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Our views 17 July 2023

JP’s Journal: Beautiful France

5 min read

Back from a week’s cycling in Normandy. Lovely scenery and really friendly people but a stark reminder of the huge sacrifices made to liberate Europe in 1944.

What I learnt was that the initial D-Day landings were a considerable success but that the fighting away from the beaches – in bocage country – was fierce and bloody. I also better understand the role played by a range of nationalities, especially the huge contribution made by Canadians – something brought home by a beautiful but poignant cemetery near to Juno beach.

Keeping abreast of domestic news was depressing. At a time of war in Europe, with sacrifices again being made, we British have lost a sense of proportion. We are excited by trivialities and celebrity, rather than facing up to hard choices. It is not easy for politicians to tell unpalatable truths – much easier to pander to media sensationalism. But unless we talk about growth generation, we will not be able to improve our health and social care systems, not able to support allies with military aid, and will slip in educational rankings. And tinkering with private equity allocations of pension funds is no substitute for real policies. Treat the causes not the symptoms. OK, 50 years is a long time off, but if the Office for Budget Responsibility is anything like right, the surge in UK debt to 300% of GDP will have profound implications much sooner than that.

On the data front there were mixed messages. UK output fell 0.1% in May, better than the consensus of -0.3%. The extra bank holiday was a negative factor, so the picture is a bit better than the bald number. There was a boost from services although this reflected less industrial action in May rather than an underlying improvement. Leaving aside this noise, the level of real GDP has barely grown in two years. And the outlook is no better. I still believe the full impact of tighter monetary policy has yet to be felt. While the main media focus is on mortgage costs, there are much wider implications that are rarely discussed: the impact on business costs and the hit to public finances, for example.

Inflation remains key to where the Bank of England (BoE) goes next. News from the US was encouraging with June core CPI falling to a 20-month low of 4.8%; this confirmed the view that US inflation is leading the way, coming down faster than in either the eurozone or the UK. This gave a boost to most global bond markets. In the US, 10-year yields fell from a high of 4.1% to 3.8% whilst the eurozone saw equally impressive declines. Bund 10-year yields fell 15bps, settling around 2.5%, whilst equivalent UK yields finished at 4.45%, a 20bps reduction on the week. Looking at interest rate expectations, the US curve is indicating at least one more hike but a pretty quick series of reductions from Q4 onwards.

The more optimistic outlook for US inflation helped to moderate UK interest rate expectations last week despite data that showed average weekly earnings rising 6.9%, above the 6.7% consensus, and supporting the case for further rate hikes. However, as noted by Melanie Baker in her recent update,  there are signs of labour markets becoming less tight. The unemployment rate rose to 4.0%  and the participation rate increased – suggesting more people coming back into the jobs market. So, whilst I do not think the BoE has finished raising rates, a downward surprise in this week’s CPI data may stay their hand.

Credit markets rallied with most other asset classes last week and sterling investment grade corporate bonds spreads have now narrowed by 10bps over the last two weeks. To put this into context, last week’s closing level on non-gilt indices saw the lowest credit spread this year and about 30bps tighter than the wides, seen in mid-March.

More generally, one of the key drivers of spread compression in all global credit markets has been the recovery in highly subordinated bank debt. After the Credit Suisse shock there were comments that the AT1 sector was uninvestible. This never made sense – it is always a question of price for the perceived risk. The real question was whether banks would deem it economic to issue hybrid debt at the yield levels required by investors. From a buyer’s perspective, bonds with double digit yields have heightened risk – but income generation and the potential for capital appreciation have rekindled interest from active investors prepared to weigh these risks.

There was an interesting twist last week on this theme, looking at a perpetual bond issued by Abu Dhabi Islamic Bank. With an order book of $7bn for a $750m deal, the bond was priced with a 7.25% coupon. This looked expensive compared to equivalent developed bank debt – but did not stop the deal moving to a 4% premium. Why was this? Well, there was strong regional appetite but, more fundamentally, the bank is well capitalised with a low loan to deposit ratio and is well provisioned for non-performing loans; the government equity stake is helpful. I am learning that emerging market debt does not necessarily equate with higher risk.

Finally, I watched the Wimbledon Men’s Final on Sunday. As well as an exceptional sporting event it encapsulated other themes. The natural cycle of succession and the mental toughness required to compete at the highest levels. The ebbs and flows of psychological advantage were brilliant.


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