Events in Russia dominated headlines over the weekend. As yet it is unclear what will happen and markets have remained calm.
But we will need to keep a close eye on events and there is a risk that, contrary to early thoughts, the Ukraine war is escalated to consolidate President Putin’s position.
Back to domestic matters. May Consumer Price Index inflation remained at 8.7% and core inflation rose to 7.1%, both above estimates. This was the fourth consecutive month of prices coming in higher than expected and contrasts with the experiences in the US and eurozone. Like Sweden had reported previously, UK inflation was buoyed by trends in admission fees for live music events. But don’t blame Beyonce and Taylor Swift as UK inflation is a broad-based issue. Services inflation rose from 6.9% to 7.4% – price rises in catering, air travel, medical services communications and accommodation all contributed. There was some good news with food inflation showing early signs of moderation and there is further downward pressure to come in energy prices.
The Bank of England (BoE) responded by raising the Bank Rate to 5%. Consensus at the start of last week was that the BoE would hike interest rates 25bps but the inflation data changed the picture. The 7-2 vote for the 50bps increase reflected concern about more “persistence in the inflation process”, especially in services. The bottom line is that the UK economy continues to generate jobs and the labour market is tight. It looks like the only way to get inflation back in its box is to generate a recession – and the BoE is doing just that. This is through squeezing the consumer (housing costs), making savings more attractive than consumption, increasing business costs, buoying the currency and, in general, sending out a strong message that inflation will be tackled. Rates will go a bit higher, but we are approaching the peak and I don’t see the current pricing of 6% for late 2023 being realised.
Where does this leave us?
Yields on short-dated UK government bonds have moved a long way in two months. My view remains that the current level of gilts looks attractive based on historic valuations and economic fundamentals. As I have referenced in recent weeks, Craig Inches, our Head of Rates & Cash, and his team have been buying gilts to go long duration versus indices and to go overweight UK bonds in our global portfolios. That is a big change for us.
The news out of the eurozone in recent weeks has been more encouraging on inflation but less so on growth. The flash composite Purchasing Managers' Index for June was below expectations with the manufacturing reading signalling more downside and services being less buoyant than anticipated. France, in particular, is showing some weakness, indicating that its relative resilience may be coming to an end. From a government bond perspective, the rise in yields in 2023 has been much less pronounced that in the UK. So, although there is scope for a pullback in interest rate expectations in the eurozone, if the slowdown in activity continues, I believe there is greater potential in UK bonds.
One of the biggest sector changes over the last year within our sterling credit strategies has been the increase in the exposure to insurance bonds. This reflected our assessment of credit fundamentals and the potential upside of ‘liability management’. Last week saw a good illustration of the latter with Aviva paying a 16% consent fee to bondholders to allow them to bring the terms and conditions of their 6.875% 2058 (with a 2038 call) debt into compliance with current Solvency II requirements.
We reckon about 9% of the fee is compensation for expected spread widening and the remaining uplift an additional incentive to consent to the liability management exercise. A great result for our clients and a good illustration of how important it is for bondholders to delve into the specifics of bond documentation. Well done Shalin Shah and our Sterling Credit team. And we expect further liability management exercises from banks and insurers looking to reduce their legacy debt, which will continue to provide attractive opportunities for active investors.
Global bond markets
Global bond markets generally traded higher over the week. US 10-year yields fell, to end the week just above 3.7%. The moves in the eurozone were more pronounced, with German yields lower across maturity ranges and 10-year rates settling at 2.35%. Italy maintained its recent outperformance with the spread differential to Germany continuing to narrow. The surprise 50bps hike in the UK saw most gilts rally strongly, reflecting investor support for the move. But pricing of future Bank Rate moves still shows the markets expect a move to 6% by year end. It looks to me that although the Prime Minster may press banks to be lenient on customers there will be no respite on the mortgage front.
Credit spread moved wider last week but there were no specific drivers. I still like credit and think there is good value across a spectrum of non-government bonds but tighter monetary policy is likely to weigh on risk assets. With investors pricing in the end to US rate hikes I think there is scope for some disappointment and re-pricing of expectations in the next few weeks. What happens in Russia, however, could change all of this.
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