UK assets still have Mini Budget risk premium

The UK Mini Budget was the defining event of the tenures of former Prime Minister Liz Truss and former Chancellor of the Exchequer Kwasi Kwarteng, a set of policies that plunged the UK into daily doses of market volatility as markets They reacted after September 23, 2022.

In the wake of the Truss fiscal event, sterling fell to a record low against the US dollar and bond yields suffered their biggest daily rises in decades, creating a liquidity crisis within pension funds that forced the Bank of England to intervene. to £1bn emergency bond purchase scheme.

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Almost a year later, the UK is still dealing with the fallout from the event, as noted by Robert Alster, CIO of Close Brothers Asset Management.

The CIO argued that although sentiment towards the UK has improved in the interim period, there will continue to be a UK risk premium attached to bond yields “until the market is convinced of the UK’s financial prudence in what regarding possible tax cuts.”

Nicholas Hyett, investment manager at Wealth Club, said UK government bond yields relative to US and European government debt “shot up immediately” after the Mini Budget and have continued to rise as the The Bank of England raised interest rates.

In June of this year, Bond Yields Soared Beyond Mini Budget Levels, with two-year bonds rising 0.38 percentage points to 4.85%, surpassing the high of 4.64% last seen after September 27. While two-year bonds have dropped to around 4.5% today, they almost hit 5.5% over the summer.

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UK shares have also suffered, as Chris McVey, manager of the Octopus Multi Cap Income fund, noted, suggesting valuations were “at levels not seen since the global financial crisis”.

Some of this discount in the UK had already been discounted long before Truss took office, largely due to the first round of political and social uncertainties introduced by the Brexit vote.

“The UK certainly faces economic and political challenges as sentiment remains stagnant,” said James Penny, CIO at TAM Asset Management.

“Yes, inflation and rates have a role to play, as they do around the world, but unfortunately Brexit has exacerbated some of the UK’s headwinds to make the economy a notable laggard on the global stage. “Not to mention an example of what not to do with other EU nations that think about the sovereignty of the former EU.”

But the severity of the selling during the Mini Budget fallout “gave domestic and international investors another reason to sell the UK”, according to Neil Birrell, CIO of Premier Miton Investors, although he argued that the UK discount presented an attractive purchasing opportunity for investors.

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Heavy market discounts have also been compounded by “corporate regulations acting as a barrier to grassroots innovation in the UK stock market”, TAM’s CIO added, arguing that the exodus of major companies from the United Kingdom towards other indices was “a humiliating blow for the United Kingdom and unfortunately gilts the structural problems that exist.”

The volatility of UK national indices has decreased over the year. Average valuations of UK-exposed companies have fallen from around 14 times earnings in the 12 months before the Mini Budget, to 11.7 times in the 12 months after.

This represents a drop of 16.4%, similar to where they were before the Mini Budget in the summer of 2022, according to data from Wealth Club.

Negative ratings

At the time of the event, several rating agencies downgraded their UK risk ratings, many of which remain in force.

Moody’s downgraded the outlook for the UK Government and the Bank of England from ‘Stable’ to ‘Negative’ a month after the event, a move Fitch Ratings reflected when he downgraded the UK’s public debt rating, along with S&P Global. The three ‘Negative’ ratings remain current at the time of publication.

Wealth Club’s Hyett said the persistent declines suggest “some nervousness remains, and that can be seen in various measures of market risk.”

He said: “Overall it appears that while the risk premium investors demand for holding assets in the UK has increased and investors have not forgotten about the Mini Budget, it has not been a dramatic change.”

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At the time of the event, US Treasury Secretary Larry Summers stated that the UK was “behaving a bit like an emerging market, becoming a black market”, a comment that divided opinion among experts.

Hyett described the statement as “hyperbole,” while Penny said she agreed and understood Summers’ point. However, she does not believe this should define the UK in the future.

“The UK has a respectable economic record, but needs new stimulus and innovation to help drive domestic opportunities,” he said.

“Necessity is the mother of invention and the UK’s evident need for revitalization should drive a more significant move towards more growth-focused government policies, regardless of which party is in charge.”

Vivek Paul, chief investment strategist at BlackRock Investment Institute in the United Kingdom, said the country’s financial credibility stems from the unified strength of its institutions “which has been tested” over the past twelve months, but said “ultimately have prevailed.”

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“The intervention of the independent Bank of England calmed UK markets and the wider UK parliamentary system exerted its influence,” he added.

The BlackRock strategist argued that global financial organizations had been challenged by inflation and rapidly rising rates, which “posed financial cracks – in the US, think of the problems regional banks faced in the spring, and in the UK, think about the bond market disruption. 12 months ago.

“Therefore, the underlying picture globally has been one of increased volatility in fixed income assets in particular. However, UK-specific risk certainly increased at the time of the Mini Budget and the market questioned the credibility UK prosecutor,” he said.

This context of uncertainty was especially relevant as the UK heads into its next election cycle and, in relation to the run-up to the last general election, in which Boris Johnson was installed at number 10, “the perceived risk around UK assets has now declined. , but it hasn’t evaporated,” Paul said.

He noted that both current Prime Minister Rishi Sunak and Opposition Leader Keir Starmer were making “comparatively modest” fiscal promises, which he considered “revealing”.

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Robert Burrows, macro fixed income manager at M&G Investments and member of the Bond Vigilantes, said the fallout from Truss-Kwarteng’s policies had “sent a strong message from markets to politicians.”

He said this ultimately limited “any future government in terms of fiscal spending, along with the need to demonstrate fiscal prudence.”

His colleague Miles Tym seconded this, adding that while bond markets have been quieter in recent months, “governments have been reminded in very clear terms of the need for credible fiscal policy.”

“Markets have a long memory,” Paul said. “On a longer-term horizon, we believe international investors will likely perceive UK assets as riskier than they did ten or fifteen years ago.”