Monday Digest

Posted 21 August 2023

Overview: Bonds are back
Last week was another difficult one for both equity and bond markets. As a result, the positive returns of July have mostly been erased so far in August. Overall, world markets are largely unchanged from a year ago. Many commentators have pointed to the rise in global bond yields as a big driver of the reversal in sentiment, or at least the underlying cause of a renewed re-rating of equities on the back of higher bond yields. The US 10-year bond yield has risen to 4.3%, higher than at any point going back to July 2008, while the UK 10 year gilt yield has risen to 4.7%, the highest since June 2008.

At first glance, investors may think the rising yields are building in higher long-term inflation expectations, but this current move does not appear to have been spurred by a worsening inflation backdrop. Inflation expectations – as implied by the pricing of inflation-linked bonds – for the next two to three years seem to have fallen back a little. Therefore, what has changed is the ‘real’ yields, which have turned more positive after spending many months (even years) near or below zero. Real yields matter, and the rise in US real yields has come at a point when US economic data suggests ever more strongly that reasonable and persistent growth – rather than looming recession – may force rate cuts.

So, capital markets appear to be undergoing a rather technical shift, based on the re-rating on the back of higher-for-longer bond yield expectations, making recently extended equity valuations untenable, even if the earnings outlook has marginally improved. Given that August is a month with low trading volumes, it could continue to be negative, especially if the momentum trading funds start to add to the flows. However, a valuation adjustment would be no bad thing in the medium term, as it would alleviate some of the recent market nervousness.

Sterling strength nothing to write home about
You might be surprised to learn that, on a trade-weighted basis, the best performing major currency of the year so far is none other than the Great British pound. Sterling has gained 5.13% against the UK’s trading partners since the start of 2023. Moves in currency values are normally seen as reflecting confidence – or lack thereof – in regional economies. But the commentary around Britain’s economy this year has been nothing but glum. Although the UK has not officially dropped into recession, growth has been effectively zero for over a year. And yet, sterling has gained against its peers. So what’s behind sterling’s strength?

After a series of rate rises from the Bank of England (BoE) and the recent fall back in implied inflation expectations, the real yield on 10-year gilts is now just under 1.5%. Should we read this also as an expectation of higher growth? It is possible, but unlikely, given the wider pessimism about the UK economy. More likely, the move up in real yields is a consequence of the BoE’s aggressive stance – necessitated by persistent and UK-specific supply-side problems – together with an extended bond market sell-off. Nominal UK gilt yields are now above where they were during October’s ‘mini budget’ crash, and have risen much more steeply than German yields, for example.

Moreover, while a rising pound has helped ease input costs, Brexit-driven changes mean the goods and services British consumers buy from abroad (which are still overwhelmingly from Europe) are structurally more expensive now than a few years ago. The flipside of being able to buy more from trading partners with your pound is that those partners can buy less from you – making British firms less competitive. This might not be much of a problem if the economy is vibrant enough to handle it, but it does mean that both UK assets and its currency have become more expensive relative to economic fundamentals. Put another way, sterling looks vulnerable in the medium term. Over the coming months, we might see a slide – particularly against competitive currencies like the yen. The pound is strong now but, unfortunately, this may not be a good thing for the British economy.

Is Russia struggling to shift its oil supply?
Oil traders are feeling bullish. In July, international oil benchmark Brent crude was one of the best performing indices, gaining 11.9% in sterling terms. Last week’s jitters came after further economic disappointment in China, but some industry analysts see them as just a hiccup. Thanks to meaningful production cuts from OPEC+ (which includes Russia), predictions of $90 per barrel (pb) or even $100pb are being floated. That would be quite the turnaround. Brent has not settled above the $90 mark since mid-2022. Since then, supply side fears have faded, and global demand has become the key concern.

Saudi Arabia, the world’s largest crude exporter and OPEC’s de facto leader, recently extended its voluntary production cut of 1 million barrels per day to September and noted that cuts may deepen in the future. Russia also promised to export 300,000 fewer barrels per day in September, showing the cartel’s commitment to maintaining high prices. According to one recent survey, the total production output of OPEC+ hit its lowest point since August 2021.
For us, the most interesting player in this supply tightening is Russia. Despite some near-apocalyptic warnings when Moscow launched its invasion of Ukraine, the aggregate effect of Russia’s war and the ensuing western sanctions on global oil supplies has been relatively small. This was – as widely suspected – down to a rerouting of Russian supply to Asia, most notably the large energy-intensive economies of India and China. That is why, in the early part of last year, Russia’s trade balance (exports minus imports) stayed surprisingly healthy despite its apparent supply cuts.

In the last few months though, Russia’s trade balance has deteriorated significantly. This is clear from the slide in foreign currency reserves, which threatens to bubble over into a full-blown rouble crisis as widely reported last week. Last Wednesday, Moscow hiked interest rates by an extraordinary 3.5% to stop the bleeding, and its finance ministry is reportedly proposing tough capital controls. One of which would force Russian exporters to sell up to 80% of their foreign currency revenue within 90 days of receiving it or risk being banned from government subsidies.

It is particularly jarring that the rouble has slid so much while oil prices (including Russia’s discounted offering) have climbed, as the former is unequivocally a petrocurrency. It puts further pressure on Russia’s economy and finances, though as always, the question is whether this pressure reaches the inner circle. Optimists might suggest this leads to ceasefire talks, although the more likely outcome is increased friction between Russia and Saudi Arabia over production cuts, with the former needing revenues to fund its damaging war. In either case, oil prices could struggle to go higher over the medium term.