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Our views 28 September 2022

JP’s Journal: Rationality and markets

5 min read

There are times when markets are irrational. Actually, that isn’t true – it stems from a misunderstanding of what markets represent. Put simply, markets represent a clearing price for goods, services and assets. Markets do not reflect economic value, fundamental value or any other notional concept.

However, it is easy to forget this. As rational beings we want to establish the worth of an asset. The market moves in the last three days are a good illustration of what markets are about. As a brief recap we have seen a mini-budget that loosened fiscal policy, a depreciation of sterling against the US dollar, a rise in government bond yields as investors anticipated a tightening of monetary policy from the Bank of England (BoE) and a fall in implied inflation (put another way real yields have risen more quickly than nominal yields).

In the last few days we have seen disorderly markets. The main reason is the investment strategies of UK pension funds. Basically, the Liability Driven Investment (LDI) approaches these funds use to hedge interest and inflation risk require collateral to be posted when derivative positions become negative. The sharp rise in gilt yields moved many pension funds offside on their interest rate derivative positions. As a consequence, there has been a requirement to post collateral (e.g. cash) , which has necessitated the selling of supporting assets such as units in cash funds and investment grade credit bonds. As an illustration, the longest dated index linked bond hit a price of £42 today; in November 2021 it was nearer £400. This is not a typing mistake.

Today we saw the BoE pledging to support the long end of the gilt market for two weeks. The aim is to bring stability and break the vicious circle of rising yields and collateral driven selling. It has worked, so far, with gilt yields falling from their highs.

So where from here? The first point is that, in my opinion, UK government bonds are cheap. With markets pricing a 6% bank rate by May next year the economy faces some severe headwinds. Yes, the energy price cap will help, and tax cuts will boost spending power but the impact of higher interest and mortgage rates will negate these benefits. I don’t see lower corporation taxes doing anything in the short term to boost investment. Second, credit is cheaper still. Yes, we are heading for a recession and interest costs will rise but this is more than discounted in valuations. The last time I saw such value was over 10 years ago. I appreciate that there is a lot of bad news out there: Russian belligerence, gas price hikes, the prospect of falling house prices, a significant budget and current account deficits in the UK. But that is the time to stay calm, evaluate probabilities and invest for the medium term.

I don’t think the mini-budget was a smart political move. During a cost-of-living crisis a reduction in the top rate of tax was naïve. And, from a market perspective, the new Prime Minister (PM) was aware of the implication for bond markets – it was something her leadership rival was at pains to point out. But the status quo was not appealing either: managed decline with low growth will not deliver the services that the electorate expect. I think the goal of 2.5% long-term growth is unachievable but we have to think of ways that we can raise our growth rate. I suspect that the next PM will reverse the small-state, free-market philosophy that Liz Truss is keen to espouse. And it may be that the next PM will be able to look at the European single market through a different lens. But who that is and the timing of it is something we will see play out.

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. This is a financial promotion and is not investment advice. 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.