Log inFrom political chaos to bond market stability – Market Update from Jilly Mann
In light of events in the UK over the last week, I wanted to provide an update on portfolios and the changes we have made to our client portfolios.
- Update on events in UK politics
- Gilts, the Pound and the Truss economic legacy
- The current economic cycle and echoes of the past
- Conclusion
Update on the UK political environment
Events over the past week are unprecedented and it never fails to surprise me that we seem to lurch from one set of historic economic circumstances to the next with ever increasing speed. I wrote last week that we were reducing our UK equity exposure, however, at the start of this week, we sold all of our direct UK equity allocation. Whilst we retain some limited exposure to particular UK sectors such as commodities via some of our global equity funds, essentially, we have taken a firmly negative view on the UK equity market as the political chaos has worsened.
I repeat the mantra that markets need certainty. To an extent Jeremy Hunt replacing Kwasi Kwarteng as Chancellor of the Exchequer brought some stabilisation to markets, but it came at the cost of unwinding the vast majority of Liz Truss’ mini-Budget.
From a fiscal perspective, unwinding the mini-Budget was a positive move, albeit there are consequences for business and homeowners with the energy support scheme being brought to a close earlier than anticipated next Spring. Markets were only ever going to be assuaged by this move for a short period of time. One cannot view a situation where a newly installed Chancellor unwinds the new Prime Minister’s policies so mercilessly and believe that the Prime Minister can survive.
We then looked ahead and read the rumours that perhaps Jeremy Hunt may not remain in situ depending upon who becomes the new Prime Minister. At time of writing those on the shortlist appear to be Penny Mordaunt, Rishi Sunak and Boris Johnson seeking to emulate his hero Winston Churchill by returning from political exile. What now plays out remains to be seen, but global markets, UK business and in fairness, even the Bank of England, cannot look at the situation in the UK and plan ahead with any confidence.
We then factored in the potential for a General Election to be called and that added a further layer of uncertainty, simply because the Labour Party would appear to be a shoo-in were a General Election called now. However, as a shadow cabinet they haven’t been hugely clear or consistent on their own policies and plans for the future during their time out of Office.
Unfortunately, the week has evolved as we feared it might do for the UK market and our decision to sell down on Monday has proven prescient.
Gilts, the Pound and the Truss economic legacy
We still retain a relatively high cash weighting within our portfolios. This presently earns a reasonable rate of interest (1.4%), but we don’t want to hold an overweight in cash for the long term. Inflation is running far higher than interest rates and will continue to do so for some months to come, thus eroding the value of cash savings, even those attracting higher rates of interest. As a holding position though, the cash weighting allows us to generate a positive return within portfolios, whilst also waiting for an opportunity to buy when we see a compelling case to do so.
I wrote in the last update about UK Government Bonds, Gilts and the Pound. The good news to come out of Jeremy Hunt’s unwinding of the mini-Budget is that the Gilt market and the Pound have both stabilised. One lasting impact to come out of the past couple of weeks has been a quiet confidence that no political party, Chancellor or Prime Minister is going to repeat the mistakes of the Truss Government. Whoever is in charge may have quite different policy ideas, but I think we can be confident that none of those policy ideas are going to be so bold that they risk destabilising the Gilt market or the Pound unnecessarily.
The chart below demonstrates the movement in both UK Gilts and the FTSE 100 over the last week, since Jeremy Hunt unwound the mini-Budget. UK Gilts in blue are up 3.79% and the FTSE 100 in red is up 0.37%. A short time period undoubtedly, but it represents the upside potential within Gilts compared to UK equities, if market confidence can be restored.
That may mean that more sombre fiscal policy announcements will make for a longer and harder route out of the inflationary world that we currently live in. However, that approach should result in greater collaboration between the Government and the Bank of England, which then underpins the Bond market and avoids further scaremongering such as occurred last week with Final Salary Pension Schemes.
That said, the Bank of England still need to work out a viable plan for Quantitative Tapering, i.e. the selling of Gilts back into the market to reduce the Government effectively creating and maintaining artificial liquidity in the Bond market. One would hope that the Bank of England also now restore some calm and come out with some clearer guidance on future interest rate moves, the impact on the Gilt market and inflation targets.
If we start to see some clear signposting from the Bank of England and the Government, whoever is in power, then markets will start to settle and at least become less unpredictable, whether or not that results in UK equity markets rising or treading water for a period of time.
