Transcription
It's been another bad week for the UK economy, with UK bond yields once again rising to the highest level for 30 years. Not only that, but the pound has had a bumpy ride, and a falling pound and higher bond yields are a toxic combination. Just ask Liz Truss.
And all this comes on the back of several years of very low economic growth and growing concern over a doom loop of rising debt, higher tax, and lower economic growth. If you wanted to paint a picture of a UK economy on the brink of collapse, you could easily point to the widespread pessimism and grim economic data. But is the UK really facing an economic meltdown? Or is it just a self-reinforcing cycle of bad news and persistent panic about the next tax rise, fiscal black hole, and government U-turn?
Well, whatever the long-term forecast, there's no doubt that this rise in bond yields is a major headache. It makes borrowing much more expensive. And the UK, of course, is doing a lot more of that borrowing because as debt rises and bond yields continue to go up, interest payments will only continue to rise. When you spend a higher share of GDP on debt interest payments, you need to raise taxes just to meet the debt interest payments. And we will see that there are several factors which are likely to push up yields even further in the long term.
The problem is though that markets have been pretty negative about the UK ever since the Liz Truss mini-budget of 2022. The unfunded tax cuts and market reaction caused bond yields to rise above comparable countries. But the problem is that even after the removal of Liz Truss and reversal of her policies, there was little improvement in market sentiment. It means that any bad news in the UK is pounced on by the markets as a warning sign. Despite Germany's own fiscal problems, the gap between UK and German bond yields has risen in the past few years. The UK now has one of the highest borrowing costs amongst advanced countries.
So what is it that markets dislike so much about the UK economy? Well, firstly, the long-term debt situation of the economy is pretty grim. The OBR forecasts rising debt as a share of GDP. Now, to prevent this kind of surge in debt requires quite severe spending cuts, serious tax rises, or a miracle in terms of higher economic growth. And markets are not impressed by recent performance: very limited efforts to constrain spending followed by U-turns and a sense of no real direction. In an age of populism, no political party is really in the mood to point out some of the unwelcome choices facing the UK economy. So, higher bond yields do partly reflect the dismal outlook for finances and also the likelihood that with low growth and political constraints, the outlook will probably deteriorate in the coming years.
However, it would be a mistake to say the UK is at risk of default, at least at the moment. This shows the credit default swap rate for government debt. A higher figure indicates markets think government default is more likely. So Turkey and South Africa are in trouble. But the UK has one of the lowest credit default swap rates in the world. And there's no problem at the moment selling UK gilts; it's just very expensive.
Now, in the short term, higher bond yields really reflect the fact that the UK stands out as being an outlier in terms of inflation. At 3.8%, it's roughly double that of Germany and the Euro area. And this high inflation does not represent a booming economy. Far from it. More like stagnation with an uptick in unemployment, giving us the worst of both worlds.
Now, at this point, you could well ask, why worry about UK debt of 100% of GDP when we've had debt of over 240% in the past? It's hardly a sign of imminent collapse when we've survived much worse in the past. And whilst this is always worth bearing in mind for some context, I think it's fair to say there are many important differences to that golden age of the post-war period. Debt fell in that period, of course, because of strong economic growth. But with an aging population, low confidence, numerous shocks, falling labor participation rates, a lot of regulation, many of the problems per capita growth has largely eluded the UK in recent years. And the result has been a rise in spending on pensions, healthcare, and benefits. But tax revenues are stagnant. The outlook, according to the OBR, is pretty grim.
Now, to plug the shortfall, the government is raising taxes, which have the effect of holding back growth and also sometimes increase inflation and create this new cycle of higher borrowing, which can push up bond yields even more. It is an unwelcome cycle to be in.
Now, the fall in the pound this week is particularly concerning because the UK is becoming increasingly reliant on foreign buyers of UK gilts. A big factor in the rising bond yields is the fact that UK pension funds are reducing their exposure to UK gilts. In the past, pension funds committed to largely defined payouts, making gilts attractive. The pension funds are largely switching to contribution-based pensions, which prefer higher risk equities. And the result is a big drop-off in demand for long-term gilts from the UK pension industry, which used to be the biggest buyer of UK bonds. And this is forecast to continue to decline in the decades to come. And what it means is the UK will rely more and more on overseas buyers.
But relying on overseas buyers to fund your debt has two big drawbacks. Firstly, government debt around the world is rising. Bond yields are rising everywhere, even in past safe havens like the United States and Japan. So, there will be a lot of competition to attract foreign buyers. And this means the UK will need higher bond yields in the future to attract enough foreign buyers. And the second problem of relying on foreign buyers is that the value of the pound becomes much more influential for the state of the economy. For example, if the pound were to crash, overseas buyers will sell UK bonds, potentially creating some kind of sovereign debt crisis, as you can't finance the debt from your domestic buyers.
