A drastic, debt-fuelled shift in the government’s economic strategy, has spooked the markets. But how will the changes impact you?
Just a couple of weeks into her premiership, Liz Truss and her chancellor Kwasi Kwarteng lit up Westminster and the financial markets when they unveiled a dramatic shift in economic policy. Their ‘mini budget’, announced the biggest package of tax cuts in 50 years. The aim, they say, is to turbocharge a stagnant economy to 2.5% annual GDP growth, a level the UK has struggled to maintain since the global financial crisis in 2008.
The most immediate tax cut is a reversal of the 1.25% spike in National Insurance and dividend tax implemented by the previous chancellor Rishi Sunak in April. This will come into effect in November which, combined with Truss's freeze on the energy price cap at £2,500 for two years, will help people cope with the hard effects of inflation expected through the winter.
Then, next April the basic rate of income tax will reduce by 1p to 19p. Sunak’s previously announced plan to increase corporation tax for larger companies from 19% to 25% has been scrapped, as has a cap on bankers' bonuses which the government says restricts the competitiveness of London’s financial services sector. The most controversial inclusion in the mini-budget announcement, the abolition of the 45% top rate of income tax, will not go ahead after Truss and Kwarteng were forced into a U-turn.
Finally, stamp duty thresholds have been increased, reducing the burden of stamp duty, with no tax due on purchases up to £250,000, rather than £125,000, and first-time buyers will pay no stamp duty on the first £425,000 for house purchases of up to £625,000, raised from £300,000 and £500,000 respectively. This is a permanent change in stamp duty thresholds which the government hopes will help keep the property market alive as mortgage rates continue to rise.
How will this affect me?
The impact at an individual level is difficult to measure as while many taxpayers will be taking home more of the money they earn, if you have an investment portfolio it’s likely that this has already been heavily impacted in light of the government’s move to flood so much borrowing into the market to fund the tax cuts. It is also unclear how the changes will affect inflation. Generally, tax cuts fuel inflation, in which case the cost of living would normally rise further.
Yet what makes the next year so unpredictable in terms of how the tax cuts will impact spending and inflation, and fulfil the economic growth the government wants, is the conflicting forces at play. Firstly, unlike the other historical tax-cutting events which people have turned to for comparison – Anthony Barber’s disastrous ‘dash for growth’ in 1972 and Nigel Lawson's budget in 1988 – there is now an independent Bank of England in charge of monetary policy.
This means while the government is seeking to fuel demand in the economy through its fiscal policy – i.e. giving people more take home pay to spend on goods and services – the Bank is seeking to do precisely the opposite through its monetary policy. Interest rates are already at 2.25%, up from just 0.1% a year ago, and could rise to 6% next year. If these higher rates remain it will cause mortgage payments to soar for a generation of homeowners for whom rock bottom rates were the norm.
Level up or trickle down?
Secondly, the inflationary environment and energy crisis are such that households are already in the midst of the biggest real-terms fall in incomes since the 1970s. Given the existing squeeze on households, it seems unlikely that the tax cuts – – will offset the rises in utility, food and other bills that consumers have been forced to absorb this year (For Scottish tax payers their budget will not take place until December so the impact on their tax rates on earnings is awaited). Add in higher mortgage costs and will people be inspired to spend more than they ordinarily would?
If the majority of the population indeed does not feel they have the extra money in their pockets to spend, it will fall to higher earners to ignite economic activity. The U-turn on the abolition of the additional rate of income tax has done little to dampen the view that Truss is a proponent of supply-side, or ‘trickle down’, economics, whereby additional spend by the wealthiest people has a knock-on effect which multiplies value across all groups.
“Anybody who's done GCSE economics knows about the multiplier effect,” says Graham Bentley, Chair of the Ascot Lloyd Investment Committee. “You spend money in the shop, the shop spends it somewhere else or puts it in the bank which lends it to someone else, so the value is multiplied. But do wealthy people who get more in their pocket actually spend it?
“Though our circumstances today are unique, history tells us that when rich people are given more money through tax cuts they tend not to spend it, particularly against a backdrop of rising interest rates which in fact incentivises them further to save it.”
The government will be hoping that by the time the majority of their tax cuts are implemented in April – and Kwarteng has signalled there are more announcements to come before then – inflation will be on a downward trend, enabling the economy to grow during a period in which consumers are past the worst of rising prices. Will the economy finally get the post-pandemic boom that many touted before Russia’s war in Ukraine put paid to it? This is far from certain.
