Monday Digest

Posted 29 September 2025

Running out of steam

Last week’s mild equity falls were probably about end-of-quarter rebalancing. After a strong rally in the last three months, there’s some inevitable profit-taking at the end of September. But we shouldn’t get complacent: there are some narrative shifts too. This week’s probable US government shutdown doesn’t help the near-term economic outlook either.

The first narrative shift was that small cap stocks struggled. Previous optimism about growth and interest rate cuts turned into nerves about long-term bond yields and tighter financial conditions. The next narrative shift was against the US mega-techs: soul-searching about the AI investment boom caused a sell-off on Thursday, after Nvidia’s $100bn investment in OpenAI was likened to the circular vendor financing of the late 1990s TMT and dotcom period.

These moves caused algorithmic trend investing strategies to reduce their equity exposures. These strategies built up substantial equity holdings after a months-long rally, and higher volatility requires them to sell. Underlying this, market liquidity is tailing off, after being strong over the summer. Or rather, Western liquidity is tailing off; Chinese liquidity is high, which is why its stock market was one of the only good performers last week. In the West, liquidity is now coming more from private borrowing than central banks – which strains risk sentiment. That’s why the ‘buy the dip’ mentality faded.

Less liquidity doesn’t mean negative markets, just volatile ones. We have yet to see any real signs of stress in the economic data. The latest US jobs data looks flat, rather than weak, for example. US businesses aren’t hiring but they’re not firing either. Global business sentiment is mixed but unalarming, suggesting global growth is moving along and company earning should be supported.

Tighter liquidity and higher yields mean stock valuations will have less support. Markets ground to a halt last week without that support, and could be volatile in the weeks ahead. But with a decent if unspectacular economic outlook, investors should keep their cool.

Donald Trump and his administration believe that the Democrats can be blamed for a failure to pass the stop-gap government funding bill (which is needed to maintain most government payments from October onwards). The administration thinks voters will blame Democrat leaders but may also see an opportunity to deem any shutdown as a “threat to national security”. Both US equities and bonds have become less sensitive to these episodes but it might become more of an issue if the fight becomes really nasty.

The UK economy – better than it seems

Most coverage of the UK economy is negative: weak growth, high inflation and perilous government finances. But the FTSE 100 is up more than 12% year-to-date and sterling has gained against the dollar. Consumers aren’t confident – but confidence diverges sharply between age groups. Older Britons have become more downbeat since last year’s election, while younger people are more hopeful.

That’s not just political leanings: tax changes and property market weakness have played a role too. Both are more likely to effect older people. Young adults are more likely to rent, so stagnating rents helps their finances.

Inflation is stubbornly high (3.8% in August) and preventing the Bank of England (BoE) from cutting interest rates. The BoE regularly warns about a tight labour market – from welfare changes, the pandemic, Brexit and curbs on immigration – which has pushed up services inflation. CPIH also includes local taxes, so local government infrastructure spending contributes to inflation too.

That spending should hopefully lower longer-term inflation, though. Underinvestment in supply eventually means higher consumer costs. Tellingly, a large portion of recent inflation comes from regulated prices like energy, water and transport. Pimco’s CIO said last week that UK inflation will likely fall in line with other developed markets, allowing the BoE to cut rates.

It’s worth bearing in mind that real growth and retail sales are still positive – albeit strong. Households have substantial savings and balance sheets are stable. US tech companies are increasingly investing in UK tech infrastructure, and Britain could benefit from being a halfway house between the US and Europe (the latter is currently going through a generational fiscal boost). There’s anecdotal evidence of skilled workers that might have settled in the US now relocating to the UK, which, if true, could boost long-term productivity.

The UK economy has its problems, but domestic investors should step back and have another look.

Death Cab for QT

The Bank of England (BoE) plans to reduce its Quantitative Tightening (QT) bond sales, but chief economist Huw Pill was critical of the move.

To understand gilt markets, you have to consider the buyers: Defined Benefit Pension Schemes. They typically buy long-term gilts and many use a Liability Driven Investment (LDI) framework which matches current assets with expected payouts. To boost their returns, pension funds used investment managers – who can borrow to buy bonds, while pension funds can’t. Pre-pandemic, this meant more long-term gilts being bought than the government could issue – encouraging the government to issue more over the long-term. That imbalance flipped in 2022, when yields rose and the “net-present-value” of pension funds’ liabilities fell, but their bond assets fell too. It to a head during the Liz Truss moment: sharp yield rises made them forced sellers.

Huw Pill is right that dialling back QT doesn’t address these underlying gilt market problems. But QT is arguably making them worse. The regulatory changes that led to the LDI problems in 2022 happened years previously, but it wasn’t until QT started that the gilt supply-demand balance rapidly shifted. Stopping QT wouldn’t be ‘problem solved’, but the BoE shouldn’t make things worse by actively selling long-term gilts.

When 30-year gilt yields spiked a few weeks ago, we preached calm: it was real (inflation-adjusted) yields that went up, which can only stay so high if UK growth is strong. Yields have already fallen noticeably, but the structural problems complicate things. Previous LDI demand for long-term gilts shift the government’s issuance to the long-term, meaning there’s now an imbalance between the supply of long and short-term gilts.

You would expect global investors to see through this imbalance and consider high long-term gilt yields attractive. But demand has been slow. That either means the structural problems are worse than we make out – or that global investors really are positive about UK growth. We give some reasons to think the latter separately.