JP’s Journal: A moving target

Writing this on Sunday morning is a bit of a risk. With politics and markets moving so quickly this risked needing a rewrite on Monday. However, standing back a bit my views are:

• The government’s focus will be on restoring financial stability
• Tax cuts will be reversed / wound back
• Real benefits will be protected
• The energy cap will evolve to more targeted support – if extended
• Quantitative tightening (gilts) will be postponed
• The next election will probably confirm that the electorate want strong state interventions

In political terms it means that the element of the Conservative Party that supported Brexit as a means of fostering a small state, with light regulation and an emphasis on market solutions, may be weaker. The four most recent leaders of the Conservative Party have been very different, reflecting various strands of political thinking and temperaments. It seems to me that an effort will be made to patch together a coalition of the unwilling – which I can see resulting in policies not dissimilar to Boris Johnson’s but without his leadership.

Domestic and global economic issues

What does this all mean for the economy and markets? The instability will hasten and deepen the recession. The higher mortgage rates we are already seeing will push down house prices, damaging household balance sheets at a time of a squeeze on disposable income. It is true that there are many households without mortgages but the segments of the economy most exposed to higher mortgage rates are probably experiencing the greatest squeeze on incomes. Inflation will come down in 2023, with the Governor of the Bank of England confirming that policy has been too timid in recent months and that this will be rectified. It is difficult to know how the latest change in fiscal policy will impact the Monetary Policy Committee’s decision but an increase in bank rates to at least 3% looks nailed-on for November.

Our own issues need to be set in a global context and it is fair to say that not all problems are homegrown. US Consumer Price Index came in above expectations last week, dashing hopes that the Federal Reserve was going to pivot to a more dovish stance. China continues to struggle economically and the energy crisis is sapping activity in Europe.

Yields higher still

From a market perspective the big change is in UK real yields, with index linked gilts at the centre of market disruption. To see the volatility of the last three weeks in real yields has been a real eye-opener, even for someone with over 30 years’ experience in bond markets. I am sure it has been even more revealing for the Liability Driven Investment (LDI) managers who have been at the sharp end of the fallout of their strategies. It seems to me that a lot of nonsense has been talked about pension funds in recent days. This is a liquidity issue – serious in itself – but not an issue of solvency; higher rates should be good for pension funds in general. When the dust settles it will probably mean less leverage in LDI approaches and a reduced exposure to illiquid assets (private debt and private equity).

Where next for real yields? As a bear of index linked bonds for the last 10 years, I now find myself in the opposite camp. Frankly, I don’t know where real yields are going this week or next. What I do feel strongly is that real yields of 1.75% for 20-year bonds represent outstanding value in this age of uncertainty. They may not give the best return and indeed it takes courage to buy this asset class when the last 12 months has seen such awful returns, but investors may be asking themselves what looks better right now.

Credit markets were weak last week, given the wave of selling from pension funds. Non-gilt sterling credit spreads hit 2%, a far cry from the sub 1% of last year. With yields on benchmarks now above 6%, I see good value in sterling credit.

So, let’s end on government bonds. Jeremy Hunt’s comments over the weekend and the prospect of a further announcement on Monday have steadied the ship (and Hunt duly reversed almost all the tax cuts previously announced). Interest rate expectations have moderated but still see bank rate at 5.25% in six months. The handling of policy in recent weeks has been extremely poor but, standing back a bit, it was never going to be easy to wean ourselves off the addiction to cheap money. The pain in markets will now filter through to the real economy. Let’s be clear on my view: 2.5% long-term growth of 2.5% is an aspiration that will not be realised. The UK, and Europe for that matter, will continue to adjust to a low growth environment in which the levels of public services will struggle to meet rising expectations.

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.