The new government announced its mini-budget

Bond and currency markets were not impressed

A country’s currency and bond markets are typically the most telling barometers of economic health. On these measures, investors are giving the UK an unequivocal vote of no confidence.

Rising yields, falling bond prices, weak currency, and huge volatility

• The upward march in gilt yields sharply accelerated after 23 September following the release of the Government’s mini-budget. Moves in yields that are more typically associated with an entire calendar year occurred over just a few days.
   
• As of close on business on 27 September, the rapid rise in yields had translated into an eye-watering loss on the ICE BofA UK Gilts All Stocks Index of -30.2% (bond prices fall as yields rise), making the UK the worst-performing developed bond market according to Bloomberg data. The 10-year gilt yield rose above 4.5% for the first time since 2008, taking it higher than the equivalent US Treasury note, something that has not happened since 2014. The magnitude and speed of recent price declines in UK government debt has been reminiscent of moves more typically seen in emerging markets.
   
• At the time of writing, the Bank of England (BoE) has just pledged unlimited purchases of long-dated bonds, along with the postponement of its planned start to quantitative tightening. This move is in response to fears that frantic de-risking across liability-driven portfolios triggered by a tsunami of collateral calls could risk an imminent crash in the gilt market. The BoE’s announcement has led to a huge retracement in gilt yields, the moves of which are the largest in living memory. The question is whether yields can stabilise around this lower level, in spite of the UK’s deteriorating fiscal position.
   
• Sterling remains the weakest performing major currency year to date according to Bloomberg data, and has reached an all-time low against the US dollar.

 
Rising government debt fosters inflation

The catalyst for the latest sell-off in UK assets was the announcement of the mini-budget. The market reacted unfavourably to the large fiscal stimulus package, which investors clearly view as an unfunded borrowing splurge that risks an unsustainable debt trajectory and makes the Bank of England’s (BoE) job of taming inflation all the more difficult. Markets are now pricing in a significantly higher terminal Bank Rate (5.9% vs. 4.4% at the start of the month). The implication is that the BoE will need to increase interest rates even more aggressively to combat the inflationary impact of the budget announcement, although the messaging is now further complicated following today’s announcement on asset purchases.

Higher interest rates will be needed to attract foreign capital in order to fund the widening current account deficit. This, in turn, puts the housing market at risk as many fixed-rate mortgages are on relatively short 2-year or 5-year terms. The government’s hope is that tax cuts will pay for themselves through higher future economic growth. For this to happen, the UK needs to address the long-term headwind of anaemic productivity growth.

Weak currency is good for exporters, bad for everyone else

Sterling has fallen significantly this year versus the US dollar, and is approaching half its value (vs the greenback) of 2007. Market onlookers have begun to speculate that it may reach parity, a scenario once viewed as implausible. Although the weakness in the currency may give a competitive boost to domestic firms that export to overseas markets, it exacerbates the inflationary pressures on imports. Focusing on the UK, the three-month moving average of non-EU import prices have soared nearly 30% over the year ended July according to the Office for National Statistics (with sterling weakening further since then). By contrast, import prices on goods from the European Union have climbed “only” 10.5%. One piece of good news for the UK: Import-price inflation from the EU might be peaking. The bad news: Even if import price inflation begins to subside, overall consumer price inflation will likely stay uncomfortably high well into 2023.

SEI’s view: Care and caution are the hallmarks of good planning

For brave investors with cash to invest, current depressed prices may represent an attractive entry point. Prices have fallen and yields have risen, presenting an income-generating opportunity. For existing investors, the declines are quite unsettling. Nowhere more so than in the Institutional space where the rapid rise in rates has triggered a wave of collateral calls on liability-driven investment vehicles, which often has to be funded by selling down growth assets. Forced de-risking puts further upward pressure on yields, which is the reason for the BoE’s latest intervention.

We anticipate further market volatility as the BoE and other central banks across the globe must navigate an increasingly complicated economic and geopolitical environment. In the past, central banks have been successful in supressing market volatility; today the reverse may be true. In market conditions such as these, we believe patience and caution are warranted. Short-term markets conditions are not typically a good reason to make changes to a sound long-term investment plan.

 

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