Posted 3 October 2022
Overview: UK gains global attention – for all the wrong reasons
Last week provided evidence for the fragility of capital markets, which have been grappling with the strain of transitioning from an ultra-low interest rate environment back to the one we knew before the global financial crisis of 2008. A policy mistake from a new government trying to fend off a looming recession rattled international capital markets to such an extent that it prompted a melt-down in the fundamentals of the UK’s capital market, which was only alleviated after the Bank of England (BoE) intervened in its capacity as lender of last resort.
The BoE’s swift and decisive action saved the UK government from presiding over more extensive damage in the short-term, but a fair amount of damage to the reliability of British political institutions, not to mention the damage to international trust levels, has been done. This means that the cost of capital for the UK, its businesses and consumers, is very likely to be higher than it would otherwise have been, which in turn will further reduce consumers’ ability to spend on non-essential goods and services.
Where things go from here is deeply uncertain. The International Monetary Fund’s rebuke – as well as worrying comments expressed by central bankers in the US – demonstrated the depth of the global concern. Given the UK these days relies on international investors rather than domestic savers to buy up newly issued government debt (gilts), and that the sterling gilt market cannot at all rely on being as big and systematically unavoidable as the US government bond market, any politician changing the perception of risk-free lending to the UK government does so at their own peril – as this very young government subsequently learned very quickly.
Our perspective on the bond market rout
Bond traders are still reeling from events over the last week. While UK-based investors will clearly be worried about the weakness in sterling and gilts, globally diversified portfolios – like the ones we manage on behalf of our clients – have a relatively low exposure to UK assets, and are therefore less sensitive to Britain’s specific issues. For markets more generally, the real danger lies in financial collapse and contagion, although given the BoE’s emergency intervention in longer-dated bond markets last week, that scenario now looks unlikely. Even so, it is an unwelcome additional complication, particularly given the already-fragile state of global bond markets.
After more than a decade of easy money, the world’s major capital markets are feeling the squeeze of rising yields caused by surprisingly strong and persistent US growth. As a result, bond values have fallen and risk assets like equities look relatively less attractive. Meanwhile, the tighter financial conditions and higher input costs from the energy price shock are casting a shadow over the near-term outlook for corporate profitability. In the US, where the post-pandemic economic recovery is going better than elsewhere, these pressures are much less pronounced. American companies do not appear burdened with unmanageable debts, nor have they been particularly affected by weak global demand, as the energy price crisis has affected the US much less. Despite some negative signals, US businesses are still motoring along, and employment remains strong. This tight labour market means the US Federal Reserve (Fed) has had to push real rates high enough to squeeze inflationary growth. But that has meant higher real returns on US debt, which has substantially pushed up the value of the dollar. This has led to currency weakness elsewhere, increasing inflation and putting pressure on other central banks to follow suit. To add to that, non-US growth has clearly deteriorated substantially – the UK being a prime example.
In this environment, it is hard to see dollar strength ending or reversing any time soon. But if the world’s reserve currency does stabilise, other supply-side inflation pressures would lessen. We have already seen signs that oil and other commodities (outside of European natural gas) have lost steam. Many emerging markets – having tightened earlier and harder than developed market counterparts – are already looking toward easing financial conditions. Asian countries, despite not going through that same tightening cycle, face nothing like the inflation pressures elsewhere, and yields are stable or falling. That said, current real yields are attractive and, if they are seen as stable at these levels, there will be plenty of willing buyers. When looking at lower yields and worse growth outlooks elsewhere – like in the UK – it is easy to see why. Those in shorter maturity bonds might soon be tempted into longer maturity assets. Yields still have the potential to rise – but the peak may be in sight.
For investors who have seen more painful losses from the government bond proportion of their diversified portfolios than the equity part, and wonder whether bond values have entered a long-term secular downtrend, it is important to recognise that fixed interest bonds have very different underlying characteristics than equities. Most importantly, western governments do not tend to default as companies sometimes do. The excessive volatility seen over the past 12 months is not a reflection of weakening governments’ solvency, but rather this asset class’s ability to protect and grow investors’ purchasing power in differing inflationary environments. When yields stop rising as growth and inflation pressure recede – and we indeed get close to the peak – the 2022 pains for bond holders should wane. But it is hard to see bond prices turning around until US earnings are on a clear downward trend, which would signal to the Fed that it can finally start to loosen its grip.