The so called mini budget announcement on Friday was largely as expected, given comments made during the leadership election and briefs given in the run up to the event. The main surprise was the removal of the higher rate band, an effective 5% income tax cut for the highest earners, as well as the forward guidance that there were more to come. With spending promises maintained, the government is hoping to fund the tax cuts announced through higher rates of growth.
The market reaction to the announcement was aggressive, with the Pound, government bonds and broader UK assets selling off. Early Monday morning, the Sterling traded at its lowest ever level against the US dollar. While traders are pointing to concern about fiscal responsibility, the movements seen appear extreme given the context. The UK has the second lowest debt to GDP in the G7 (5 out of 7 have debt to GDP ratios of over 100%) and large deficit spending was already on the cards with the open ended energy price cap subsidy. The additional “surprise” tax cuts are minimal against the well-publicized intentions to reverse National Insurance and corporation tax increases. The basic rate income tax cut was only brought forward by one year and is well covered by fiscal drag, where taxpayers are dragged into higher tax bands as a result of inflation.
The falling pound has the potential to cause short term concern as it can exacerbate inflation and could cause the Bank of England to become more aggressive in its fight against rising prices. However, the pound is not like an emerging market currency, as media commentators may like to reference. The UK has an accumulated overseas investment position, broadly offsetting the foreign investment into the country. Liabilities are owed in Pounds and assets are in foreign currency. Any depreciation in the currency improves the net position and buyers will eventually step in, either through domestic investors selling overseas assets and repatriating proceeds or foreign investors buying cheaper UK assets. In 2020, the UK had overseas assets and liabilities of around £13tn, approximately 400% of GDP.
The market reaction towards the UK appears overdone. The pound and many domestic assets are now ripe for acquisition from foreign investors willing to look through the short term noise. Ultimately, if the government can produce the growth promised, the direction of policy should be favourable to markets, which would make it an outlier among large economies.