27 Jul 2023
Last week saw three UK by-elections in constituencies previously held by the Conservatives. Two seats were won by opposition parties, following large swings; the other was retained, against most predictions. What can be read into these results?
First, that tactical voting was rife and whilst it is easier to carry out in a by-election than a general election, it demonstrated the effectiveness of concentrating the anti-Conservative vote. Second, the Conservatives face the difficulty of heading off the Liberal Democrats in the south and Labour in the north. The temporary coalition of interests put together by Boris Johnson is fragmentating. Third, expect little from Labour on new policies. The voters of Uxbridge gave a thumbs down to higher taxation for environmental initiatives.
Actually, recent news about the UK economy has been better than expected. The best data was on UK inflation where headline Consumer Price Index (CPI) fell to 7.9% and core hit 6.9%, both below consensus estimates. Energy and food prices helped, whilst the household goods category benefited from easing in general global supply chains. Less promising, domestically driven inflation still looks robust, buoyed by strong wage growth. Reflecting this, UK retail sales came in above expectations despite consumer confidence data showing another move down. Was the hot June a factor in encouraging more spending? Probably, but gains were pretty broad-based, including online shopping. Last Friday also saw the release of public finance data; again, they were better than estimated. The recent undershoot primarily reflects strong tax receipts, with pay growth feeding through to PAYE income tax, National Insurance contributions and VAT receipts. Total government expenditure was also lower than forecast despite higher social benefits spending.
All of this is a mixed blessing. Signs of domestic strength will only encourage the Bank of England to put interest rates up again. It looks to me that calls for another 50 basis points (bps) hike in August will not be realised – I think the CPI data is enough to get the BoE back to 25bps increases. Whilst markets are undecided on the magnitude of the next hike, they are definitely sensing an end game. Looking at how markets moved last week we can see that prior to the inflation, data pricing reflected a peak Base Rate of 6.25% in early 2024; post the CPI surprise that rate is just above 5.75%. That still means another 75bps of tightening is forecast and will only add to pressure on household budgets.
My call that the UK is heading for recession looks stale. But I am sticking to it. Despite the recent better data, I think it would be pretty remarkable if the combination of higher energy and food costs, more generalised inflation and a five point uplift to Base Rates does not precipitate a fall in output over a period of time. Of course, the UK’s outlook will be impacted by global events – and gains in other economies could offset domestic weakness. I just do not see that strength elsewhere. China has proved to be a disappointment; the US faces headwinds and our biggest trading bloc has largely the same issues.
Sterling markets responded positively to the UK inflation news. Ten year government yields moved from 4.45% to a low of 4.15% before giving back half these gains. Two-year gilts, which started last week at 5.2%, moved down to 4.85% before settling just under 5%. As expected, implied inflation, as measured by the difference between nominal and real yields, fell but there was also a decline in real yields. Risk assets also performed well. Domestically orientated equities saw a strong rebound whilst credit spreads continued to edge lower. Looking at investment grade sterling bonds, spreads hit their 2023 lows, representing a 40bps recovery form the Credit Suisse-inspired March sell-off. Indeed, as noted last week, one of the key drivers of credit markets recently has been the rehabilitation of subordinated bank debt. This has been beneficial to our credit strategies, especially those that have flexibility to hold both investment grade and high yield bonds.
From a global perspective, last week saw sterling bonds making up some ground against other markets. Our recent overweighting of sterling debt in our government ranges, a counter to the pessimism about sterling assets, has proved to be justified – and we think that there is further to go on this compression trade.
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