Brexit was based upon a coalition of two uneasy partners. On the one hand the free marketeers who saw the EU as sclerotic and a barrier to enterprise. Their model for growth is based upon low taxes, less red tape and regulation and the re-energising of the entrepreneurial spirit.
On the other, the left behind, who saw globalisation, and by proxy the EU, as a threat to their jobs and culture. This is a simplification but conveys the essence of the unique circumstances that came about in the 2016 referendum.
The Conservative Party tried, with Theresa May, to ‘ride these two horses’, picking someone who had little apparent sympathy for either. Perhaps, with the benefit of hindsight, the odds of success were not great.
In reality there was only one man that could unite these factions and that was Boris Johnson. Through his personality and flexibility of mindset he appealed to both the ‘low taxers’ and the ‘level uppers’. His foibles were overlooked for the sake of party unity and electoral pull.
The problem is that there is no apparent underlying philosophy guiding government policy and this does matter. Here I make an analogy with what we do at RLAM. Over many years we have expounded a clear approach to credit investment. This has been tested and at times we have been on the wrong side of market moves – with 2008 an example of a real challenge for us. However, our core beliefs of active management, portfolio diversification, preference for secured and collateralised debt, a belief that investors are over-compensated for default risk and a view that under-researched areas of the market offer some gems – all of these guide our approach to investments.
Back to the Prime Minister. A charismatic leader who loses his charisma is in trouble. The 'Levelling Up' policy announcement last week was a rehash of existing policies and little new money seems available. The failure to deliver meaningful plans to better transport in the North sits uneasily with the rhetoric of shifting investment to underperforming regions. But last week’s pivot also alienates the free marketeers as they see it involving more State intervention, government spending and higher taxes. It was a leading Brexit supporting MP who described the plans as “socialist”. In the end the government will have to decide what its core philosophy is – and clearly expound it. You have to have a reference point that you can go to at times of trouble. Otherwise, you are just knocked around by events – something that applies equally to politics and investment markets.
And markets were buffeted by events last week. The Bank of England (BoE) vote sent out a hawkish message, with four members voting for a 50bps increase rather that the 25bps delivered. Forward curves are now indicating that UK overnight rates will hit 1.75% by year end, implying five more hikes. As expected, the BoE decided to stop reinvesting maturing assets (passive Quantitative Easing (QE)), confirming that they would not reinvest the £28bn cashflow from the redemption of the March 2022 gilt that they hold.
More surprisingly, they also decided to start selling corporate bonds with the full stock of corporate bond assets to be unwound. Although the timeframe for selling envisages a long flightpath the quantum of sales is significant in relation to annual net supply into sterling credit markets. Our portfolios are generally underweight bonds held by the BoE and there may be opportunities to add to positions as sales are undertaken. All this said, there was some implicit pushback against the market interest rate profile with the BoE expecting Consumer Price Index (CPI) inflation below the 2% target at their forecast horizon.
Yields on 10-year bonds reflected this faster speed of expected tightening, pushing UK yields above 1.4% for the first time since late 2018, and while the gilt curve flattened at longer maturities, there was a meaning fall in prices, with the 2071 gilt falling 4%. In the US 10-year yields ended above 1.9% while German rates moved decisively into positive territory. Implied inflation remained stubbornly high in the UK but fell back in other markets. My bellwether gauge, long-dated real yields, saw some movement with the US rate turning positive and the UK equivalent nearing -2%; in both cases a retreat of over 50bps in the last two months.
Investment grade credit markets took the higher yields and associated equity market volatility badly. In sterling, the credit spread premium moved out to 112bps, compared to 96bps at the start of January. Subordinated financials bore the brunt of the move but most sectors saw meaningful widening. New issuance has abated in the light of market conditions and although we saw primary supply from Sage and taps of Housing Association bonds, activity is well down on expectations for this time of year. Conversely, high yield performed relatively well and while spreads remain above 4% there was no move wider on the week.
What does this mean for preferred areas of the fixed income market? I continue to be cautious on longer-dated bonds but short-dated gilts now discount our view of where rates end up. If we look at our short duration credit strategies, whether sub-investment or investment grade, yields look attractive. It is times like these that having a clear investment philosophy – that point of reference again – helps navigate uncertainty. It does not guarantee success but allows for context and perspective.
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. 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.