Fiscal largesse and UK market volatility: implications for investors

What next from the Bank of England?

The majority of the fiscal easing announced in the UK chancellor’s mini-budget was well documented. It seems, however, that the trigger for the outsized market reaction was that there were no accompanying cuts to public spending, nor any indication what fiscal rules the UK government would likely pursue going forward.

We believe the Bank of England (BoE) will likely take rates to 4.5% by January. Higher rates will hurt borrowers, and those are the people most likely to have a higher propensity to consume, while the tax cuts will largely help the relatively well-off with a lower propensity to consume.

As such, the net effect is a weaker GDP profile, starting sooner. A UK recession similar in magnitude to the 1990s seems most likely i.e., a peak-to-trough decline of around 2%.

Sterling positioning: the Asset Allocation team’s view

The market seems to be pricing in further rate hikes to come from the Bank of England. That said, so far, the central bank has underwhelmed markets with a recent statement of intent rather than immediate action.

Euro-bloc currencies, including the pound, have been on the back foot all year against the dollar. But there’s a difference between what’s priced in and what has actually happened. The Federal Reserve (Fed) has hiked rates aggressively, while European central banks have been dragging their feet in the Fed’s wake, which has caused currency weakness and, in turn, forcing the UK and European central banks to finally deliver. We believe it’s this backdrop that has led to the ‘mini’ budget having such an outsized impact on rates and currency markets.

At the time of writing 10-year gilt yields have risen above the level for an equivalent US Treasury bond for the first time since 2014. Having recently closed our underweight positioning in gilts, for now we continue to wait on the side lines.

We expect the UK government will be more careful in delivering its plan for growth. While the momentum in the pound is clearly negative, there has also been a build-up in negative sentiment which, we believe, has room to unwind. Given this, we have decided to take a moderately positive view on the UK pound versus the euro in our more tactical portfolios, but the size of our position isn’t as big as the valuation case alone would suggest because of higher policy uncertainty.

Further declines in the pound would likely see us adding to the position with a medium-term view as the valuation case builds even further and we believe it would only make support from the government or Bank of England more likely.

Fixed income outlook: the Active Strategies team’s view

Perhaps surprisingly, we don’t believe this recent bout of volatility means as much for investors as first imagined. The underlying volatility in rates has nevertheless felt horrible, especially when most of the fiscal announcements and gilt remit were as expected. 

That said, the move in short-dated gilts has been extraordinary, with yields up 100 basis points (bps) from the day before the mini-budget to 4.48% on Monday, having closed 2021 at just 0.73%.

Sub-five-year gilts have also underperformed as the market has rushed to price in more rate rises, anticipating a hike of around 180bps in November of this year and overall rates hitting an eyewatering, mortgage-affecting, 6% by November 2023.

Unsurprisingly, liquidity in the sterling credit market has suffered, bid-offer spreads are wider, and dealers are keen to neutralise book positioning rather than add risk. Credit spreads are wider, but not dramatically so (yet), with two distinct opposing forces potentially keeping this dynamic intact:

• Higher yields and wider spreads have undoubtedly made investment grade (IG) credit more interesting, with yields now over 6% for two-year IG credit.
• However, given the outright moves in gilts, IG credit may be needed for collateral management. It wouldn’t normally be the first port of call, but recent events are exerting some pressure.

Overall, it is too early to tell the winners and losers from this situation.

The path of least resistance feels wider at this point, because at times of market stress the ‘need’ to sell usually outweighs the desire to buy – at least until some semblance of stability emerges.

In the absence so far of meaningful flows either way and given the costs of doing anything against this backdrop, we have avoided significant action.

We have, however, somewhat reduced our exposure to banks. The housing market is vulnerable to changing rates and while UK banks have benefited from robust capital flows and regular stress testing post-financial crisis, their mortgage writing business could suffer.

All data from Bloomberg as at 27 September unless otherwise stated.