Soaring energy prices and an overheated jobs market make the UK a ‘petri dish’ for stagflation
But the biggest buyer will now become a seller. Threadneedle Street announced this month that it would begin unloading the bonds it had accumulated on the market. The selloff will mark a slow, predictable but significant policy shift at a time of extreme market volatility. The question is: who, if anyone, is willing to foot the bill?
Mark Capleton, a UK rates strategist at Bank of America, says there will be buyers, but only if the price is right.
He says pension fund demand is likely to be constrained after years of “de-risking” following the 2008 financial crisis. Capleton notes that pension funds now hold less than a quarter of equity assets, against more than 60% before the crisis.
“Companies have already come a long way on their risk reduction journey,” he says.
That leaves banks and foreign investors. The latter have been crucial in financing the UK’s gaping current account deficit, which, at more than 8% of gross domestic product (GDP), has been at its worst since comparable records began in the 18th century.
Current account deficits occur when more money leaves a country than comes in. The UK has traditionally lived beyond its means by spending more and saving less. This shortfall is made up for by what former Bank of England Governor Mark Carney described as “stranger friendliness”.
If these foreign investors lose confidence and withdraw their money, it could trigger a further decline in the value of the pound. The pound has already weakened significantly against the dollar this year as the US Federal Reserve has continued its aggressive rate hike policy. A survey of economists shows that no one expects the value of the pound to peak at $1.38 in 2021, until 2025.
UBS’s Rohan Khanna says the UK’s boiling job market and vulnerability to high energy prices have made it “a petri dish for the stagflation hypothesis” – a toxic combination of high inflation in a declining economy. This increases the “clearance price” of UK debt to attract investors.
He says: “With more fiscal stimulus, higher interest rates and the Bank of England selling bonds, for the average non-UK investor to be willing to buy gilts, they will have to drop enough to find that price. of balance.”
Cheaper bonds mean higher borrowing costs. If this is a permanent change, as Bank of America predicts, it will be more difficult for the UK to contain rising prices.
“Normal policy rates tended to be much higher in the UK than in the US or the eurozone before the global financial crisis,” Capleton says. “Inflation did well, but the Bank had to wave a big stick to control it.”
But not everyone is worried about Britain’s attractiveness to outside investors. Robin Brooks, chief economist at the Institute of International Finance in Washington, said investors exhausted from tying up their money in Russia are now looking for a safer bet.
“I talk to a lot of investment managers who lost a lot of money in Russia. So now people are really nervous about countries with autocratic regimes. We’ve seen major outflows from China, and the democratic checks and balances are looked at in a new light. It puts democracies like the UK on a much better footing. No matter how colorful the politics are, it’s always better than the alternative”.