The UK risks losing its status as a sound financially sovereign nation

Blain’s Morning Porridge, August 31st 2022 – The UK risks losing its status as a sound financially sovereign nation

“The miserable have no other medicine, but only hope”

This morning – The UK is at risk of breaking its “Virtuous Sovereign Trinity” of stable politics, currency and bond markets. Collapsing confidence in politics to stem the slide in sterling and thus Gilts, could see the UK stumble into a crippling Sovereign Financial crisis sooner than we think possible.

It’s the very last day of Summer – Autumn starts tomorrow! Traditionally, the week following the US holiday is the start of the critical Q3 funding season – the busiest time in the Investment Banking calendar. Every bank should be prepping IPOs, Capital Raises, M&A financing, and bond deals to launch into the September markets. Bankers are keen to rise up the league tables and lock in their big bonuses. Investors are back at their desks – looking to make good on the last few months of the year….   It’s a feeding frenzy, and a time to slip out a few deals nobody will notice into the feeding frenzy mayhem….

At least that’s how it used to be.

This year there is uncertainty piled upon instability built on a foundation of contradictions.

Rising rates, soaring inflation, crashing real discretionary spending, upwards of 20% of all corporates effectively “Zombies” as rates and costs crush them. And some folk still think stocks look good value…?

Selectively some are. There are things we need – like water, power, transport, foodstuffs. There are things we don’t – like new stuff, expensive holidays, meals out, and especially new tech. When consumers have zero discretionary spending power – there will be massive corporate pain leading to redundancies and a growing jobs queue. The Occident will become something like a siege economy.

Some stocks will be less bad than other stocks – but folk need to be very selective to make a good argument inflation-hedged stocks offer the best strong and stable returns in an inflationary/stagflationary environment.

Of course, when the going gets tough, the tough get … nervous about capital preservation.

Which is why Sovereign Bond Markets are the great bastion of security, and the flight to safety trade in times of financial peril… Sure, bonds may have negative real yields, but at least you get your money back, and unlike cash you get a bit of interest to partly compensate inflation. Yep, bonds are great for capital preservation and will enable you to sleep sound at night..

Right up to the moment they don’t..

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Whoa – Time-out for a second:  While writing the Porridge each morning I try to be completely objective – although I do like to say things as I see them, spicing up the facts with some opinions. There is no compliance officer editing my comments to make sure I’m balanced, fair-handed, or to ensure I don’t make ridiculous promises about the performance of investment.

But there are some mornings when I do find myself wondering: “If this is so obvious to me… why doesn’t everyone else see it as well? This is one of these mornings. Let me continue….

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Maybe inflation will continue to spiral out of control. That, of course, is bad news for bonds. If you buy a 5 year £100 Government bond today, and inflation remains 10% for the next five years, you will still get £100 back at maturity, but that £100 will only buy £60 worth of goods at today’s prices. Ouch. But it may still be better than a stock that goes bankrupt.

But then there are times when even Sovereigns get into trouble – and you need to factor in a host of additional risks and factors. What makes a good Sovereign go bad? Why can Japan bumble along quite happily with debt equivalent to a 3.5x multiple of GDP, while the market thinks Italy is defacto broke at 1.5x? Why is Argentina perennially broke?

What are the triggers for a sovereign debt crisis?

A number of years ago I came up with a very simple way to describe how the forces on Soveriegn Debt confidence function.

Sovereign Debt is all about confidence. I called it the Virtuous Sovereign Trinity: how the legs are the political economy, currency and debt. As long as a nation is politically stable and commercially effective, its currency is sound, and its debt market is open and stable, then it’s a tick in terms of its sovereign credit.

A sound financially Sovereign Nation will never go broke. It will always be able repay its debt. In times of crisis it will be able to borrow to cover emergency spending. It can always set the printing presses into money creation mode to repay debt. It will be able to maintain its currency by demonstrating its commercial and political stability.

However, a nation where confidence in its political system to maintain a stable and effective platform for commerce has collapsed, or where debt is spiralling out of control, and a crashing currency has triggered successive waves of inflation… then… crisis writ large and chaos.

You know where this is going…….

Yesterday, candidate for the next Prime Minister of this sceptred Isle – but certain loser – Rishi Sunak highlighted the risks the UK breaks the Virtuous Sovereign Trinity, how markets could lose confidence in the UK economy, and that gilts could become increasingly difficult to fund. Ouch.

