British Pound Rebounds As UK Government U-Turns On Tax Cuts

Key Takeaways

  • New British Chancellor Jeremy Hunt has wound back almost all of the wide ranging tax cuts that were announced by new Prime Minister Liz Truss on 23rd September
  • The British Pound and UK bonds have rallied on the news, which has caused significant problems for the government in recent weeks
  • The situation in the UK and Europe is super messy right now, and the US is looking remarkably stable in comparison
  • This differential has created a unique opportunity for investors to profit from US outperformance

In an environment that often seems to go from emergency to crisis then back to emergency again, it’s somewhat comforting to know that the United States isn’t the only country with issues. Right now, things in the US are looking remarkably stable compared to what’s going on in Europe and the UK.

Over the past couple of weeks the UK has been in complete economic turmoil, with new Prime Minister Liz Truss releasing a series of tax cuts and spending plans that shocked the markets.

The plans were seen as fiscally irresponsible and caused British bond prices to plummet. Pension funds which rely heavily on bond prices to pay out to their members scrambled to meet margin calls, and the UK’s central bank, the Bank of England, had to step in to provide emergency support to the market.

One of the major issues with the policies announced by Conserative party leader Liz Truss were that they provided significant tax cuts to the most well off. This included removing the top income tax bracket altogether and canceling a planned increase in Corporations Tax.

This week even saw President Biden weigh in on the situation, stating that “I wasn’t the only one who thought it was a mistake. I think that the idea of cutting taxes on the super-wealthy at a time when…I disagree with the policy, but it’s up to Britain to make that judgment, not me.”

The situation has become messy and is likely to continue for some time, with new Chancellor Jeremy Hunt expected to announce today further U-turns on many of the planned tax cuts.

For investors, turmoil in overseas markets can provide opportunity, as long as you have the right plan. Luckily, we’ve got one to share with you.

First, let’s look at how the UK got here and how this has impacted the market.

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Liz Truss economic plan for growth

The political system in the UK is different from the US, in that voters don’t directly elect their country’s leader. Instead, they vote for their local representative and the party with the majority in the lower house – the House of Commons – is invited to form a government.

The party members themselves are the ones who officially appoint a leader, which is why it is possible to replace the leader of the party without the need for a general election.

Previous Prime Minister Boris Johnson was forced to resign in July, with the subsequent leadership election whittled down to Liz Truss and previous Chancellor Rishi Sunak. The platforms they ran on for leadership were very different.

Truss focused on a ‘plan for growth’ which was essentially a classic case of trickle down economics. A plan which would see taxes cut and spending increased in an aim to ‘kick start’ the economy.

Sunak made it clear that he believed these policies to be irresponsible and felt that the global financial markets would not respond kindly. His platform by contrast was one that would focus on fiscal responsibility, reducing spending and raising taxes in an effort to put the country back on stronger financial footing.

Liz Truss would win the leadership race, but it turns out Sunak may have been on to something.

On September 23rd Liz Truss released her financial plan for the country, and the pound went into freefall. As Sunak had predicted, the plans to reduce income tax for wealthy households, remove planned increases for company tax and withdrawal of a recent increase in national insurance to pay for pensions and health and social care were not well received.

Markets react harshly to perceived financial irresponsibility

With many pension funds relying on stable bond markets to pay benefits to retirees, they were in danger of defaulting and the Bank of England had to step in to stabilize the bond market.

Not a good look for a new Prime Minister in her first weeks on the job.

The British Pound dropped 5% in a single day after the announcement, in a level of movement usually reserved for emerging markets. It fell a further 2% the day after, taking the pound to its lowest level in 37 years.

It came startlingly close to parity with the US Dollar, hitting $1.03 at one point before rebounded slightly the next day.

The Bank of England’s intervention managed to calm markets somewhat, but it’s hardly been smooth sailing since then.

Fallout grows as Chancellor Kwasi Kwarteng is sacked

When there’s a major mistake in politics, there needs to be a scapegoat. In order for a party to live to fight another day, someone needs to take the blame for a poor policy or poor decision making.

In this case, that person is Liz Truss’ Chancellor of the Exchequer Kwasi Kwarteng.

The role of Chancellor doesn’t have an exact counterpart in the US political system. In the UK it is considered the second most senior role in Government after the Prime Minister themselves and is responsible for setting the country’s budget, including tax policy and spending plans.

While it is officially the Chancellor’s role to set this policy, it is done with the Prime Minister’s overall plan for the country in mind.

That is, of course, until that policy crashes the UK’s economy.

Truss was quick to offer up Kwarteng to take the fall for the poor reaction, and he was forced to resign after just 38 days on the job. This made him the shortest serving post-war Chancellor in the UK after Iain Macleod in 1970, who died 30 days after taking the role.

The U-turns continue

Over the past few weeks, many of the policy announcements from that September 23rd speech have been wound back in an attempt to further calm the markets.

Today, in his first full day as the new Chancellor, Kwarteng’s replacement Jeremy Hunt has announced that almost all of the initial tax cuts and spending plans will be reversed.

In an embarrassing climb down, Hunt stated that “We will reverse almost all the tax measures that were in the growth plan. At a time when markets are rightly demanding a commitment to sustainable finances it is not right to borrow to fund this.”

UK bond prices rallied hard on the news, as did the British Pound which now hovers around $1.13.

How investors can profit from US outperformance

If all of this seems messy and complicated, it’s because it is. It’s not just limited to the UK either. Many countries throughout Europe in particular are experience significant turmoil and economic challenges.

Energy prices have been of the greatest areas of concern, with both businesses and households straining under the pressure of rapidly rising prices and an impending winter.

Overall the economies are generally not growing well with a recession either already happening or looking every more likely. And yet, the stock markets in many of these countries have held up better than the US.

Take the UK as an example. So far this year, the flagship FTSE 100 Index is down -7.93% at the time of writing, which is significantly less than the S&P 500 which is down 25.30% over the same time period.

Even looking beyond Europe, the Japanese Nikkei 225 is also faring much better and is down just 8.62% so far this year.

With the US economy looking relatively strong compared to many of these countries, this appears to be a mismatch in price and valuations. So we’ve created an Investment Kit to take advantage of this mispricing.

We believe the US market has been unfairly beaten down. It’s not without its challenges, but overall things aren’t looking too bad compared to many other parts of the world.

With that said, there are still plenty of headwinds that could cause the markets to continue to experience volatility. In order to combat this, we’ve created a sophisticated pair trade which goes long on the US stock market while also taking a short position in the rest of the world.

The US Outperformance Kit invests in the iShares Russell 1000 ETF, which holds the 1,000 biggest companies in the US market. At the same time we invest in an inverse ETF, the ProShares Short MSCI EAFE which is made up of predominantly Western European markets plus Japan, Hong Kong and Australia.

What this means is that investors can profit off the relative performance of the US to the rest of the world. So even if the overall market goes down or sideways, you can generate returns as long as the US holds up better.

It’s automatically rebalanced every week and when we believe the opportunity has gone, we’ll automatically close out the position for you.

It’s the kind of big thinking trade that’s usually reserved for super-rich hedge fund clients, but we make it available for everyone.

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Source: https://www.forbes.com/sites/qai/2022/10/17/british-pound-rebounds-as-uk-government-u-turns-on-tax-cuts/