UK assets still carry Mini Budget risk premium

The UK Mini Budget was the defining event of former prime minister Liz Truss and former chancellor of the exchequer Kwasi Kwarteng’s tenures, a set of policies which plunged the UK into daily doses of market volatility as markets reacted following 23 September 2022.

On the back of Truss’ fiscal event, sterling crashed to an all-time low against the US dollar, and gilt yields suffered their highest daily rises in decades, creating a liquidity crisis within pension funds that forced the Bank of England to step in with a billion-pound emergency bond buying programme.

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Almost a year to the day, the UK is still dealing with the consequences of the event, as Robert Alster, CIO at Close Brothers Asset Management, noted. 

The CIO argued that even though sentiment towards the UK has improved in the intervening period, there will continue to be a UK risk premium attached to bond yields “until the market is convinced of the UK’s financial prudence when it comes to possible tax cuts”.

Nicholas Hyett, investment manager at Wealth Club, said yields on UK government bonds relative to US and European government debt “spiked immediately” after the Mini Budget and have continued to rise as the Bank of England raised interest rates.

In June this year, gilt yields soared past Mini Budget levels, with two-year gilts rising 0.38 percentage points to 4.85%, past the 4.64% peak last seen in the aftermath on 27 September. While two-year gilts have reduced to around 4.5% today, they almost topped 5.5% over the summer.

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UK equities have also suffered, as Chris McVey, manager of the Octopus Multi Cap Income fund, noted, suggesting valuations were “at levels not seen since the Global Financial Crisis”.

Part of this UK discount has been priced in long before Truss took office, largely due to the first bout of political and social uncertainties introduced via the Brexit vote.

“The UK is undoubtedly challenged economically and politically with sentiment remaining in the doldrums,” said James Penny, CIO at TAM Asset Management.

“Yes, inflation and rates have a part to play as they do across the world, but Brexit has unfortunately exacerbated some of the UK headwinds to make the economy a standout laggard on the global stage – not to mention a poster child of what not to do for other EU nations thinking about ex-EU sovereignty.”

But the severity of the selloff during the fallout from the Mini Budget “gave domestic and international investors another reason to sell the UK,” according to Neil Birrell, CIO at Premier Miton Investors, although he argued the UK discount presented an attractive buying opportunity for investors.

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Heavy market discounts have also been compounded by “corporation rules acting as a barrier to grass roots innovation in the UK stock market”, the TAM CIO added, arguing the exodus of major UK firms to other indices was “a humiliating blow to the UK and sadly gilds the structural issues which exist”.

Volatility in the UK’s domestically focused indices has fallen throughout the year. The average valuations for those UK exposed businesses has dropped down from around 14x earnings in the 12 months before the Mini Budget, to 11.7x in the 12 months since.

This represents a 16.4% decline, similar to where they were before the Mini Budget in summer of 2022, according to data from Wealth Club.

Negative ratings

At the time of the event, various ratings agencies downgraded their UK risk ratings, many of which remain in place.

Moody’s downgraded the outlook for the UK Government and the Bank of England from ‘Stable’ to ‘Negative’ a month after the event, a move Fitch Ratings mirrored when it demoted UK government debt rating, alongside S&P Global. All three ‘Negative’ ratings remain in place at the time of publication.

Wealth Club’s Hyett said the persistent relegations suggest “some nervousness remains, and you can see that in various market measures of risk”.

He said: “Overall, it seems that while the risk premium investors demand for holding UK assets has increased, and investors have not forgotten the Mini Budget; it has not been a dramatic change.”

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At the time of the event, US Treasury secretary Larry Summers said the UK was “behaving a bit like an emerging market, turning itself into a submerging market”, a comment which split experts’ opinions.

Hyett described the statement as “hyperbole”, whereas Penny said he both agreed and understood  Summers’ point. However, he did not believe this should define the UK going forward.

“The UK has a respectable track record economically but it is in need of fresh stimulus and innovation to help boost the domestic opportunities,” he said.

“Necessity is the mother of invention and the UK’s evident need of reinvigoration should prompt a more meaningful step towards more growth focussed government policies regardless of which party is in charge.”

Vivek Paul, UK chief investment strategist at BlackRock Investment Institute, said the country’s financial credibility stems from the unified strength of its institutions “which has been tested” in the past twelve months, but said they have “ultimately prevailed”.

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“The intervention of the independent Bank of England calmed UK markets and the UK’s broader parliamentary system exerted its influence,” he added.

The BlackRock strategist argued global financial organisations had been challenged by inflation and rapidly rising rates, which “posed financial cracks – in the US, think of the issues faced by regional banks in the spring, and in the UK, think of the gilt market disruption of 12 months ago”.

“The underlying picture globally has therefore been one of heightened volatility across fixed income assets in particular. However, UK-specific risk was undoubtedly heightened at the time of the Mini Budget and the market questioned the UK’s fiscal credibility,” he said.

This backdrop of uncertainty was especially relevant as the UK heads into its next election cycle and, relative to the run up to the last general election, which saw Boris Johnson take up residence in Number 10, “the perceived risk around UK assets now is diminished, but it has not evaporated”, Paul said.

He noted both current Prime Minster Rishi Sunak and leader of the opposition Keir Starmer were making “comparatively modest” fiscal promises, which he found “telling”.

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Robert Burrows, macro fixed income manager at M&G Investments and member of the ‘Bond Vigilantes’, said the fallout from Truss-Kwarteng’s policies had “sent a strong message from the markets to politicians”.

He said this ultimately limited “any future government in terms of fiscal spending, along with the need to demonstrate fiscal prudence”.

His colleague, Miles Tym, seconded this, adding that even though gilt markets have been calmer in recent months, “governments have been reminded in no uncertain terms of the need for a credible fiscal policy”.

“Markets have long memories,” Paul said. “On a longer-term horizon, we think international investors are likely to perceive UK assets as riskier than they were ten to 15 years ago.”


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