RICARDO SMITH: The UK is eating cake on the treadmill

A controversial move by now former British prime minister Liz Truss’s cabinet, which tabled a “mini-budget” proposing fiscal support measures that included increased government spending and aggressive tax cuts to support the UK economy, resulted in markedly negative reactions from the market with a sharp negative spike in the pound. Truss, who has since resigned after just 44 days in office, doubled down on the mini-budget, reversed the proposed tax cuts and recalled her finance minister after less than 100 days in office. While this certainly does not compare to the Nenegate saga locally where we had three different finance ministers in a week, it is certainly unprecedented.

Given the historical nature of Kwasi Kwarteng’s appointment as the first black finance minister in the UK, questions have lingered on why markets reacted so negatively. Various individuals in history, including former US president Donald Trump, have aggressively attacked their reserve banks and cut taxes. Notwithstanding the tone-deaf comments by of the international commentators, even dubbing the proposed fiscal policy as being “third world” in nature, there are differences between the circumstances.

First, inflation is in double digits in the UK, and reserve banks across the globe certainly seem more afraid of inflation than they are of markets. The dichotomy proposed between accommodative fiscal policy and tightening monetary policy threaten to work against each other. Accommodative fiscal policy would add further tailwinds to inflation, which would require even more aggressive tightening by the Bank of England. Tightening monetary policy and raising interest rates increases the cost of servicing debt, which would put further strain on the government’s budget, particularly if it is going to run a fiscal deficit by cutting taxes and increasing spending. This is further compounded by the fact that we are coming out of a pandemic, where most governments’ fiscal standing is yet to recover from the coronavirus-induced economic recession and the support measures that were implemented in response.

However, the recalling of Kwarteng by Truss certainly left more questions than answers, which was already a sign of the wheels falling off, not to mention the recent resignation of her home secretary Suella Braverman, which spoke to more systematic issues.

We have seen this policy dichotomy before in Europe when the European Central Bank was looking to tighten monetary policy, while the governments within the eurozone were implementing expansionary fiscal policy. This led to the euro debt crisis with countries such as Portugal, Italy, Ireland, Greece and Spain (dubbed the PIIGS) requiring external intervention and bailouts when their governments and economies were on the verge of collapse. One would certainly hope that this type of policy setting does not catch on to other economies in the region.

Meanwhile, in the US, just as we reached close to the previous projected peak, interest rate expectations were revised further up by the US Fed. Markets reacted negatively to this, wiping out the positive rallies we saw from the positive surprises in second-quarter earnings. There are certainly signs that inflation is near the peak, in particular moderately decreasing inflation prints, negative month-on-month commodity and energy price inflation and significantly lower annualised month-on-month inflation.

However, this cooling of inflation is happening at a slower pace than desired by markets. A particular issue is around second round effects. As the initial shock came from supply-side disruptions, a second wave is coming from the broader economy pricing in higher inflation in their profit margins and revising their prices upward. This is what the US Fed is obsessed about containing, and not necessarily energy prices themselves.

From an outlook perspective, even with the recent upward revisions in interest rate expectations by the US Fed, it would certainly appear that we are still closer to the top of the rate hiking cycle than the bottom. Of particular concern, much like Truss’s government, Jerome Powell’s US Fed seems to be losing credibility, albeit for different reasons. These credibility issues are around inflation forecasts, reaction time and interest rate expectations.

However, a couple of positives on the US relative to the UK are that the US does not appear to be eating cake on the treadmill, and there is alignment between monetary and fiscal policy. They have taken the approach of pain now, for gains later. The US Fed is not cutting rates any time soon, at least until inflation is within target. Furthermore, the US Fed’s reaction, albeit late to the party, was aggressive — putting them significantly ahead of the herd with respect to the rate hiking cycle.

Meanwhile, most of the healthcare counters within our portfolios have continued to do well with Johnson & Johnson most recently positively surprising markets with their third quarter earnings release — and has held up well during this volatile period. Nike on the other hand, disappointed markets with their recent earnings release but mostly due to factors external to the business — including high inventory levels caused in part by an unpredictable supply-side lag time, which we expect to improve as the economy normalises.

• Smith is chief investment officer at Absa Stockbrokers & Portfolio Management (acting), and at Absa Global Investment Solutions.