A recent report by the Public Accounts Committee (PAC) put the cost of the pandemic in the UK at approximately £372 billion. PAC has warned that UK taxpayers will be paying for coronavirus (COVID-19) for decades. But what does this mean for investors now, and in the future?
A BBC article published last month claimed that UK government debt stands at over £2.2 trillion, which equates to approximately 99.7% of GDP - a rate not seen since the early 1960s. In June, a surge in inflation meant the government spent £8.7 billion in interest payments alone. To compare, U.S. gross federal debt stands at approximately $28 trillion, approximately 127% of GDP.
Historically, “high public debts are followed by significant and linear declines of both aggregate investment spending and productivity growth” according to a 2012 academic paper. Further economic research claims that “an increase in government spending puts upward pressure on interest rates which, in turn, leads to lower private investment”.
So, it all hinges on interest rates. If inflation rises - as we are seeing talk of at present - central banks have to decide between maintaining inflation by increasing interest rates and keeping interest rates the same therefore devaluing currency, potentially triggering a financial crisis. Government spending and interest rates are independently managed, however, also intertwined. The Bank of England (BoE) have numerous things to consider - they have a government mandate to maintain a 2% inflation target, but not at the cost of bankrupting them.
In June BoE Governor Andrew Baily said in an interview that the BoE believes current inflation is transitory, and whilst 0.5% above target, they will not hesitate to use policy tools if the causes behind rising prices are persistent. Essentially, they’re saying that these jumps in inflation are mere bumps in the road as the UK transitions out of lockdowns.
So, back to the £372 billion debt. In 2006 the UK finally paid off the debt it created from World War II, and arguably, government debt really never needs to be paid back. Instead, it can be refinanced, and this is done through bonds. As old bonds mature and investors get their capital back, the capital can be repaid with newly issued bonds.
Many equities are priced relative to the return available on cash bonds, therefore if interest rates are low then the value of equities will rise. Low bond yields and low interest rates combined, make equities more attractive.
Conversely, should interest rates increase, the cost of borrowing increases, both for consumers and for companies too. This means that mortgages, car loans, student loans and other borrowing increases, leaving taxpayers with higher costs and less disposable income (for buying shares!). But we will see the cost of borrowing increase for companies too.
A rise in inflation and interest rates doesn’t necessarily spell a dark patch for equities. The value of stocks within certain sectors will undoubtedly prevail, as will the health of well-established companies that are not credit constrained.
The proof will be in the pudding, as they say, predicting the future is something no one can do, but understanding the landscape in which our investments sit is an important part of investing.
At Upside we believe that learning is continuous, and key to becoming great at investing, which is why it forms the backbone of our ecosystem. There’s a science to being right.