September was a difficult month for all investors with both equities and bonds selling off. For much of the year, our team has been advocating to remain in North American equity markets relative to international markets. After all, North America faces less geo-political uncertainty, a stronger currency, and a more resilient economy, evidenced by low unemployment and high nominal GDP growth. On September 23rd, the United Kingdom (UK) provided us further reason to overweight North America as the country’s pension funds struggled with the government’s announcement for tax cuts and fiscal stimulus, which caused a historic rise in yields and a drop in bond prices. The question is, how did the UK get to this point? By looking at the timeline of events, we can get a better idea of the cause of this crisis and the lessons learned.

This is an example of when fiscal and monetary policy do not align and how it can create uncertainty in the markets. On one hand the UK had its’ monetary policy focused on curbing inflation with higher interest rates; and on the other hand, new fiscal policy was attempting to stimulate economic growth. In turn, this divergence in policies creates a lack of confidence in the financial systems, which can snowball into an economic crisis. This is evident with the recent price action of bonds which are meant to be ‘safe assets’.

At the time of the writing (October 17th), Jeremy Hunt, the new finance minister of UK, declared that the previously proposed “mini-budget” and tax cuts will be reversed. The UK market reacted to this news in a positive manner as yields on 30 year bonds dropped, the pound rose against the U.S dollar and the UK stock market showed some strength. Ultimately, this episode has taught us that Investors want both fiscal and monetary policy to be aligned, as that is the best way to ensure inflation can be brought down as quickly as possible. This remains the priority for investors, and any deviation from this goal will result in investors heading for the exit.

With that said, investors should still expect this type of volatility to continue in the U.K., as the credibility of the government is extremely fragile. This is punctuated by the fact that some are questioning the future of the new Prime Minister. The lack of confidence and uncertainty in the UK government is just another example of European geo-political risk that make it difficult for us to invest in the region. For the time being, we reiterate our overweight and bias towards North American equity and fixed income markets.