The drama never ends
The great thing about working in financial markets is that no two days are ever the same. News comes along, generally in a way that no one has predicted, and news moves markets, generally in a way that no one has predicted. This has certainly been the story in the UK over the last few weeks. Without putting any value on whether this will happen or not and how markets will respond to it, as I write, the suggestions are that Liz Truss will reverse some of the fiscal proposals made by her chancellor at the end of September. The drama has been engaging – criticism of the Bank of England (BoE) by politicians despite the Bank preventing a pension fund disaster, speculation about the removal of the prime minister, and public recognition amongst overseas policy makers that ignoring the markets and the fight against inflation (the Truss/Kwarteng approach) is not the best way forward. The great gilt market meltdown of 2022 will be enshrined in City folklore for some time to come. It certainly hasn’t helped in the process of setting an investment strategy!
I was probably too early in the trade, but it appears more and more people are thinking about buying bonds. Indeed, the huge amount of selling of gilts and corporate bonds this last couple of weeks suggests that there are buyers, beyond the BoE. It’s a truism but what has been sold has been bought by investors that see the longer-term value in assets that have been the subject of something of a fire sale. The market is extremely volatile but current yield levels are attractive and, as the UK has demonstrated, central banks don’t want markets to become disorderly (or yields to move too high).
More and more of the conversations I have with colleagues and others conclude that we are close to the end of the rate cycle and that a lot of the bottom-up information we have on inflation is actually improving. Upstream price pressures are easing – lower commodity prices, lower transportation costs – and this should feed through to final price developments at some point. The September US consumer price inflation number was – again – a surprise to the upside, but an optimistic interpretation of that is that goods price inflation does appear to be slowing. In the services sector, inflation is still strong but in areas like housing we are sure to see slower activity as higher interest rates have an impact. Even with the higher than expected inflation rate, the market pricing of where the US Federal Reserve will eventually take rates was hardly changed. Generally the view is that the Fed can bring inflation down by hitting demand. It’s no longer just a supply side issue.
I discussed the issue of financial instability last week and it would be very strange indeed if the transition from “lower-for-longer” rate expectations to “restrictive monetary policies” did not create volatility. A lot of borrowing and hedging activity in recent years was predicated on the view that rates would stay low. Now they have risen and this is causing problems. Nowhere is this more evident than in the UK. The need for pension funds with liability driven investing (LDI) derivative overlays to raise cash to meet collateral requirements has accentuated the move higher in market yields. And boy, it’s been volatile. A lot of this LDI activity is focused around longer-dated bonds and we have had some amazing moves. The October 2050 UK gilt, for example, has traded down from a cash-price of 95.5 in July, to 39.7 currently, equating to a yield range of 350 basis points over the same time period. Long dated UK bonds have traded like super charged equities in the last three weeks.
Despite the protestations of the UK government, the common view in the market is that the ill-judged announcement of unfunded tax cuts was the trigger for the market turmoil. As I write, the speculation is that the government is going to have to row back on many of the proposals made at the end of September. You couldn’t make this up, but Halloween has been pencilled in as the date that the Chancellor will provide more details of his fiscal plans (whatever they might be by then). The BoE is ending its temporary bond support activities, but the political drama is far from over. Those gilts might continue to be trade in wide ranges.
It is essential that some stability is brought to the UK market. The rise in market interest rates has already pushed up the cost of mortgage borrowing, which will provide a huge shock to household budgets when existing fixed rate loans need to be refinanced. The volatility in markets is not good for corporates either. Suggestions that renewable energy companies will be subject to a windfall tax goes against the incentives required to expand renewable energy production in the UK. Not knowing how long a government is going to be in place is clearly not ideal for corporates trying to navigate an inflation shock and a global growth slowdown. While the UK market is cheap and the currency is attractive, these headwinds are going to remain in place for some time.
More than rates to worry about
More broadly, my sense is that the consensus remains that the inflation cycle will peak soon (it has been soon for almost a year now) and that this will bring an end to interest rate hikes. Thinking beyond that is difficult because the certainty around when that actually happens is elusive. But the range of other uncertainties is wide – the extent of the global slowdown and what other social, economic and political consequences that has: the potential for an alarming escalation of the war in Ukraine; a deterioration in US-Sino relations ahead of the 2024 Presidential elections. If the outlook for rates was the only thing we had to worry about that would be fine. But it is not. The proposal from the Biden Administration to restrict US semi-conductor exports to China has already hit stock prices of chip manufacturers.
This tension between cheap (and getting cheaper) valuations and uncertain fundamentals is not going away any time soon. As I wrote last week, putting cash to work on the basis of a long-term view is challenging when portfolios have already had a significant hit this year and when volatility is set to remain high. More financial distress is likely – if it can happen around the normally pretty staid UK pension sector, it can happen in other places. So, sorry to repeat, short-term fixed income looks like one of the only places to hide for the time being.
Earnings recession priced?
The current earnings season for equities should be telling. Price action at the market level – across geographies – and at the individual stock level seems to have already priced in much of what an earnings recession should look like. My colleagues in the UK equity team have plenty of examples, and the UK market is cheap in absolute terms and in the context of global equities, given what has happened to the pound. But again, would you buy just yet when it is not clear whether the current Prime Minister or the Chancellor will be in office this time next week?
The one thing I take some comfort from is the rise in real yields looks to be overdone. Relative to the long-term trend, the rise in the US 10-year real yield – taken from the Treasury Inflation Protected Securities (TIPS) market – is more extreme now than it was during the global financial crisis. We don’t hear much about the real interest rate anymore, but the current real yield of 1.6% is way above previous estimates of the real long-term equilibrium interest rate. If real yields stabilise or move lower this would be a very good sign for all markets – equity multiple contraction would stop, growth equities would look better than value, and bond yields would stabilise. Real long-term yields are probably not going back to being deeply negative – central banks are less important buyers of government bonds these days as they row back from quantitative easing and as global reserve growth has slowed – but real yields should not keep going higher.
Looking forward (if you can)
The multiple forces creating current levels of market volatility are beyond the scope of analysts to understand, explain and certainly forecast. The shocks to the global economy of recent years are profound – COVID, the energy shock and the transition to a different interest rate regime. There is no date at which they will stop impacting the economy and markets. But the shock waves should become less in amplitude and good value in markets should again let us report positive investment returns.
That long-term optimism applies to my view of Manchester United as well. Erik Ten Hag can’t sort things out straight away and it is clear that the squad is having difficulties adapting to the way he wants them to play. But they are getting results (leaving aside the Man City debacle) and have won eight of the last ten games. They must have a good shot at competing for a title this season and success is the best ingredient for more success. Win ugly, but win.