Now, if you look at what a real economic crisis looks like, it's usually a combination of high debt and a falling currency. But is that a toxic combination? Now, it is true that this week the pound had a bad day. But it's always worth zooming out from one bad day, and you can see actually that the pound has actually strengthened this year. So why would the pound rise when the economy is supposedly doing very badly? Well, ironically, because inflation is high, interest rates are much higher than elsewhere in the world, more than double ECB rates. And this makes saving in the UK relatively more attractive, at least in the short term. So you could argue that the pound's strength is misleading, mainly relying on higher inflation and higher interest rates.
So the big question is, what does the future hold for the pound? Should you be setting up and putting your money in gold or other currencies? Firstly, relatively high inflation is really bad news, as it will make the UK less competitive. It's not just one-off shocks. The UK is seeing things like rising electricity prices to be the most expensive in Europe, hurting manufacturing in particular. Now, evidence of poor competitiveness is also evident in the UK's current account deficit. This means that we import more than we're exporting of goods and services. And this current account deficit is wider than most major competitors, except the US. And this current account deficit means that we require capital inflows to finance it. You know, we're buying more imports; we need money coming back in somehow. But the big question is, will the UK be able to continue to attract sufficient capital inflows? Because of low economic growth, low business investment, and things like higher stamp duty and housing, the UK is not particularly attractive for foreign investors at the moment. Using the Big Mac index, the pound is around 13.5% overvalued compared to the US dollar. But the major long-term fear for the pound is more about whether the UK economy can recover from its current state of relatively high inflation, economic stagnation, and rising debt.
Now, if you predict the imminent collapse of the pound, you might well ask, well, who is the pound going to collapse against? On some metrics, the UK isn't an outlier. Debt is higher in several European countries like France and Italy. The French government is once again teetering over how to reduce its debt. The US government's unorthodox embrace of tariffs and attacking Fed independence. Is it causing the dollar to fall from favor? The US has seen the biggest slowdown in economic growth this year and has a much higher budget deficit than the UK. The Eurozone may have low inflation, but with growth similar to the UK, it's hardly doing well. The point is, the problems of the UK in terms of low growth, aging population, rising debt are not unique. Many advanced countries are facing very similar problems.
Also, if you wanted to paint a more optimistic picture of a UK economy, you could point to some factors. Firstly, this exceptional high inflation is partly a result of rising utility bills, high tax, which should, in theory, be one-off factors. With low economic growth and a weakening labor market, inflation should fall in autumn quite sharply. Although a cynic may well say the Bank of England have been forecasting this fall in inflation for quite a long time. Other positive factors include some signs of economic growth, even if pretty weak. The UK equity market is severely undervalued compared to at least the United States and has actually received a boost in capital inflows from the US this year. Certainly, if you're looking for a bargain, Britain is relatively cheap these days. Although that's a ringing endorsement or not, I don't know.
Also, there are some factors that could help ameliorate the current situation. Moving to one forecast per year rather than two would reduce some of the damaging speculation about constant tax rises and fiscal black holes. The Bank of England has been one of the most aggressive central banks in selling bonds accumulated during QE. They could halt or at least slow down the process of quantitative tightening to give a bit more breathing space. Also, better coordination of fiscal and monetary policy to perhaps avoid tax-induced inflation.
However, having said that, I wouldn't be too quick to dismiss the more doomster forecasts because the deterioration over the past two decades has made the UK much more vulnerable to a global economic shock. And I would argue a new video is coming soon, but markets haven't really reflected or priced in the big changes we are seeing in the US economy and the future of the dollar. The likelihood of a US recession has now increased to 93%. And should the US pull the rest of the world into an economic slowdown, it would really magnify all the current pressures on the UK economy. And the past 10 years do show that black swan events seem to be becoming really quite common these days.
And also, it's more than just economic data. The past 20 years have seen real cracks in British institutions and British policy and a general feeling of malaise, which is quite strong, at least on YouTube anyway. But and there are some justifications for this. You've got a rising waiting list, potholes in the roads, railways incredibly expensive to build, and just a sense that things aren't working. We're not keeping up with the energy demand and prices rising as a result. And it does seem to some extent that the cumbersome state of the UK government is struggling to address these new issues. So managed decline could increasingly spiral in the wrong direction. So even if there is no imminent crisis on the horizon, the relative decline of the economy is a real cause for concern, and quite easily some black swan event or global slowdown could magnify all the pressures holding back the UK economy.
Well, I hope that's not too negative. Some crumbs of comfort there, but it's going to be a tough few years and a tough budget coming up. So, we'll have lots of videos coming on that pretty soon, what to expect, and what Rachel Reeves should be doing. So, let me know your comments and thoughts, and I'm glad to be back after a nice holiday abroad in America. Cheers.