains a possibility under her successor.

The UK market continues to trade on low valuations relative to its peers and has an attractive dividend yield. It is a familiar refrain, but its international flavour means that the UK market is not the same as the UK economy and the majority of UK companies will remain unaffected by the dramas at Downing Street. Investors should not be panicked out of the UK stock market because of this political uncertainty.

It is tempting to say that the past month has marked a low point for the UK and its reputation should rebuild from here. Given its recent history, this may be premature. However, it is fair to say that any flirtation with fiscal indiscipline is over and politicians of all hues will be trying to rebuild the UK’s stability.

Sources

[1] Refinitiv Datastream/Evelyn Partners, Data as at 20 Oct 2022