In addition to UK equities, we have also sold some of our infrastructure allocation, some of our renewable energy funds and further tweaked down our US equity allocation.
The current economic cycle and echoes of the past
The overriding message is that we have shifted towards a defensive position, with an overweight in bonds and cash, with a corresponding underweight to equities. We have made this move relatively early in this phase of the cycle, but we have been waiting for signs that now is the right time to do this. When we think back to previous market downturns, the Global Financial Crisis in 2008 stands out as we look again at how we positioned portfolios then. Back then we shifted portfolios heavily out of equity and into Government bonds and high grade fixed interest (i.e. the best quality bonds we could find). As the economic cycle progressed, we then diversified our bond allocation so that we had less Government and high grade bonds, whilst moving into more corporate and high yield bonds. We then introduced selected equity allocations before we moved the portfolios back into a more normal investment spread between equity and bonds.
The chart above represents UK Gilts throughout the 2008 calendar year. The chart below represents UK Gilts throughout the 2022 calendar year to date.
It is clear that 2022 has seen a much deeper fall in UK Gilts than was experienced in 2008, but if we look at the trajectory of UK Gilts in mid October for 2008 and 2022, it is eerily similar. We don’t yet know how the remainder of 2022 will play out for UK Gilts, but the echoes of 2008 are definitely present as we look at the sector today, albeit with a much greater opportunity set for a recovery in UK Gilts from the depths of a minus 30% return year to date than we saw in 2008. The Bank of England’s approach to Quantitative Tapering will be critical for this recovery to continue.
The downward shift in markets has been happening for 12 months and if a typical economic cycle is 15-18 months, then we feel that we are approaching the endgame of this particular downturn. I do caveat that with reference to the likes of Russia or China, whereby specific risks remain which could derail the cycle for a period, but all things being equal, we do think that most outcomes are now factored into market valuations. The UK being the outlier at present where we simply have a lack of certainty at the moment.
We have taken the opportunity to buy more Gilts and high grade Fixed Interest this week. Gilt yields have started to decline, the pound has stabilised and this is a positive for Gilt funds, because valuations should rise as a result. We think this is a sensible move, because we have confidence in the belief that nobody will risk repeating Kwasi Kwarteng’s approach to economic growth.
The bond market is a forerunner to equity markets and our approach is based on the belief that we think we will see greater returns from the bond market within portfolios than we will from equity markets in the coming weeks. On a risk versus reward basis, we are always assessing the risk we take versus the potential returns available, both up and down. The bond market has seen unprecedented falls over the last year, but now we feel that this is the time that the tide will turn for bonds and if we are correct then the recovery could be both swift and profitable.
Equity markets may rally on given days and we do have some equity exposure, but it is focused on areas which we think we still produce returns in these uncertain times. For example, commodities and inflation-proofed assets, whilst we retain some US exposure. We still feel that the US market is relatively insulated from the travails of the rest of the world and so whilst they face their own inflationary challenges, they are actually very different from Europe and the UK. Europe and the UK are structurally challenged by energy price inflation in a way that the US is not, but the US will face a property and wage inflation conundrum that they will need to find a solution for.
The direction of US interest rates and inflation targets has been relatively clear for a while now and that is a message which the UK and Europe need to adopt, with whatever solution they think best. Europe remains threatened by the war in Ukraine and although it may be hard to believe, the UK Government’s support for the cost of living crisis is on a pedestal compared to the political inertia in both Germany and Italy where energy price inflation is soaring out of control with no household support and no alternative plan. If we do see a resolution in Ukraine, then we will likely see a rally in European markets, but with two European powerhouses in the form of Italy and Germany both lacking political leadership or popular support, we have limited exposure to Europe and would need to be convinced that any relief rally could be sustained beyond a week or two.
Conclusion
To conclude, markets may look daunting at the moment, but we have been taking steps to avoid much of the uncertainty which abounds. We may be right in our view on UK equities and some protracted political uncertainty or the situation may resolve itself sooner than we anticipate, but we would rather take a cautious, defensive approach to managing portfolios wherever we can in times such as these.
We do retain some selective equity exposure to pick up any upside that may be there, but as we look at markets today, I would expect to see us continue building our bond allocation further. Thanks to our defensive approach, the movement in equity markets is unlikely to mirror the movement in our client’s portfolios and so whilst we appreciate that these can be unsettling times, please keep in mind that when reading any headlines about movements in the FTSE 100 as an example, your own valuations are unlikely to replicate such movements exactly.