UK gilts have underperformed other government bonds over the last year. Sunil Krishnan explains why the worst may be over.
Read this article to understand:
- Why gilts have underperformed other government bonds
- Why UK inflation remains so persistent
- What this means for gilts
Over the last 12 months, in what has been a challenging period for fixed income, the UK has faced particular difficulties, highlighting the importance of a globally diversified portfolio.
After the shambolic mini-budget last Autumn, the UK has returned to more mainstream and market-friendly economic management. Yet the returns on UK gilts compared to US Treasuries have not improved. Looking at one-year returns, gilts have underperformed US Treasuries by seven per cent and German bunds by about five per cent.
In other words, if an investor had bought gilts at the expense of US Treasuries at the height of the mini-budget crisis, they would barely be better off now. The period from April to early June saw a dramatic sell-off, and what happened can be described as a play in three acts.
Figure 1: Seven to ten-year government bond returns (GBP hedged)
.png)
Source: Aviva Investors, Bloomberg. Data as of July 14, 2023.
Act one: The mini budget
At the time of the mini budget, there was concern about the UK's ability to get a grip on inflation and the risk that eventually the required monetary tightening would cause a recession. But, with independent institutions like the Office for Budget Responsibility (OBR) and the Bank of England being sidelined, UK borrowers also had to pay more because of uncertainty about how well the UK's economic institutional framework was holding up (see Multi-asset allocation views: How politics are influencing markets).1
In the face of a weakening of the guard rails around UK economic management, international investors can decide not to hold sterling as a currency if they are not sure it will hold its value. They can also demand a higher term premium for bonds, the additional return they need on top of cash interest rates to tie their money up for longer in government bonds.
They did both, but the challenge was short-lived. To give an example, UK ten-year gilts underperformed their US equivalents by about ten per cent from mid-August to mid-October 2022. However, by early November, those losses had been made up.
One of the first priorities for the Sunak/Hunt government was to offer reassurance the institutional framework would not be challenged. That quickly allayed investors’ fears and led to a substantial rally in gilts.
It also led to a reasonable rally in sterling, to the extent the Bank of England was given the assurance there would be no government pressure on it to change policy and a proposed review of the Bank’s policy framework was scrapped. That provided support for continued rate rises and the pound.
After a period of looking like a significant outlier, the UK no longer seemed dramatically out of line with other countries that had seen rises in government bond yields and borrowing costs.
Act two: Recession fears
From November to January, global investor concerns shifted to a widespread expectation the UK and Europe would experience a recession last winter because of rising energy prices.
But thanks to deliberate policies to increase energy sources and storage, as well as a lull in fighting in Ukraine, the biggest cost-of-living fears did not materialise. This allowed Europe to go through only a mild recession and the UK to avoid it altogether.
Figure 2: Evolution of consensus Q1 2023 real GDP forecasts (per cent, quarter-on quarter)
.png)
Source: Aviva Investors, Bloomberg. Data as of July 14, 2023.
Act three: Persistent inflation
From February to mid-June 2023, investors continued to expect a slowdown in UK economic activity, this time driven by higher interest rates. As recently as early August 2022, the base rate was 1.25 per cent, rising to 3.5 per cent by the end of the year and to 4.25 per cent by the end of March.
There was a general assumption the UK is more than averagely exposed to rises in Bank of England base rates because of its large mortgage market, where most householders borrow at either variable or short-term fixed rates. Therefore, markets expected rising interest rates to translate quickly into higher mortgage rates, dampening economic activity.
But higher rates did not push the UK into a recession. The value of retail sales in the year to December 2022 was just over three per cent, broadly in line with the last five years. Markets expected this to slow sharply in the first quarter of 2023: in fact, it accelerated slightly, which came as a big surprise.
The other surprise was that monetary policy did not lower inflation either. Markets expected inflation to have dropped to between three and five per cent by July 2023, possibly lower if higher interest rates had led to economic difficulties. Yet year-on-year consumer price index (CPI) inflation had only shifted down to 7.9 per cent in July, from 10.5 per cent at the end of 2022 – and still over ten per cent at the end of March.
In contrast, there is evidence of inflation slowing more convincingly in other economies. US year-on-year inflation peaked in June 2022 at nine per cent and is now at three. Euro area inflation peaked later, at the end of October, at 10.6 per cent but is now 5.5 per cent.2
Figure 3: CPI inflation (per cent, year-on year)
.png)
Source: Aviva Investors, Bloomberg. Data as of May 31, 2023.
Why is UK inflation so stubborn? Nature and nurture
This experience puts the spotlight on differences between the UK and its US and European counterparts. Some are due to policy and others to the nature of the UK economy, but all help explain the persistence of UK inflation.
In terms of policy, the UK’s approach to managing energy prices was more volatile than in other countries. Even though continental Europe was facing the same pressures, countries found a way to even them out more for households. In theory, that might mean energy prices start to come down more quickly in the UK, but that is yet to come through.
