Monday Digest
Posted 20 January 2025
Global stocks bounced back 2% last week and bond markets calmed. UK investors did not even have to rely on a weak pound to boost sterling-based returns. UK government bonds recovered from the previous sell-off, as we cover below. Lower-than-expected inflation data for December makes an interest rate cut at the Bank of England’s (BoE) next meeting likely, and there was a refreshingly dovish speech from one BoE committee member. Annual inflation will almost certainly go up (due to higher energy prices) but we have argued the BoE should ‘look through’ near-term inflation and at least one BoE official seems to agree.
Markets were also worried about sticky US inflation, but those fears receded. December’s inflation report was in line with expectations, but investors reacted as though it was lower. The most encouraging signs are slower wage growth (despite job gains) and a smaller contribution from the shelter component. High interest rates are still compressing activity, which gives the Federal Reserve scope to cut. Global markets would welcome that, considering recently tighter financial conditions – thanks in large part to the strength of the dollar.
Tight liquidity conditions might mean downgrades to global growth forecasts this year – which will hurt smaller companies in particular. Notably, last week’s equity bounce-back became much more focussed on the mega-caps as the week went on, having initially started in small-cap. Oil prices also increased, but that looks like a pure supply-side story, following US sanctions on Russian shipping. Geopolitics are uncertain ahead of Donald Trump’s inauguration – but hints are the Ukraine will be a top priority, and that Trump could be more supportive of Ukraine than most assume.
Trump’s second term brings uncertainties but potential rewards. It helps that we start it with calmer markets than a week ago. Long may that continue.
Gilt and anxiety
Thankfully, UK government bonds (gilts) calmed down this week. The previous spike in gilt yields was led by higher yields elsewhere, but exacerbated by concerns over Britain’s economy and government fiscal policy – which many feared would lead to persistent ‘stagflation’ (no growth but high inflation). This then hit the same structural gilt market weakness revealed after the Liz Truss ‘mini budget’ in 2022: pension funds’ overexposure to volatile inflation-linked gilts. You might have expected pension funds to end their overexposure after that crisis, but the Bank of England settled the gilt market and meant funds reduced rather than closed their positions. Recent gilt volatility reignited the problem.
We said last week that this panicked selling made long-term gilts very cheap. Theoretically, long-term real (inflation-adjusted) bond yields should represent the market’s expectations for long-term economic growth. One of our preferred measures for this (constructing a theoretical future bond out of 15-year and 30-year yields) spiked above 2.5% last week, which suggests strong growth despite all the commentary focussing on the UK’s weaker long-term growth prospects. This suggests that gilt panic was more about short-term sentiment than long-term expectations and long gilts are a good buying opportunity.
Sure enough, gilt traders took the buying opportunity this week, pushing yields down from their highs and putting them once again in line with US yields. This was helped by the government reiterating its commitment to fiscal discipline and, particularly, unexpectedly low inflation data from December. This settled the nerves and allowed investors to appreciate how cheap long-dated gilts are. The narrative that gripped gilt markets last week always looked too dire to be true; this week’s news made it even less convincing. We shouldn’t expect plain sailing – given the UK’s uncertain outlook – but historically high yields make long-term gilts look good value.
More to come from India
India has had huge success in the last few years, but positivity has faded in recent months. Its stocks are up 30% since the start of 2023 and GDP grew 8.2% in the 2023-24 fiscal year. Foreign investors have sold out of India since the autumn, though, and growth has slowed. Interestingly, capital outflows have coincided with investor optimism about China, following Beijing’s stimulus announcements. Realignment away from China was previously helping India in trade and investment terms, and it looks like the sentiment about the two markets mirror each other.
Economists expect the Reserve Bank of India (RBI) to cut interest rates next month, but inflation is still high and the rupee has fallen sharply against the dollar. Currency weakness will likely be inflationary, given India imports 90% of its oil. But, the RBI isn’t independent (the government installed a more dovish governor just last month) and seems comfortable letting the rupee slowly decline. India has consistently higher inflation than elsewhere, which means its currency is losing its real value quicker than other nations – a recipe for further declines.
The RBI’s dovishness makes sense when you consider purchasing power, though. The rupee’s recent slide hasn’t been by as much as the difference between Indian and global inflation. That effectively means the rupee’s purchasing power has increased; Indians are able to buy more, despite the weaker currency. That’s what you expect in a strong economy, but policymakers won’t want India’s purchasing power to increase too quickly, as that would undermine the cheapness that has boosted Indian trade and investment. A managed decline in the rupee is therefore reasonable.
The long-term case for India is strong, despite the recent decline in foreign investor sentiment. It’s based on long-term trends of domestic economic reform and global trade realignment – which both have room left to run.