The pound’s performance over the past week is reminiscent of Black Wednesday, the 16th September 1992 when the UK government was forced to withdraw sterling from the Exchange Rate mechanism. Less than a month in the job, the new government’s Chancellor of the Exchequer Kwasi Kwarteng has delivered a shock and awe budget, comprising massive tax cuts on top of the already substantial energy price subsidy. Following the budget, the pound tumbled against the US dollar by 3.7% last Friday and at its worst point by another 4.8% on Monday. Financial markets are dismayed by the cost to the Treasury. The energy subsidy alone is expected to cost £60 billion and the tax cuts another £103 billion over four years. This comes almost immediately after the unprecedented Covid rescue programme.

The pound’s weakness is partly a US dollar story. The US currency, backed by energy self-sufficiency, the Federal Reserve’s tightening monetary policy and shrinking global dollar liquidity, has been beating all currencies over the past year, but the pound’s weakness stands out. Blame is directed at the government’s economic policy. The newly announced tax cuts amount to 2% of GDP and another £72 billion of government debt. Government debt is already at 100% of GDP a far cry from the 40% debt ratio when the Thatcher government launched a similar growth budget 40 years ago.

The budget tore up all rules and conventions. Perhaps most alarming is that the Office for Budget Responsibility, which traditionally provides independent oversight of fiscal decisions, was completely side-lined. In fact, the budget provided no forecasts on public finances. The Institute for Fiscal Studies called the budget the “biggest tax cutting event since 1972”, which risked putting UK debt on an unsustainable path. Former US Treasury Secretary Larry Summers said, “Britain will be remembered for having pursued the worst macroeconomic policies of any major country in a long time.”

Kwarteng is going all out for growth. With this budget, and he has since stressed that this is only the start, he hopes to put the economy on a trend growth rate of 2.5%. It is now likely that the UK economy will skirt recession next year, unlike Europe and many parts of the world, but at what cost? Added fiscal stimulus will worsen the inflation outlook forcing the Bank of England to be more aggressive in hiking interest rates. Rate hikes may also be needed just to shore up the pound, especially as the UK is running its largest current account deficit since WW2 at 8.3% of GDP and is therefore excessively dependent on foreign capital inflows. Interest rate futures predict the BOE’s benchmark interest rate, which was hiked last week to 2.25% will be 3.75% by the end of November and above 6% by May. Gilt yields have surged by the most since 1992. 10-year yields jumped after the budget to 4.14% compared with 3% at the start of the month. 2-year yields jumped from 3.51% to 4.45% over two days.

Lower income taxes will help consumers, but the benefit will be taken away by higher interest rates. Sharply higher mortgage rates will impact the residential property market, which according to many analysts is in dangerous bubble territory. Lower corporate tax rates and stronger economic growth will assist share prices, but higher interest rates will lift the discount rate used to value company earnings.

The Chancellor believes his policy will boost the economy’s supply side. He is also implementing regulatory reforms, including around 40 new low-tax investment zones, looser rules on new infrastructure investment and the scrapping of caps on bankers’ bonuses. The reforms may be helpful but the biggest constraint to growth is the country’s labour shortage. Brexit has put an end to the abundance of migrant labour. Without it, the economy will have to rely on substantial productivity improvements to achieve growth targets.

Will the pound keep dropping? Given its substantial decline so far, it is tempting to believe that it can’t weaken further, that parity with the dollar is such a strong psychological level and unlikely to be breached. However, in 1972 ahead of the last great fiscal gamble, the pound traded at £2.61 only to depreciate to £1.59 by 1976 and to £1.07 by 1985 following the Fed’s brutal inflation beating monetary policy. History tells us that the pound could weaken further, especially in the current strong dollar environment. Meanwhile, Brexit woes continue. The bonanza of new post Brexit trade agreements just haven’t materialised. Existing trade deals have largely been replicated. Since leaving the EU, the UK has signed replicated deals with 69 countries. Only 3 new trade agreements have been signed. The big prize, a new trade deal with the US, has fizzled out. There are no current negotiations with the US, and Prime Minister Liz Truss has threatened to tear up the exit deal it negotiated with the EU.

What does all this mean for investors and Overberg’s client portfolios? There is a lot of cash in portfolios, which has been raised over the past 12 months to position portfolios more defensively. The cash is currently held in US dollars. The investment companies, listed on the London Stock Exchange, which comprise our clients’ portfolios, are quoted in pounds but the underlying exposure is across global markets and asset classes and so will not be affected by the currency’s weakness.