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Repentance and good deeds can win people’s hearts. But Kwasi Kwarteng’s U-turn on scrapping the 45% tax on top earners is not enough to restore Britain’s fiscal credibility. The measure made up less than 5% of the £45bn unfunded tax cut package in the “mini” Budget unveiled 10 days ago.
Moreover, the huge reversal proves a damaging argument about Liz Truss, Chancellor of the Exchequer and Prime Minister. That’s it: they lack intuitive judgments about the mood of the market or their own party.
Their initial unforced error led to a massive spike in gilt yields. This confusion is ominous. The market is on fire. Mild bad news can spark a massive sell-off, as the case for U.S. tech stocks bears out.
The UK bond market has been extremely volatile. But signs of stress are widespread. In the U.S., the Merrill Lynch Options Volatility Estimate (Move) index rose last Wednesday to its second-highest level since 2009. The index is derived from U.S. Treasury bond options and can reflect the volatility of the bond market, much like the Vix index reflects the volatility of the stock market.
Britain has made itself vulnerable to bond ‘vigilantes’. Kwarten put Britain’s reputation at risk by ignoring forecasts from the Office for Budget Responsibility, firing key Treasury officials and targeting growth at an incredible 2.5%.
But he is right to point out that the UK has a lower debt load than most G7 countries. Other countries are also swallowing the poison of high inflation, slowing growth and tightening monetary policy. For many, the soaring dollar has hampered efforts to fight inflation.
The war in Ukraine and tensions with China have added to the uncertainty.
This is dangerous territory for investors. But there are also opportunities. High volatility helps macro hedge funds around the world, which try to forecast movements in interest rates, currencies, stocks and commodities. The HFRI Macro index is up 9% this year.
Quality stocks with low debt and high dividend yields should be resilient. During periods of high inflation and rising bond yields, value stocks outperformed growth stocks, according to a UBS analysis of data going back to 1975.
The price of 30-year British government bonds has fallen by nearly a third in the past year. The FTSE 100 fell less than a tenth of the UK’s. This is not a normal pattern. There will be more unpleasant surprises as the market moves further into uncharted territory.