UK markets have experienced aggressive swings over the last couple of trading sessions, with the pound hitting new lows and Gilt yields spiking.
What’s going on, and where might this end?
The end of last week saw two events which dismayed inflation hawks. First, on Thursday the Bank of England delivered a 50bp hike. Arguably not a surprise, but following the Fed’s 75bp move the previous day (importantly followed up with a hawkish press conference) it underwhelmed. We were also disappointed with the lack of any form of statement or Q&A alongside the decision; none were scheduled but that didn’t need to stop the governor, Andrew Bailey, from calling for one anyway. Markets are moving – guidance is useful.
However, it was Friday’s ‘mini-budget’ that really shifted the pricing of UK assets. We will leave other commentators to dissect the detail of the Chancellor’s changes, but in summary he announced the biggest tax cuts in 50 years with the hope of driving enough growth to avoid recession. A highly stimulatory budget, but one that raises the risk of higher inflation for longer.
Why did UK Gilts take the announcement so badly? The tax cuts were not accompanied by the same magnitude of spending cuts, and thus the conclusion is they will require increased borrowing to bridge the gap. The current government’s vision is that the increased growth the cuts will generate will lead to an increased tax take in time, and in the shorter term efficiency gains can save some government expenditure. There is therefore an asymmetry in the ease of calculating the costs today and the potential gains tomorrow. The market is choosing not to extend the trust the Chancellor may have hoped for that the plan will succeed.
While the pound’s weakness is already well beyond the level fundamentals such as purchasing power or interest rate parity would indicate, investor confidence – or in this case lack of it – is the dominant driver of its near term outlook. Currency markets hate untargeted fiscal expansions, especially when accompanied by high inflation, so the mini-budget’s tax cuts led to a risk premium on Gilts and fears about the funding of the UK’s deficit. The Prime Minister and Chancellor are breaking with conventional wisdom, which markets could be minded to view positively if there was some grand new theory behind these decisions, but so far this more detailed explanation has been lacking. For now investors are saying ‘going for growth’ is not enough. The cost of tax cuts can be priced in detail fairly easily, while the tax gains from growth require a range of multi-year assumptions – assumptions need to be sold.
The key issue here in our view (and this is not just confined to the UK) is the feedback mechanisms between markets and governments, which developed from periods of macroeconomic stress, are no longer in place. Over the QE era governments have been almost unconstrained in their ability to borrow, and as a result the power of the ‘bond vigilantes’ of old waned. It’s a long time since Bill Clinton’s advisor famously said: “It’s the economy stupid.” In 1992, paying attention to the bond market and considering its reaction to any policy decision was second nature to governments. That is no longer the case, but cabinet members will have to quickly relearn the skill if volatility is to be reduced and the outlook of the pound and UK assets as a whole improved.
We can’t know how long it will take the government to realise it needs to up its game selling its policies to the market, whether they will be believed, and ultimately how successful they will prove to be.
As investors, how can we mitigate against this increased level of volatility? There is still significant value to be found in UK fixed income markets, in our view, but this needs to be done selectively. We are focused on identifying the areas of the market that are best insulated from bad news, rather than predicting the news itself. We like UK names with majority overseas revenues and companies with non-cyclical earnings, and we remain focused on short dated bonds (this is not limited to the UK) to minimise the downside from changes in inflation expectations.
Buying these kind of bonds won’t necessarily produce quick capital gains. As long as doubts about the UK’s trajectory continue, UK bonds will trade with an additional risk premium. However, this means that when we have done the work to find solid UK bonds, we get the benefit of collecting a risk premium which overcompensates for the underlying risk.