- The Bank of England (BoE) has recently been criticized by politicians, although the central bank averted a pension fund disaster.
- There was also speculation about the prime minister’s ouster and the public realization in politics that ignoring the markets and fighting inflation is not the best solution.
- The recent collapse of the UK Gilt market has not helped define an investment strategy.
- Cheaper valuations continue to be offset by uncertain fundamentals. These tensions will not be resolved anytime soon.
- A fall or stabilization in real yields would bode well for markets. For now, however, short-term bonds remain one of the few safe havens.
First bond buyers
Bond investments are becoming more and more interesting. The massive sell-off of UK government and corporate bonds in recent weeks suggests there are other buyers outside the Bank of England (BoE). It is a truism that what has been sold will be bought by someone who sees long-term value in assets that were the subject of a sale. The market is extremely volatile, but current yield levels are attractive. As the UK example shows, central banks do not want markets to become disorganized (or yields to rise too high).
We are increasingly concluding that we are nearing the end of the interest rate cycle and that much of the fundamental inflation data we have is indeed improving. Upstream price pressures are easing – lower commodity prices, lower transport costs – and this should be reflected in final prices. US consumer price inflation for September surprised – again – to the upside. But an optimistic interpretation is that the rise in commodity prices appears to be slowing. Inflation is still strong in the services sector, but in areas such as housing we will certainly see a slowdown in activity as higher interest rates take hold. Despite the higher-than-expected inflation rate, the market’s view of how far the Federal Reserve (Fed) will eventually raise rates remained scant. The general consensus is that the Fed can lower inflation by acting on demand. It is no longer just a supply side issue.
Turbulent gilt market
It would be surprising if the shift from the expectation of “low interest rates for longer” to “tight monetary policy” did not cause volatility. Much of the borrowing and hedging of recent years has been based on the assumption that interest rates will remain low. Now they are up and causing problems. This is most evident in Great Britain. The need for pension funds with liability-driven investment derivatives to raise cash to meet required collateral exacerbated the rise in market yields. Much of this LDI activity is centered on long-term effects, and it’s making some great moves. For example, the UK government bond maturing in October 2050 has fallen from 95.5 place in July to 39.7 percent now, a yield range of 350 basis points (bps) over the same period. Long-term UK bonds have traded like highly rated stocks over the past three weeks.
Despite protests from the UK government, the market’s general view is that the hasty announcement of unfunded tax cuts was the catalyst for the market turmoil. There is currently speculation that the government will have to withdraw many of the proposals made at the end of September. The BoE is ending its temporary measures to support the bond market, but the political drama is far from over. UK government bonds may continue to move in a wide range.
Continued headwinds for UK assets
It is important that the UK market stabilizes somewhat. Rising market interest rates have already pushed up the cost of mortgages, which will come as a major shock to households when existing fixed-rate loans need to be refinanced. Market volatility is also not good for companies. Proposals that renewable energy companies should be subject to a profits tax are at odds with the incentives needed to expand renewable energy generation in the UK. Not knowing how long a government will be in office is not ideal for companies trying to weather an inflationary shock and a global growth slowdown. While the UK market is cheap and the currency attractive, these headwinds will continue for some time.
Many more risk factors than just the interest rate
Overall, the consensus seems to remain that the inflation cycle is about to peak (almost a year now) and that the interest rate cycle will end. Any further considerations are difficult because it is difficult to be sure when this will actually take place. But there are a host of other uncertainties: the extent of the global economic slowdown and its associated social, economic and political consequences, the potential for an alarming escalation of the war in Ukraine, or a weakening in the US-China- relations before the 2024 presidential election. If interest rates were the only thing we had to worry about, that would be fine. But this is not the case. The Biden administration’s proposal to limit US semiconductor exports to China has already weighed on chipmakers’ share prices.
Short-term bonds one of the few safe havens
The tension between cheap (and increasingly cheaper) valuations and uncertain fundamentals is not going away anytime soon. Investing cash from a long-term perspective is challenging, especially when a portfolio has already suffered significant damage this year and volatility remains high. More financial stress is likely – if it can happen in the normally sluggish UK pensions sector, it can happen anywhere. Short-term fixed income appears to be one of the few safe havens for now.
Is the earnings recession priced in?
The current earnings season for stocks should be instructive. Price action at the market level – across all regions – and at the individual stock level already appears to have priced in much of what should delay an earnings recession. Our UK equities team has many examples and given what has happened to sterling, the UK market remains cheap in absolute terms and relative to global equities.
Exaggerated increase in real return
One consolation is that the rise in real returns appears exaggerated. Compared to the long-term trend, the rise in US 10-year real yields – as measured by the market for inflation-linked government bonds – is now even more extreme than during the global financial crisis. The current real yield of 1.6 percent is well above previous estimates of the real long-term equilibrium interest rate. If the real yield stabilizes or falls, it will bode very well for all markets – the decline in stock multiples will stop, growth stocks will outperform value stocks and bond yields will stabilize. Long-term real yields are unlikely to dip deep into negative territory again – central banks are less important buyers of government bonds today as they exit quantitative easing and global reserve growth has slowed – but they should not rise further.
The multiple forces causing current levels of market volatility cannot be understood, explained, let alone predicted by analysts. The shocks to the global economy in recent years have been profound – Covid-19, the energy shock and the transition to a new interest rate regime. There is no specific date when factors will stop affecting the economy and markets. But the amplitude of the shock waves should decrease and good valuation in the markets should again bring us positive investment returns.
Chris Iggo, CIO Core Investments at AXA Investment Managers
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