Sam Sivarajan holds a doctorate in behavioural finance and has led wealth management teams at several of Canada’s largest financial institutions.
Liz Truss's brief tenure as British Prime Minister saw her pitch an ill-advised plan to reduce taxes that the market rejected.Frank Augstein/The Associated Press
Can a head of lettuce outlast the Prime Minister of the United Kingdom? That at least was the challenge posed by a British tabloid earlier this year. As you likely recall, it was a challenge the lettuce won.
After weeks of leadership debates, Liz Truss was chosen by members of the Conservative Party to replace Boris Johnson as their leader and became British Prime Minister, but had to step down on Oct. 20, after only 44 days in office (and less than a week after the lettuce stunt was launched). Are there lessons for Canadian investors that can be drawn from her rapid rise and even faster downfall?
Well before finally stepping down, Ms. Truss had to backtrack rapidly on key planks in the platform on which she was chosen. One key plank was her plan to reduce taxes to kick-start growth. On the face of it, no one would argue with wanting to grow the economy or rethinking tax policy as one lever to make this happen. So where did it all go wrong for Ms. Truss and Kwasi Kwarteng, her even shorter tenured finance minister?
There are many facets to the story, of course, but one key element in her downfall is that she had either not done her homework or not shown convincingly to the market that she had. Briefly put, her government was proposing a massive reduction in tax revenues that implied a dramatic increase in national debt. When questioned how and when this debt would get repaid and what the cost of debt servicing would be in rising rate environments, the answers were vague and less than reassuring.
Government bonds, especially those of stable democracies like Britain and Canada, are relatively risk-free as long as the buyers know they will get repaid and that tax, inflation and interest policies are relatively stable during this holding period. Ms. Truss could not provide this confidence to the holders of British government bonds (gilts). As a result, prices of existing gilts fell and the yields (the fixed interest the bond is paying, or “coupon,” divided by its current price) increased dramatically – the prices of 30-year gilts moved more in one day than they had in any one-year period over the previous five years.
As the value of gilts fell, pension funds holding them were required to provide cash collateral to offset the losses generated by the drop in gilt prices. Pension funds couldn’t sell assets as quickly as required, creating further strain on the system, setting in motion an additional sell-off in the gilts market, rising yields on government debt around the world including the United States and Canada, a dramatic drop in the British pound’s value, and an equally dramatic increase in borrowing rates for British consumers and homeowners. The Bank of England had to step in and commit to buying as much as £5-billion of gilts a day for the next 13 days. This calmed the markets and the yield on gilts dropped a full percentage point (note that yield and price are inversely related).
But the damage was done: The differential between yields of gilts and German bunds, the equivalent German government bond, shot up to 1.25 percentage points within a few days of the launch of the government’s mini-budget. Partial reversals of the budget in the following days helped, but the differential stayed around three-quarters of a percentage point until the budget was effectively fully reversed and Ms. Truss stepped down.
So, what are the lessons to be drawn from this short but tumultuous episode?
First, for populist politicians and for voters everywhere – beware. Even if voters buy the voodoo economics pitched to them, the market likely will not. And while the market has no vote at the ballot box, it can bring down governments just the same – as Liz Truss, only the most recent student of that lesson, painfully learned.
Second, for investors, there are a few key lessons. Investors are also voters, consumers and taxpayers. It is difficult to separate those hats, as each hat affects the other. No one would say no to lower tax rates – but the whole package matters. The same level of spending with lower tax revenues means that the debt ball is kicked down the field for future generations. This is the classic investor problem of “hyperbolic discounting” – or, in more colloquial terms, a bird in the hand is worth two in the bush. We want to have our cake and eat it too. But, as British taxpayers found out, be careful what you wish for. The market didn’t believe the plan the U.K. government put forward and punished it by driving interest rates higher, U.K. stocks and the value of the pound lower. What taxpayers might save in taxes, they would have to pay in higher mortgage interest rates, portfolio losses and higher cost of importing foreign goods – much of which will remain long after the policy reversal.
Another lesson for investors is that government policies, and policy mistakes, are a risk to their portfolios. We are entering a period of prolonged high inflation, high interest rates, economic recession and political and geopolitical volatility. Mistakes in any of these areas, even by well-meaning and well-intentioned policy makers, can have reverberating consequences – to us as voters, consumers, global citizens and investors. All an investor can do is to be vigilant and incorporate policy risk into how they approach their finances.