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Reaction to the early announcement of the UK’s medium-term fiscal plan

19/10/2022

In this short note, produced by Columbia Threadneedle Investments, in partnership with LV=, we summarise the reaction to the announcement of the UK’s medium-term fiscal plan, and outline what it means for investors in our Smoothed Managed Funds.

In summary:

  • On Monday 17 October, the new Chancellor, Jeremy Hunt, announced some of the measures to be included in the forthcoming Medium-Term Fiscal Plan. 
  • Hunt confirmed that the cancellation of the increase in National Insurance (NI) would proceed, but the planned reduction in the basic rate of income tax a year early would be cancelled altogether. The Energy Price Guarantee will now last for six months rather than two years.
  • Hunt’s announcements have heralded positive moves for sterling and for government borrowing rates. Market expectations are that interest rates will not need to rise as far as previously feared when the Monetary Policy Committee next meets in November.
  • Gilt markets have reacted positively, with yields moving down from recent highs. 
  • Higher yields make bonds more attractive, and within the Smoothed Managed Fund portfolios, we have been adding to bond exposure in recent weeks. While the recent yield falls are therefore welcome, we believe that if the government can deliver a credible fiscal plan, yields should stabilise at a lower level than we see today. Until this occurs – and if attempts to replace Truss become messy – further large moves cannot be ruled out.

On Monday 17 October, the new Chancellor of the Exchequer, Jeremy Hunt, announced some of the measures to be included in the Medium-Term Fiscal Plan, which is due to be fully published on 31 October.

This followed three turbulent weeks in UK politics and markets since the previous Chancellor, Kwasi Kwarteng, announced his Growth Plan on 23 September. The lack of an independently validated fiscal plan alongside this “mini budget” had shocked markets and led to falls in sterling and rises in government bond yields. Fearing contagion across the markets, the Bank of England (BoE) made emergency interventions in bond markets to provide a break for pension plans whose leveraged portfolios were impacted by the speed and severity of these moves.

Kwarteng had attempted to mollify markets and his parliamentary colleagues by cancelling a small component of his tax plans – the additional rate of income tax which applies to high earners – and by bringing his fiscal plan forward from November to October. On 14 October, however, Prime Minister Liz Truss accepted more was needed. She sacked her Chancellor, appointed Hunt in his place, and announced that the planned reduction in corporation tax would no longer proceed. This was a significant change, meaning that around £20 billion of the £45 billion cost of the mini budget had been unwound within three weeks.

The announcements on 17 October bring the rises in taxes after the mini budget to £32 billion per annum[1]. Hunt confirmed that the largest remaining tax-cutting measure in the Growth Plan – the cancellation of the increase in National Insurance (NI) that occurred earlier in 2022 - would proceed. Indeed, this had already passed through the House of Commons with cross-party support, so reversing this would have been challenging. But NI is income tax in all but name, and the new Chancellor gave with one hand and took with another when he announced that the final significant tax measure in the mini-budget, reducing the basic rate of income tax a year early, would be cancelled altogether. Various other smaller changes were also cancelled.

By announcing these measures now rather than waiting until the end of the month, the Chancellor will have hoped to assuage the concerns of the government’s lenders, the financial markets. So far he appears to be doing a better job than his boss. Her eight-minute press conference on 14 October lacked detail and confidence: almost immediately, sterling began to erase the gains it had made in the wake of Kwarteng’s departure. In contrast, Hunt’s announcements have heralded positive moves for sterling and for government borrowing rates. Policy in government and at the BoE appears now to be in alignment rather than at loggerheads, with the BoE governor, Andrew Bailey, saying that having spoken to Hunt, “there was a very clear and immediate meeting of minds between us about the importance of fiscal sustainability and the importance of taking measures to do that"[2]. Market expectations are that interest rates will not need to rise as far as previously feared when the Monetary Policy Committee next meets in November.

The tax changes make fiscal sustainability more achievable, and should have limited impact on aggregate demand. There is more to do, however. Recent analysis from the Institute for Fiscal Studies suggests that further fiscal tightening – likely to be a combination of spending restraint and tax increases – will be needed if the ratio of debt-to-GDP is to come down[3], which is the government’s stated aim. This is the task for 31 October.

The new Chancellor revealed yet another change: the Energy Price Guarantee, which Truss herself had championed before the mini budget, would also be tweaked[4]. It will now last for six months rather than two years, with more targeted help likely to follow from April next year. In a final humiliation for Trussonomics it was revealed that windfall taxes on the profits of energy companies could be on the table.

Overall, bringing forward the announcement of these measures by two weeks finally puts the government on the front foot. It no longer has to be in responsive mode with markets and instead has bought itself time to get its fiscal plan in place. Gilt markets have reacted positively, with yields moving down from recent highs – no doubt to the relief of the BoE whose interventions have now ended.

Higher yields make bonds more attractive, and within the Smoothed Managed Fund portfolios, we have been adding to bond exposure in recent weeks. While the recent yield falls are therefore welcome, we believe that if the government can deliver a credible fiscal plan, yields should stabilise at a lower level than we see today. Until this occurs – and if attempts to replace Truss become messy – further large moves cannot be ruled out.

 
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[1] https://ifs.org.uk/articles/response-chancellors-mini-budget-reversals 
[2] BBC, Bank of England chief warns of fresh interest rate hike, 16 October 2022
[3] IFS, A response to the Chancellor’s ‘Mini-Budget’ reversals, 17 October 2022; IFS, Mini-Budget response, 23 September 2022
[4] Bloomberg, UK Scraps Energy Bill Price Freeze After This Winter, 17 October 2022

 

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