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A sharp pickup in volatility in the UK fixed income and currency markets was a defining feature of September, particularly late in the month following the release of a ‘mini budget’ by the new government. Here, our Fixed Income team outline the key issues that are influencing investor sentiment.
The economic outlook in the UK for 2023 and 2024 is undoubtedly challenging, albeit not considerably worse than neighbouring economies in Europe. Currency weakness has grabbed headlines, but at current levels (around £/US$1.10), sterling is not yet in genuine ‘danger territory’ in our view. Importantly, the pound remains within recent historical ranges on a trade-weighted basis, although the currency picture could change again quite quickly given current levels of market volatility. Moves in the UK bond market have been more extreme, but there are domestic technical catalysts that have exacerbated the volatility, and the Bank of England’s emergency intervention – announcing it would start buying long-dated gilts to provide much-needed market stability – was an unambiguously positive indicator for market conditions. Separately, while the recent ‘mini budget’ in the UK was poorly judged politically, the actual details suggest it could provide a mild fiscal boost, including a much-needed energy package.
A challenging outlook
The UK undoubtedly faces a difficult economic outlook, but this has been the case for some time. The subdued conditions primarily reflect record low consumer confidence measures, amid a historic squeeze in real wages. A combination of a weak economic outlook and persistently high inflation is part of the reason the Bank of England itself has been quite a reluctant policy hiker – despite pivoting to a hawkish stance in late-2021, before other major central banks, policy settings have subsequently been tightened in smaller increments than in the US. It should be noted that there are pockets of resilience and strength in the UK economy. In particular, the labour market continues to show record low unemployment, historically low redundancy rates, high job vacancies, and a reasonable level of wage growth. The labour market is showing signs of peaking, however, and we should expect moderating business confidence and tightening financial conditions to dampen the outlook. Nonetheless, the fact remains that the fundamental economic picture is not wholly negative.
While it is likely the UK economy will dip into recession in 2023, we assign a similar (~50%, if not slightly higher) probability of sub-zero growth in the Euro-area as well. The UK’s situation is not dissimilar from European peers; the economy is facing extreme inflationary pressures from a combination of supply-chain disruptions and a variety of energy-related issues, which is feeding into severe real wage cuts across the economy. The dominance of the UK’s service sector is a double-edged sword: while growth is sensitive to consumer confidence levels, the overall economy is less likely to suffer from industrial closures due to energy rationing, which seem possible on the European continent in the months ahead.
The new government getting busy
The recent ‘mini-budget’ was the catalyst for a sharp spike lower in GBP vs other major currencies and a surge in UK interest rate expectations, but this warrants some further analysis. The package itself that was unveiled by the new Chancellor of the Exchequer has two key components to it. First, a significant fiscal boost via the Energy Support Package. This is difficult to cost ex-ante, as it relies directly on the market price of natural gas (current estimates suggest ~£60 billion over the next six months). The package should have the dual impact of lessening the blow on consumers from higher energy bills, while also mechanically limiting the energy contribution to UK inflation. Eye-popping forecasts of 18% inflation into Q1 of next year were almost entirely driven by the UK’s energy price setting model, and will now be avoided. The second component is a supply-side tax cut, including a reversal of a previous increase in National Insurance. Although there are serious political considerations around this package, the UK’s tax burden as a percentage of GDP is still expected to be historically high following the cuts.
The key takeaway is that although the fiscal boost has been considered ill-judged by the market, we do not believe it is as extreme in its detail as some media commentary suggests.
Recent market moves have worsened the domestic economic situation, and are discussed here in turn. First, GBP has suffered considerably this year, but the vast majority of the move reflects broad US dollar strength. The USD has performed extremely well against all G10 peers in the year to date, owing to a combination of relative economic strength, energy independence, a more vigilant central bank, and a broad ‘safety premium’. The key currency pair to watch, in our view – as the single largest contributor to sterling’s trade-weighted valuation – is EURGBP. Although this pair moved considerably during September, the exchange rate remains firmly within five year ranges. At the time of writing, the pound had weakened by ~6% in the year to date (which, for context, is the same amount it moved in the other direction in 2019). We are closely watching EURGBP as an indicator of whether market stress will continue to affect the UK economic outlook. Above €/£ 0.95 would likely see a much higher level of concern from the Treasury and the Bank of England, but at current levels (<0.90) we believe the risk of currency intervention or unscheduled rate hikes is relatively low.
Moves in the gilt market have been more extreme than in the currency, and will likely have a more meaningful impact on the economy through household and corporate interest burdens. The moves we saw in the last two weeks of September – with 10-year gilt yields skyrocketing from a little over 3% to more than 4.5%, and back down to around 4% by month end – reflected genuinely disorderly markets, not dissimilar from 2020 or even 2008. Although UK interest rate expectations have been increasing steadily throughout the year, forecasts have now ratcheted up quite considerably (to a terminal policy rate of ~5.6%), and yields on longer dated maturities have moved higher. The single largest catalyst for this was the imminent approach of the Bank of England’s debt market sales (‘Quantitative Tightening’, or QT), as the market was pricing in the removal of one of the largest buyers of gilts in the market.
UK ‘real yield’ valuations have been extremely low throughout the last decade, and we had been expecting this to need to increase to attract private demand. However, the scale and speed of the repricing was extremely disorderly, and reflected the forced unwinding of very long-dated swap positions held by liability-driven investors (primarily UK pension funds). These moves have resulted in the Bank of England postponing its QT program, and actually recommence Quantitative Easing (QE) operations in the longer end of the gilt curve. This intervention had an enormous and immediate impact on the UK debt market, and may reflect the longer-term postponement of balance sheet reduction (which, all else being equal, may mean the higher terminal rate pricing is ‘correct’ to compensate). In terms of the actual economic impact of the move, households will likely be squeezed further through increased mortgage costs, and firms will be financing themselves at much more penal rates. The irony is that all of this is consistent with what the Bank of England wanted monetary policy to achieve in the current inflationary period.
Opportunities for active managers
Volatility in the UK rates and currency markets has provided opportunities for skilled investors to exploit. Several of our actively managed fixed income portfolios have recently benefited from short duration positions in the UK gilt market, for example, designed to benefit from anticipated upward movements in yields. Similarly, funds able to implement currency positions have benefited from active underweight exposure to sterling.
We have a team of specialist investors located around the world, providing on-the-ground insight into evolving market drivers and themes in different regions. With bond and currency markets continuing to face significant uncertainties – including energy price volatility, inflationary pressures, central bank policy changes, and geopolitical instability – these expert local insights are expected to be more important than ever in the period ahead.
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