Q&A: will the UK’s economic gamble work?

Amid the turbulence that has followed the UK’s mini budget, we spoke to economist Azad Zangana to find out more about its implications for the economy, households and markets, and what might come next.

You can subscribe to the Investor Download podcast via Apple, Spotify, Google or wherever you get your podcasts. New shows drop every Thursday at 5pm UK time. The below is an edited transcript of the conversation.

UPDATE: the podcast was recorded on Tuesday afternoon, prior to Wednesday morning’s announcement from the Bank of England that it will buy long-dated gilts.

In response to this move, Azad Zangana says:

“The Bank’s decision to step in to stabilise the gilts markets with purchases makes sense in the short term, but this is ultimately a credibility issue with fiscal policy. This is the wrong time to be acting as lender of last resort, when it goes against the Bank’s primary objective of fighting inflation. It seems that the BoE will fight the market instead of hike rates aggressively as the market is demanding, resulting in a worse outlook for sterling.”

The UK’s new government, led by Prime Minister Liz Truss, last week announced a wave of sweeping tax cuts to promote growth in the country’s spluttering economy. At the same time, the Bank of England (BoE) has moved to raise interest rates in a bid to curb rising inflation. And in the last few days, the value of the pound has fallen to all-time lows against the US dollar due to fears about the UK’s fiscal position and an impending recession.

To make sense of what’s been happening, we spoke to Azad Zangana, an economist at Schroders.

So, what’s been happening in the last few days?

Azad Zangana: “Well, essentially we’ve had a more dovish update from the BoE than financial markets expected. Meanwhile, the change in administration has led to a very big increase in spending related to the energy crisis. And on top of that, we have some big unfunded tax cuts.

“The pound has taken quite a big hit. It fell to a record low at one point, although it has since rebounded. It also fell against the euro and is generally weaker across the board. And then in the bond markets, we’ve also had a very big selloff in UK government bonds (gilts). That means that the yield has risen (prices have fallen), and the cost of borrowing for the government has gone up. Before the mini budget statement, the 10-year yield for gilts was at 3.5%, and that has shot up to 4.3% in just a few days.”

Why has the market reacted so fiercely?

Azad Zangana: “I think a lot of this is because it was such an unexpected change in policy from the government. This is the same government that’s been in power for a very long time now. We haven’t had an election; we have had a leadership change. And that change has led to a very big turnaround in policy, moving away from an interventionist government to one that wants to now shrink the state and provide more fiscal support. But the other issue is that we’ve moved away from fiscal prudence. This mini budget statement has been delivered without the independent scrutiny of the Office for Budgetary Responsibility (OBR). This is the organisation that was introduced by this government to stop chancellors spending too much or putting the public finances on an unsustainable trajectory. So, that was also seen as a big negative for the markets.”

How has that affected the government’s relationships with some of these organisations?

Azad Zangana: “The OBR will likely come out later this year and say very clearly that the public finances are now unsustainable, and action needs to be taken to reverse these trends. Meanwhile, we’ve got the BoE, which is trying to slow the economy down by raising interest rates and starting quantitative tightening. It now finds itself in a situation where demand has been stoked up by the government. And so, the BoE may have to raise interest rates by even more than previously expected, and that’s certainly what the market is telling us now.”

Will the Bank of England be forced to raise rates before its next scheduled meeting?

Azad Zangana said: “To a certain extent, the market is doing the job for the BoE. At the last Monetary Policy Reports Meeting in August, the Bank was telling everybody that if it kept interest rates at 1.75%, that would be more than enough to get inflation back under control within its forecast horizon. As of today, the market is predicting interest rates reaching 6% by the middle of next year. The impact of this is that mortgage rates are going up anyway, because they’re priced off swap markets and gilt markets. They’re not priced off the BoE directly. So, in a sense, the BoE can afford to wait and see where markets settle, but if the selloff continues in a very aggressive way in the next week or so, then it may have to come back in, and quite quickly, just to settle the markets.”

What impact will a weaker pound have on businesses and which sectors are most at risk?

Azad Zangana said: “The energy sector, which is priced in dollars, will be significantly impacted. Much of the retail sector will also be affected, because the UK doesn’t really produce a great deal of goods domestically. However, the good news is that the UK imports quite a large amount in euros, and not just in dollars, and because the fall against the euro has been smaller, it won’t be quite as bad as if it was just all against the dollar. However, it’s still quite significant nonetheless, and obviously, this is all driving up inflation as well.”

Have we reached the bottom yet in the pound and the stock markets, and maybe even bonds?

Azad Zangana said: “Probably not in the pound. I think the market will want to see a change in either the direction of the government or the stance of the BoE, in that they need to become much more hawkish. In the stock markets, share prices were already looking quite cheap on an valuation basis. And now, with sterling falling so much, they’re probably looking even more attractive for overseas buyers. However, international investors won’t want to buy sterling assets until the pound stops falling, and this won’t happen for a while yet.”

How much of a risk does the current situation pose to household finances?

Azad Zangana said: “The biggest challenge for households in the past few months has been rising energy prices. This has been alleviated, to a degree, by the government’s energy price guarantee. However, we are now seeing mortgage rates starting to rise, and potentially rising by even more because of this help from the government. This will likely have a negative impact on some households. And I say “some households” because most households don’t have a mortgage at all, and of those that do have a mortgage, only about 20% of households have their mortgage maturing within the next two years.

“So, really, it’s a very small part of the population that will see any negative impact from higher interest rates in the near term, and this is why we’ve been saying for some time that the BoE ideally needs to raise interest rates to a level whereby households change their behaviour, start to really focus on saving money instead of constantly spending money. And that would mean interest rates of maybe 6% or 7%. So, that seems to be the direction we might be heading in. As for the weakness in the pound, of course it will hurt households across the board, but the impact is far smaller than, for example, the energy crisis or the impact from mortgage rates in general.”

What are the options left open to the UK government and the Bank of England to try and ease the UK through this crisis?

Azad Zangana said: “We have already had a hint from the government that it’s going to announce a plan for medium-term fiscal finances. I think that must happen quickly, if possible, but we know that there’s an election coming up in two years, and the government’s not going to apply austerity, or even announce any kind of austerity, before that election is won. So, really, it comes down to the BoE, which will have to accelerate those rate rises. We must go from the 50-basis point rise that we saw at the last meeting up to maybe a 100-basis point increase at the next meeting or even more, just to stabilise the currency. It needs to ensure that demand in the economy slows significantly to get inflation back down.”

How badly has what’s happened over the last few days affected the outlook for the UK economy, and the country, as a viable investment opportunity?

Azad Zangana said: “There’s lots of comments out there comparing the UK to an emerging market, and if we can stand back from all of this, I think there’s a lot of merit in those comments. It’s very rare that we see interest rates coming up in markets, and the currency falling at the same time, especially in a developed market. So, that’s been incredibly negative. The uncertainty around the situation with the pound obviously puts off a lot of international investors. However, at the same time, the government has taken some significant steps to try to make the UK a more attractive place to invest, by cancelling the rise in corporation tax and by getting rid of the additional rate of income tax. These are all designed to try to draw in capital from around the world, capital that may have left because of these higher taxes that were introduced, but also because of Brexit recently.”

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