Posted 31 October 2022
Overview: New governments, new and old challenges
The most turbulent October experienced by UK bond markets since 2008 is drawing to an end and one could easily get the impression nothing of significance happened. Sterling is back to where it traded just before that fateful 23 September ‘fiscal event’, and bond yields are likewise roughly back to where they started Autumn. Rishi Sunak’s new government is seen as one where the Treasury is firmly in charge and fiscal prudence, rather than fiscal experiments, dictates the agenda. This is good news: it shows the UK still has effective institutions capable of reversing errors and preventing major collateral damage. Unfortunately, though, some of its credibility in international capital markets has been lost.
A difficult winter still lies ahead for consumers and businesses as higher prices and an ongoing energy price shock, stretch budgets to breaking point. But equity and corporate bond markets on both sides of the Atlantic were buoyed by near-term energy price falls in the early part of last week. The reason? The current oversupply of liquid natural gas (LNG). Stores are full, and the current warm weather has reduced the need for heating. The influx of tankers shows that the redistribution of global gas to cover the loss of Russian supply has been achieved sooner than most had expected. However, Europe’s gas-dependent nations are not out of the woods yet, as a colder than average winter would substantially reduce those stores, given pan-European storage capacity covers only two months of use.
Last week’s economic data painted a gloomier picture – albeit with some mildly positive growth surprises. Business sentiment, as measured by the ‘flash’ purchasing manager indices (PMIs) for October were generally below 50 for both services and manufacturing, indicating likely contraction in the next few months. However, US consumers seem to have grown pessimistic, and more so than their counterparts in Europe. The Conference Board’s highly-regarded index of Consumer Confidence slipped, as did the service sector PMI. But perhaps the biggest indicator of a US slowdown came from Q3 corporate earnings announcements last week. Amazon spoke of rising costs and slower economic growth. Its margins have come under strong pressure and now sales are growing tepidly. For US equities, the environment is one of declining medium-term earnings expectations but improving valuations.
We start the week at a slightly odd juncture; that a fall in one of the world’s largest companies is actually good news. For US equities, the environment is one of declining medium-term earnings expectations but improving valuations. This occurs more often in the midst of recession rather than before the start, but the old adage reminds us that history does not repeat itself, but it often rhymes. Over the coming weeks, we cannot expect news of inflation and economic headwinds to recede at once, but with the growing signs of the transatlantic misbalance narrowing, the outlook is no longer deteriorating. Oddly enough for markets, this can inject considerable positivity, which explains buoyant markets into the close of last week.
Is Britain ‘back’ after its fiscal fiasco?
Throughout her short and not so sweet premiership, Liz Truss and her team pushed the narrative that global forces were to blame for the chaos in markets. Indeed, Truss used her last Prime Minister’s Questions to tell MPs that sky-high inflation and rising interest rates were because of the Ukraine war and global energy supplies. While nobody seemed particularly convinced, there was certainly some truth to this. Government and corporate credit conditions had deteriorated markedly over the last few months. Even so, the former-prime-minister’s fiscal plans played a big part of the acute crisis, and the impression of Britain turning into a fiscal profligate put pressure on weak spots that were already there.
Truss wanted to give tax cuts to both businesses and individuals and use borrowing to offset the difference. This effectively meant giving money to the private sector in the hope that it would produce short-term growth. The problem was that rising interest rates would negate any funding benefits that consumers and businesses might receive, by way of higher mortgage and business loan servicing burdens. Now that Jeremy Hunt and Rishi Sunak have reversed all of those decisions, British assets are now seemingly more stable. Sunak’s ‘adult in the room’ persona has assuaged some market fears.
For gilt traders, the focus will be on the Office for Budget Responsibility’s (OBR) forecasts, which will be released on 23 November shortly after the mid-November Autumn Statement. Given Hunt and Sunak’s indications, budget plans will be fiscally tight over the five-year period although we should probably expect a neutral – or even slightly positive – position in the nearer term. The UK’s fiscal position will undoubtedly show deterioration. Yields have risen sharply, forcing the government to pay more on its debt. The OBR’s overall forecast will certainly look worse, the key question being by how much.
How strong can the dollar go?
US currency strength has been one of the defining features of this year. The proximate cause is quite simple. The world’s reserve currency enjoys a so-called ‘exorbitant privilege’, and one aspect of this privilege is its safe haven status for owners of capital in distress. This year has seen plenty of distress, with war, slowing global growth and a myriad of other risks pushing investors into the security of dollar assets. This would be a significant force even if the US economy was weak but, to the contrary, US growth has held up much better than other major markets (of course, partly fuelled by the capital inflow). So much so that the US Federal Reserve (Fed) has had to tighten policy harder than most – pulling even more capital in through higher interest rates.
It may seem odd to say that American assets are supported by capital flows, considering US stocks have lost nearly 20% in local currency terms for the year to date. But the strength of the dollar has insulated foreign investors from equity weakness, and these losses have been considerably smaller from the perspective of investors based in other currencies, with the S&P 500 falling only just over 6% in sterling terms. Relatively, US credit spreads have held up better than elsewhere, while the equity risk premium – the return investors demand for a given level of risk – has been remarkably stable, where elsewhere it has fallen significantly.
Should risks to global trade persist, and growth dynamics across the world keep deteriorating, investors will put even more of their money in US assets. But given how much of those headwinds are already priced in, it is worth bearing in mind what that situation would look like. US companies make around 30% of their earnings overseas, and the number is over 50% for the tech sector. These companies therefore depend on global demand for US goods, but that demand is seriously undermined by falling global growth and a strong dollar.
The US has been more expensive than the rest of the world for some time, and yet investors have proven no less eager to hold dollar assets. Geopolitical tensions are what drive this desire – and as long as they remain elevated a reversal of dollar strength will be hard to sustain. At the very least though, we suspect that the pace of the dollar’s ascent is at or near its peak. The global economy cannot afford it any other way.