BlueBay AM: Brits home and abroad taking a pounding

October 7, 2022

Although newsflow from the UK is coming thick and fast, with the government already forced into a humiliating U-turn with respect to part of its fiscal plans, attention moved back across the Atlantic, where a relatively soft ISM report breathed new life into hopes that a Fed pivot could see the FOMC slow its pace of monetary tightening at its November meeting.

Our own meetings with US policymakers in the past week also lead us to conclude that the Fed would like to hike by 50bp, rather than 75bp, at its next meeting. Interest rate sensitive sectors such as housing have slowed to a standstill and there is a sense that with policy moving beyond neutral this is creating more stress in the system.

However, any hopes for a 50bp move may hinge on next week's CPI print being a benign one. August inflation data was a source of some disappointment, though with gasoline prices declining there is more optimism that the September print brings better news.

Not much of a recession

In addition, it seems clear that the Fed is keeping a very watchful eye on financial conditions. Rate hikes have been intended to slow the economy through tighter financial conditions, and so should these start to ease with S&P rallying back above 4,000, then this may also be a factor that leaves the Fed in a position where it concludes that it needs to make another outsized 75bp hike. Aside from this, growth is expected to moderate and a mild recession seems likely early next year.

However, with unemployment only projected to rise to around 4.5%, it seems like this won’t feel like much of a recession, and although there may be credit impairment in some sectors and issuers, on the whole the credit cycle may be relatively benign. The ongoing risk is that inflation continues to disappoint and this requires interest rates to continue to rise to 5% or more.

However, there seems to be some increased confidence that this won't be required and the top of the cycle sees rates around 4.25-4.50% in Q1 next year. Notwithstanding that, early rate reductions seem less likely and against this backdrop we think that 10 year Treasuries are close to fair value in a 3.50-3.75% range.

The relatively benign backdrop for the US stands in contrast to the much weaker backdrop across the Atlantic. Inflation data may continue to be problematic in the Eurozone for a few more months to come, and so it is hard to see the ECB slowing its monetary tightening path, with rates still well below neutral.

Should this mean that ECB rates are rising more quickly than the US, this could ordinarily be seen as a basis for a turn in the euro. However, with growth disappointing and the ECB being pushed to hike into a slowing economy, it is less clear that a major turn in FX will be seen just yet.

Looking at the UK from overseas, there is a real sense that policymakers have managed to undermine confidence and trust in the country. This means that a permanent UK risk premium is built into prices as a result, given that the UK needs to attract foreign capital to finance its balance-of-payments deficit. There is incredulity at the Conservative Party selecting a leader even more unfit to lead than Boris Johnson and concern at how events may develop without a clear sense of a plan seeming evident.

UK assets stay in focus

Broadly speaking, some stability in UK assets may mean that the focus for markets will be what happens once emergency QE purchases are scheduled to end in the middle of the month, and thereafter what will happen at the next BOE meeting in November.

It may appear that liquidations from pension funds may be abating for now, and so emergency gilt purchases may be wound down, but we are sceptical that a plan to give the market a Halloween scare by starting QT on October 31st is the best idea just now. Nevertheless, our strongest conviction is that the BoE won't raise rates before its November meeting and when it gathers it will want to raise rates by much less than is currently priced in.

As previously argued, the UK housing market won't be able to withstand rates going to 5 or 6%. Moreover, the recent 'mini-budget' is likely to have done more to harm confidence and push the economy into recession, than it has done anything that will boost aggregate demand.

Although the fiscal commitments are huge, the biggest concern should pertain to the plans to cap energy prices at April levels, as that could cost the taxpayer as much as GBP150 billion over an 18-month period. Yet this measure helps mitigate, rather than boost inflation, and so it is not clear that the BoE should become much more hawkish in light of this. A much weaker pound is a risk.

However, the economic damage from much higher interest rates and mortgage costs could easily be much greater than that resulting from a slide in the currency, even if this is seen to be denting national pride. Furthermore, we think that if gas prices stay elevated, then there will be more moves to tax windfall profits in the power market and also steps to roll back subsidies on the better off in society, and this may ultimately mitigate some of the cost.

UK politics may be messy for some time to come, but there remains a path to muddle through as an economy, if the BoE does not add to government mistakes. A weaker pound and a steeper yield curve may be a price well worth paying to avoid crippling rate hikes and it seems unlikely that growth will lead to much in the way of demand-pull inflation pressure.

Early end conflct Ukraine not in sight

An early end to conflict in Ukraine would be one bright spot, which could materially improve prospects across Europe and worldwide. In the short term, there has seemed little prospect of this with Zelensky not prepared to have a dialogue with Putin, Ukraine troops scoring impressive gains in the battlefield and Russia raising the stakes by alluding to the threat of nuclear intervention.

However, the sense in Washington is that an end to war will come as a result of negotiations. This will be decided between Moscow and DC, with Europe largely irrelevant. For now, back channel talks continue but there is a sense that both sides are seeking to strengthen their position going into any negotiations. With fighting likely to slow into the winter, so the November G20 could be a point where a political breakthrough could come, yet for now, it is very difficult to position for this.

An early end to conflict and a hope for a Fed pivot could mean that Q4 is a happier quarter for investors than has been the case in 2022 year to date. Sentiment is bearish and so a year-end rally could be overdue. However, there is also a sense that the speed and scale of US tightening this year will inevitably expose weakness in the financial system and there will be things that break as a result. This may warrant some continued caution for now.

Meanwhile, it would make sense to us that for markets to turn, so inflation needs to be seen to turn first. With this happening, so it will be possible to project a top in rates and government bonds can stabilise. Thereafter, the outlook for credit may stabilise, with equities likely to be the last asset class to benefit.

Elsewhere, in credit markets volatility has remained elevated and liquidity impaired in the wake of UK pension fund selling pressure. This should start to abate in the days to come. Meanwhile Credit Suisse saw CDS spreads jump above 300bp, triggering financial concerns.

However, we see this more of a function of the stock price being depressed by the likely need for a discounted rescue rights issue, than any credit concern per se. Banks continue to look relatively well placed with rising margins offsetting credit impairments and balance sheets buffered by very strong capital reserves.

Looking ahead

Today's US payrolls report, followed by next week’s CPI, marks the two big data events in the month, and so there may be a clearer picture of how the economy is evolving in a week from now. Softer data suggesting a Fed pivot could help stabilise sentiment and suggest an improved outlook.

There is a sense that a lot of bad news is already embedded in market prices and with high cash balances, this may mean that markets are now more resilient. Yet with dollar cash soon yielding 4%, it is not clear that there will be as much of a burning need to put cash to work as may have been the case in the past.

Arguably investors have come into 2022 with more duration risk, more credit risk and more illiquidity risk than they have ever had before. Asset allocation is being rethought and scarring in the wake of losses may contain enthusiasm for some time to come. We are not yet at the end of the rate cycle and much of the global economy is in or moving into recession and so it is difficult to become too bullish.

Yet markets are forward looking and could well be overdue a bit of a bounce. Nominal US GDP is some 20% above pre-pandemic levels and this is reflected in corporate earnings. Financial asset prices may not yet be cheap, but they no longer appear that overpriced.

In contrast, spending pounds in the US can leave you feeling a pauper at the moment. Certainly paying USD18 inclusive of taxes for a single regular can of beer, in an average drinking establishment in DC this week, was the kind of sticker shock that really makes you want to drown your sorrows (even if you can't now afford to do so).