A bigger challenge is that the UK is a small, open economy compared to the super-blocs of North America and the euro area. As such, it is likely to import a greater share of purchases and doesn't always have much control over the prices companies charge for those imports. Therefore, even though sterling has strengthened as UK interest rate rises have continued, it has not led to meaningful declines in imported prices.
Following post-financial-crisis austerity, there has also been a stronger sense in the UK’s political debate that workers were “overdue” a pay rise, and wage increases would have to make up for this beyond just keeping pace with inflation. As a result, recent wage acceleration has not been responsive to changes in the Bank of England’s base rate or government policy. In June 2022, year-on-year wage growth was 4.7 per cent; by December it was up to 6.7 per cent.
In addition, a Bloomberg Economics analysis recently showed that while households have been paying billions of pounds more in mortgages than before the rate hikes, banks have been paying out even larger amounts in extra interest on savings accounts. It would be naïve to see higher rates as stimulating more spending, given interest income does not tend to generate much consumption while mortgage payments can cut disposable income sharply. Nevertheless, with higher savings rates available and fewer people with mortgages than in previous years, rate rises are less effective at dampening growth and inflation.3
This left investors and economists wondering whether the UK’s famous sensitivity to interest rates might have weakened. The thought inflation expectations might have become unanchored from rate rises, or the structure of the economy might stop rate rises from bringing inflation down, was a contributor to the dramatic sell off we saw from April to June (see Figure 1).
All this has led the Bank of England to review its forecasts on how high interest rates would have to go. In early July, markets were expecting rates to reach 6.5 per cent by March 2024.4
Next act: Unsustainably high?
However, we don't think this is going to continue.
Firstly, there is a growing sense such high interest rates may finally be enough to start putting brakes on the economy. And because no one can see an immediate catalyst that could reduce rates in the same way as happened after the mini budget, they may well propagate across a wider range of rates – into mortgage rates, corporate bond markets and the interest paid on savings. Borrowers may not be able to escape higher resets by putting off refinancing for a few months.
That suggests such levels may be unsustainable because of the real economic impact they have – and markets are starting to react. June’s CPI report, and the Bank of England meeting the following day, both surprised investors in the direction of higher inflation and interest rates. However, two key markets showed a surprising response.
Firstly, these hawkish surprises should have led sterling to strengthen. In general, the currency has this year followed a textbook response whereby higher UK deposit rates increase the attractiveness of holding sterling. In the event, sterling weakened slightly against most major currencies, suggesting investors were starting to worry more seriously about the sustainability of interest rates the UK is delivering in the near term.
Secondly, gilts bucked the trend of previous months. This year, positive surprises in short-term rates have led yields to increase essentially in parallel at all maturities – in contrast to overseas peers, where longer-dated yields have generally smoothed out short-dated volatility. One could see this as evidence of investors giving up on traditional ideas of self-stabilising forces in the UK economy, instead seeing future rates as more of a “random walk”. The June news, however, saw a distinct flattening move in the term structure (i.e., near-term rates moving much higher than longer-dated ones). This means investors are increasingly seeing the coming months’ projections for rates as unlikely to be maintained, instead heralding a rate-cutting cycle and, in all likelihood, a recession.
Investment implications
We cannot say exactly when rates will peak, as that will depend on future inflation and related data. But relative to other markets, the UK is now closer to the biting point where higher rates cannot necessarily be sustained.
This could force investors to think about the yields being offered on gilts versus cash and instant-access savings accounts. Although the former may not be quite as income-generative as the latter, gilts allow investors to lock-in yields for their duration, whereas cash and instant-access savings rates could go down in lockstep with the Bank of England’s base rate. These are decisions investors will need to consider.
Figure 4: Ten-year gilt yields to maturity, 2008-2023 (per cent)
.png)
Source: Aviva Investors, Bloomberg. Data as of May 31, 2023.
In addition, the gilt market has already priced in a number of upcoming rate rises, meaning their value may not fall much further with the next increase. On the other hand, if higher rates start to bite, gilts offer some form of recession protection, as their value will likely rise if interest rates fall.
From a global portfolio construction perspective, not just in the UK, the inverse relationship between bonds and equities has also improved. While both asset classes were selling off together in 2022, this year, strong equity markets have shown to be weaker times for bonds and vice-versa. Of course, market performance is never guaranteed, but bonds are somewhat rehabilitated as a way to diversify portfolios.
For multi-asset portfolios, after a difficult year, these changing circumstances have improved the outlook for gilts.
References
- Sunil Krishnan, “Multi-asset allocation views: How politics are influencing markets”, Aviva Investors, November 22, 2022.
- Source for all the figures in this section: Bloomberg, as of July 5, 2023.
- Sarah O'Connor, “Why higher rates risk reigniting intergenerational conflict”, Financial Times, June 27, 2023.
- Mary McDougall, “Markets price in UK interest rate of 6.5% by next March”, Financial Times, July 6, 2023.
Important information
THIS IS A MARKETING COMMUNICATION
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.
The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.
In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: St Helens, 1 Undershaft, London EC3P 3DQ. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.
In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1 Raffles Quay, #27-13 South Tower, Singapore 048583.
In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.
The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.
Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.
Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.
