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On Thursday 8 September the UK government announced an Energy Price Guarantee (EPG). The full details are yet to be set out, as are any indications for how it will be funded.
Two weeks ago, Ofgem announced the increased caps that would apply to energy tariffs for the next quarter, starting 1 October. Based on a typical household paying by direct debit, this would have meant an increase in annual costs from £1,971 to £3,549 (the cap had been £1,277 only six months ago and was forecast to rise to more than £5,000 early next year). However, the EPG means that for such a household, costs from 1 October will instead be capped at £2,500 – a reduction of around £1,000, potentially more depending on energy prices going forward. Furthermore, this cap will be in place for two years and is in addition to a previously announced measure to provide £400 to each household over the six months from October 2022 to March 2023, while the £150 “green levy” on energy bills is set to be paused. A similar cap for businesses and public services such as schools will be in place for an initial six months. The government has also announced a £40 billion liquidity facility to help energy companies deal with volatility. This was in response to their request this week for help to deal with a potential cash flow crisis.
Protecting retail customers from the very large increases seen in wholesale energy markets will prevent this component from driving inflation to levels which had been predicted to be as much as 13% by the Bank of England and even higher by independent analysts. The government’s estimate is that as a result of the EPG peak inflation will be 5% lower than it would have been. Since the energy price shock has been a key driver of broader price inflation and subsequently wage inflation, fixing prices for an extended period should diminish these pressures on the broader economy and make the job of bringing inflation under control much easier to manage. The energy subsidies will support the economy, helping households maintain their spending levels, although the rise in energy costs we have already seen are impacting heavily on consumer sentiment. The EPG intervention is intended to create certainty until 2024, which will likely be an election year.
Under the EPG, the gap between the price paid by households and the prices in energy markets will be met by the taxpayer. The details have been deferred to the chancellor’s fiscal statement later this week but are presumed to involve very significant borrowing given the new government’s determination that tax is not the right solution. So, while the EPG should mean the strain on GDP is shallower in the short term, it may be longer lasting. The Institute for Fiscal Studies has estimated that costs could be more than £100 billion a year and exceed the total cost of support provided during the Covid-19 pandemic. The actual cost, of course, depends upon the path of wholesale energy prices. Oil prices, incidentally, have fallen significantly in recent months.
Going forward it will be important to monitor what other European countries do and if they also cap the price for unlimited usage. If we face a cold, dark winter, this will have consequences for the cost – and indeed the success – of the EPG policy as energy prices could cease to act as a curb on demand and energy shortfalls could occur. The UK government has said that a campaign to reduce energy consumption will run parallel to the cap, but we will have to monitor the situation over the coming weeks as the plans of other European countries, as well as those of the UK government, are made public.
Financial markets will watch the Bank of England’s actions closely following this large stimulus. But already this has had implications for government bond yields across the maturity spectrum, the pound and equity markets.
In fixed income, gilt yields across the curve began building a sizeable concession from the middle of last month as rumours of a possible price freeze initiative began to circulate, in addition to the well telegraphed tax reductions. In a weak period for core governments generally, the UK market has been a clear underperformer. The correction may have run its course in short- to medium-dated maturity bonds and we could see a steepening of a flat UK yield curve. At the long end, however, the high and open-ended cost of the energy cap will entail significant additional gilt issuance, and yields have already moved higher as investors ponder the debt that looks set to be accumulated because of these huge subsidies for energy bills. Breakeven rates have remained elevated in long maturities, while short-dated index-linked securities have underperformed as peak inflation forecasts are marked down.
In anticipation of the emergency energy package, and reflecting the daunting scale of the economic challenge, the pound has fallen to its weakest level since 1985. However, we could argue the slump is predominately a story of dollar strength. It underscores the challenges faced by the new government as it grapples with double-digit inflation and warnings of a deep economic contraction. The risk here is that foreign investors lose confidence in the UK’s future fiscal path.
Valuations of domestic UK stocks, both cyclical and defensive, are touching the same lows witnessed ahead of the Brexit agreement and the Covid vaccine – and now ahead of any cash hitting consumers’ and business’ bank accounts from the proposed subsidies. Market positioning is also as extreme, with little optionality being priced into profit expectations for those companies most exposed beyond the most immediate timeframe.
As long-term investors, we are cognisant of short-term risks but also of the need to balance that against longer-term cash flow in our assessment of intrinsic value. With many domestic cyclicals back at 2008 lows, we see opportunity in this part of the market to sustain our weights in the more advantaged businesses that should continue to take market share and move forward on the front foot as these headwinds abate.
As such an example, we have sustained our weighting in Marks & Spencer, a domestic cyclical which has been sold down to valuation levels last seen during the depths of the global financial crisis and most recently Covid-19, the latter being a time when much of its selling space was shuttered and investors were fretting over solvency as well as the wider sector. At the time we viewed this as an overreaction, and the business has emerged with its transformation program much accelerated, a balance sheet with much less financial debt, a food business in rude health and a clothing business benefiting from capacity exit by weaker competitors. Looking to the future, we see the challenges faced by M&S as similar to any consumer-facing business, but believe the company remains on the front foot and the market is once again excessively discounting the prospects for the shares.
We expect the portfolios in the Smoothed Managed Fund range to navigate this period relatively well. They have been underweight in the energy sector, which is poised to benefit from recent oil price falls, and the portfolio favours investments in companies with strong balance sheets – companies which should therefore be well positioned for the current tough economic environment and any subsequent periods of growth. More broadly, the exposure to UK assets, equities and bonds, and the pound in the portfolios is well balanced by being diversified across geographies and asset classes. The portfolios also benefit from holdings in global equities, bonds and currencies, and while they have experienced the simultaneous negative performance of equities and bonds, they have benefited from being exposed to diverse global themes and asset classes.
 Office of Gas and Electricity Markets: https://www.ofgem.gov.uk/publications/ofgem-updates-price-cap-level-and-tightens-rules-suppliers
 UK Investor, Energy bills to hit £5,000 per year in 2023, 12 August 2022
 The Times, Bank plans £40bn safety net to help energy sector, 8 September 2022
 18.6% according to Citi (https://www.ft.com/content/778e65e1-6ec5-4fd7-98d5-9d701eb29567) and 22.4% according to Goldman Sachs (https://www.reuters.com/world/uk/goldman-slashes-british-growth-forecast-predicts-q4-recession-2022-08-29/)