According to the FT (Rishi Sunak warns of risk that markets lose faith in UK economy), he was speaking to a gathering of some of the 160,000 older, rich, white men choosing our next PM. He raged against the winner, next Prime Minister, Liz Truss, that it would be “complacent and irresponsible not to be thinking about the risks to the public finances”.

The most telling comment in the FT article was: “During the Q&A, not a single Tory member mentioned the cost of living crisis — the nearest was a query on better insulation of homes. The biggest applause came for Sunak’s stance on cultural issues: “I want to take on this leftie woke culture that wants to cancel our values, our culture and our women.”

The FT also commented: “Some have said the Tory leadership contest is taking place in a parallel world to that inhabited by many voters, and on Tuesday party members turned up in Bentleys and Porsches to hear Sunak’s pitch.”

The UK has long prided itself on stable politics. That appears to be breaking down – and it  changes global perspectives on UK investment opportunities.

Its curious to think of how Sunak – who got the job as Chancellor when his then boss, Sajid Javid refused to allow Boris and his then sidekick Dominic Cummings to take over his role and sack his advisors – is becoming the voice of Tory reasonableness. No doubt he will continue to do so from the back benches, although most pundits think he’ll be off to the USA. Sunak warned against taking away the Bank of England’s independence, and that the Conservative Party “risked its reputation” for fiscal discipline.

I nearly choked at that one…

What “reputation”?

Let’s face it.. since David Cameron took office as Prime Minister on May 11, 2010, the UK hasn’t had its best decade. Cameron had the great advantage of being able to blame his coalition partners – the Liberals – for all the mistakes in his first government, before winning a proper majority on the basis he’d promised a Brexit referendum. He never considered, even remotely, the likelihood he might lose – and walked off in a huff when he did in 2016. He was followed by the not very strong or stable Theresa May, and then by Boris – which ended in farce and acrimony. And now Truss.

Brexit and the enforcement of Brexit purity has dominated every action and thought of government. It has morphed into a cancer eating into the UK’s ability to maintain confidence in our Virtuous Sovereign Trinity. Since Brexit, Sterling has lost about 16% of its value against the Euro.

In the meantime, the UK’s institutions of state; education, health, defence, transport infrastructure, energy security, even water – (FFS – we are nation where you know it’s going to rain because it’s not raining yet..). Nothing… absolutely nothing works.

Yet, the Tories may still get lucky..

Aside from the wealthy Tory members (all 160k of them who choose our next PM), the remaining 62 million UK citizens have much more on their minds than who wins the Tory election jolly. We live in the real world. We are looking at whole cataclysm of pain, including:

• A crippling cost of living crisis impacting across society
• Goldman Sachs warning of 22% inflation
• 70% of pubs closing
• High streets being denuded by failing shops
• Food banks and Clothing handouts for the kids
• Soaring energy and food bills
• Liz Truss promising to cut taxes – which doesn’t help when you just lost your job and face the bureaucratic nightmare of trying to claim benefits
• Financial Penury
• Our kids futures being crushed.
• Etc, etc, etc…

I am trustee of a major health charity. We are seeing massive increases in clients suffering depression, mental health issue and in fear from their collapsing finances. These fears are demonstrably making their health worse. The same is true across the whole of society.

What’s the solution? Sound government by grown-ups would stand a good chance of creating the stability and confidence the UK needs to borrow its way out of the looming crisis. Picking a jury that hasn’t already decided Liz Truss will just be No 4 in line of Tory failures will be a problem. The UK needs a clean start. It’s probably time for an election – although I have limited confidence Labour can do much better.

(Disclosure – I voted for Brexit and I voted Tory in 2019. Definitionally these two crimes again humanity qualify me as an idiot.)

Five Things to Read This Morning

Garuniad – Russia switches off gas pipeline citing maintenance

WSJ – Inflation Bets Recede After Powell Speech

BBerg – Inflation in UK Shops Climbs to Highest Rate on Record

FT – UK trade ministers says anxieties over Australia and New Zealand deals misplaced

Torygraph – Pound sinks to two-year low as “deep, dark recession” looms.

Out of time, and back to the day job…

Bill Blain

Strategist – Shard Capital