What is certain is the financial markets have already demonstrated their displeasure at the government’s bold shift in economic policy. The pound fell to a historic low against the dollar and there were also historic falls in UK bond prices, though both rallied following intervention by the Bank of England and then the U-turn on the additional rate of income tax. Issuing new gilts at a higher rate, due to rising interest rates, clearly makes the fixed interest rates on existing rates far less attractive, weakening their value. The yield on the UK’s benchmark 10-year gilt jumped sharply. Volatility among an asset traditionally viewed as a safe haven caused havoc on investors’ portfolios. Investment involves risk.
“When advisors have conversations with clients, we have a process of ascertaining risk and typically the starting point is that buying a fixed interest security – a gilt or corporate bond – provides greater certainty than an equity,” says Bentley. “As long as the company or government doesn't go bust, you know there’s a certain amount of income you’ll get, and at a certain day in the future, you’ll get money back for your gilt. You don't have that certainty with shares, so logic dictates that those with a lower risk tolerance buy more of these 'lower risk assets'.
“However, if the market thinks the government is doing something very risky, as it clearly does right now, it will respond accordingly. It means your average investor, who isn't in a position to do anything about it, is sitting on what they thought were safe investments but they are in fact behaving like the riskiest investments ever. Index-linked gilts have already fallen about 50% this year.
“We are now in the bizarre situation of living in a country that has rising interest rates and a falling currency, which is normally what you see in emerging markets, and it means the way things behave is not the way they would normally behave. The question is how temporary this period will ultimately be. At what point does inflation and interest rates top out? And at what point then do we get more stability in bond prices? There is a major uncertainty in the market.”
What should I do?
Perhaps the biggest question of all, certainly for those relying on investment portfolios for their retirement, is whether you should be making any changes in light of the government’s new economic direction. When any fundamental facts change, it is sensible to reinvestigate where you sit, so a discussion with your adviser is wise. Given the current volatility in the bond market, it may be tempting to reconsider the types of assets you hold relative to gilts. Your adviser will help you identify assets which might benefit from an era of supply-side economics.
However, history dictates that most assets revert to the mean – they go back to their average behaviour at some point. This means a new investor today is likely buying gilts at a good price. Theoretically, then, somebody who was prepared to buy gilts six months ago because they thought they were safe should be even more prepared to buy them now, if they expect prices to revert to the mean. “If you've lost 20% on gilts already this year,” says Bentley, “you would be crystallising that loss probably right when you are going to get higher income streams coming into your portfolio because gilts are being issued with higher coupon rates.
“Clearly that’s very difficult to say to somebody's face who just lost 20% when they never imagined that would be an outcome from their supposedly safe investments. But we are where we are. If you expect prices to revert to the mean, then you should stick with it however painful it’s been and however you feel that your rational expectations have not been fulfilled.”
Diversifying to win
The biggest lesson, as it always is, whatever the economic circumstances, is the importance of portfolios which are built to diversify risk. An investor with a diversified portfolio will have no doubt been shocked by the huge fall in bond prices, but they might also have been pleasantly surprised by how their US equities, for instance, are performing because of the current weakness of the pound. This is why your Ascot Lloyd Financial Adviser will always recommend a diversified, long-term financial plan which is built to withstand unforeseeable shocks in certain markets.
“These developments are of course important, and you should absolutely discuss them with your adviser, but in the grand scheme of a 25 or 30-year financial plan, we know there will always be peaks and troughs.” says Gavin Foster, Independent Financial Adviser at Ascot Lloyd. “With a long-term approach, we can always be reassured that the worst years in the market are inevitably followed by the best years in the market, one should remember that periods of economic expansion generally last longer than the short-term market shocks to the downside.’.
“Markets generally trundle along offering similar rates of return over a longer period of time. Every now and then, there's a spike to the upside or a spike to the downside, but it’s usually counterbalanced by the opposite in the next year or years. However much we plan for one objective or another, the fact is diversification is always beneficial, however bizarre the benefit might arrive. For the most part, that's why we say stick with it rather than changing the rules.”
If you would like to discuss how the policies announced in the ‘mini budget’, and the government’s new economic direction in general, will impact you and your financial plan, please get in touch with your Ascot Lloyd Financial Adviser who will be happy to help.