13 Feb 2023
Jonathan Platt, Head of Fixed Income
The UK is not in recession but nor are we growing. Q4 growth was zero, having fallen 0.3% in Q3. Not a technical recession – that is yet to come. The breakdown was a bit mixed. Surprisingly, fixed investment was up 1.5%, contradicting the downbeat nature of recent surveys.
Government spending contributed, growing by 0.8%, but net trade was negative, despite the softness of sterling. In the latter part of the quarter there were signs of renewed weakness, although the distortions caused to spending patterns by the World Cup are difficult to assess. Services output was also impacted by strikes and, possibly, by higher instances of flu. Overall, however, I have been surprised by the resilience of economies in the face of the double whammy: higher inflation and rising cost of money. The combination of government support and private sector cash reserves has, so far, cushioned the fall in real disposable income.
There were mixed messages from the Bank of England (BoE) last week. A more dovish member of the Monetary Policy Committee stated in a speech that interest rates in the UK were too high at 4%, arguing that inflation is pretty much guaranteed to fall through 2023. The reasoning is based upon the “long and variable” lag between raising interest rates and impact on activity. With 10 successive rate rises there is some merit in this view. However, the Governor of the BoE was also on record, saying that inflation could be more persistent and noting that their inflation forecasts showed a risk skew to the upside. All bases covered, I guess.
The bullish tone to fixed income markets faded last week as the more hawkish central bank rhetoric gained attention. The most puzzling immediate response to rate early February hikes was in the euro area where yields fell sharply. At their best, Italian 10-year yields hit a low of 3.9%, a fall of 40bps in a day. This is despite clear guidance of a further 50bps hike in March. The messaging from the European Central Bank remains pretty clear to me: getting inflation down is the priority even if this means pain on the growth front. This was well articulated by the Croatian Central Bank Governor, Boris Vujcic, a known hawk on policy: rates are going up again and will stay higher, for longer, than the bond markets are pricing. So, rates in the euro area are now generally higher than they were at the end of January. In Germany 10-year yields ended the week at just under 2.4% whilst the French equivalent hit 2.8%. An outlier is Italy, where yields are still a bit lower.
In the US, the usual, predictable and now rather boring annual row over the debt ceiling has kicked off again. But there are real problems here. Republicans, having welcomed the largesse offered by President Trump, have mysteriously rediscovered their fiscal prudence whilst some Democrats cling to the Money Magic Tree. I am quite sure the US is not going to default on its debt but the wrangling will go on and the US debt pile will grow. What this means is that budget deficits are not going away. In 1998 Bill Clinton foresaw budget surpluses “as far as the eye can see”. Wars, financial crises, and health emergencies show the limits of predictive power.
Yields on 10-year treasuries continued to rise through the week as the jobs data report indicated strength in the economy. With a close around 3.75%, the benchmark yield has risen 35bps in recent weeks and the indicative year end Fed Funds rate is 0.5% higher. The story in the UK is similar. From a February low of 3% the 10-year gilt yield ended the week at 3.4%. Implied inflation in both areas rose – real yields rising by less than nominal rates. Credit markets paused for a breather. Investment grade spreads were, for choice, a bit tighter but there was not much change in high yield markets. New issuance continued apace, but not at the level seen early in the year.
What does this all imply? At danger of over-extrapolation markets are seeing a soft landing in which global inflationary pressures ease, rates peak in H1 and the loss to growth momentum is modest. Corporate earnings come under some pressure but not enough to offset the potential for multiple expansion (PEs) in a world of declining interest rates. In this environment credit markets experience higher defaults but current yield spreads more than compensate.
Where are the pitfalls? There are several but let’s just look at one. Suppose the consensus on energy prices is wrong. Inflation projections are based on the continuation of oil prices around current levels (Brent at $85/ barrel). With the news over the weekend of lower Russian supply and signs of stirring in the Chinese economy it could be that the herd is wrong.
If that is the case the narrow footpath between inflation and recession will be more difficult to navigate. There is little room for either policy mistakes or ‘left field’ shocks.
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.