28 Oct 2022
Jonathan Platt, Head of Fixed Income
Michael Dobbs, author of House of Cards, would have been hard pressed to come up with the story lines that have played out in the UK in the last few months.
A charismatic but flawed leader toppled by his own shortcomings and the fracturing of his Brexit inspired coalition. Not replaced by the man who wielded the fatal blow and who commanded most support of Conservative MPs, but by a toneless conviction politician who wanted to break free from the philosophical mush of the last six years. The problem being of course, that this new approach lacked grounding in economic reality. The instinct to challenge the relative downward trajectory of the UK was surely right. But in doing it in such a ham-fisted way, she undermined the case. To hear Liz Truss described as a libertarian fanatic will sit uncomfortably with those who believe that real growth comes from markets working freely, the entrepreneurial spirit and the energy of small businesses, backed up by a welfare system. But no politician with a sense of self-preservation will venture in that direction for some time.
What the markets have now determined is that future governments will be hemmed in. The Labour Party is an obvious winner from current events but there is a stark message: fiscal orthodoxy will be required. Differences between parties will be evident in their messaging around values, but in terms of economic policy there will be reduced choice. The Labour Party will spend more and tax more but all within confines determined by bond market participants.
And the message here is global. We can become parochial when looking at the recent shambles. But the underlying dynamics at work are impacting most major economies. We are moving from an environment in which money was ridiculously cheap. The adjustment process will be painful for consumers, businesses and governments. For the consumer, mortgage costs are going up at a time of squeeze on disposable income, businesses face higher input and debt costs, whilst government deficits have to be financed at much higher levels. We can blame whoever we like – but the reality is that we are seeing a move towards normalisation. Central bankers and government now have to confront a situation in which monetary policy will be tightened against a recessionary background. How they wish they had moved earlier and taken some upfront pain – now the medicine will taste a lot worse.
The change in the UK energy cap policy means inflation will not come down as quickly as anticipated next year. My view is that the Bank of England will hike by 75bps in November despite the tighter fiscal policy now being outlined. And the latest UK inflation data is not a comfortable read with Consumer Price Index creeping above 10% again and core inflation hitting 6.5%. Whilst transport costs pushed inflation down, the chief worry was food price inflation, reaching 14.6% for food and non-alcoholic beverages. To compound the policy dilemma, UK retail sales fell 1.4% in September – quite a bit weaker than expected. Sales volumes are now 1.3% below pre-pandemic levels and there are signs that buyers are cutting back on food purchases. Overall, Gross Domestic Product is on track to contract in Q3.
Bond markets were volatile, but the global trend is for higher yields. US 10-year rates moved up 20bps to 4.2%, a level last seen during the Great Financial Crisis. In Germany, 10-year yields nudged 2.5% before settling back at 2.4% – and remember that rate was negative seven months ago. In the UK we had a rollercoaster ride that reflected the politics: 10-year yields oscillated between 4.4% and 3.8%, before ending the week at just over 4%. The volatility also played out in index linked gilts. Looking at 20-year yields, we see that over the last month, the rate has ranged from 2% to slightly negative. But over the past 10 days, since reaching 1.75%, we have seen a consistent decline to the current level of 0.45%. Implied breakeven inflation rates hardened a bit over the week, perhaps reflecting the news on the energy cap.
Conditions in credit markets stabilised with the abatement of selling pressure from UK pension funds. Indeed, we saw pretty consistent demand at the long end of the sterling investment grade market as investors sought to lock into the higher yields. Non-gilt credit indices closed with spreads around 1.86%, back from the 2% seen 10 days ago.
Where is the value now? I still think investment grade credit is attractive. The combination of higher gilt yields and wider spreads compensates for the worsening corporate outlook. Short-dated high yield strategies fall into the same camp: yes, global default rates are going to rise but this is reflected in the yields available. And if real yields back up from their recent rally I think they offer a good hedge in uncertain times.
How does it work out in the end in a Michael Dobbs novel? There is no spoiler alert – you will need to read his books. But If I was envisaging an unbelievable storyline, I would have had the rejected charismatic leader coming back to lead his party to election victory, against all odds, in two years’ time. That is not going to happen. In the real world we need politicians who admit the struggles we face. Cakeism is dead. At least, I think it is.
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.