215. Why the UK stock, bond and currency markets hated the mini-budget

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Sam Slator (SS):

I’m Sam Slator from FundCalibre, and today I’ve been joined by Darius McDermott and Juliet Schooling Latter, to have a chat about what’s been happening in the markets in the last quarter. Maybe, we’ll start with what’s been happening in the last week or so? Today is the 29th of September. We’ve had quite a few big moves in stock, bond and currency markets, particularly in the UK, following the new Chancellor’s mini Budget. Perhaps you could explain to our listeners exactly what’s been going on please?

Juliet Schooling Latter (JSL):

Yes. Well, we live in interesting times, don’t we? So, sterling’s been weak for some time now, partly due to the strength of the dollar, and partly due to the uncertainty over the UK economy.

We have quite high inflation, which has caused the Bank of England to raise interest rates to combat it. On the other hand, we have a new government, which is attempting to stimulate the economy with a raft of new measures announced, tax cuts are designed to boost growth. The main issue with these new measures, is that the government’s got to borrow more, and hence the UK’s debt increases, and stimulating the economy is likely to fuel inflation.

So, sterling assets look less attractive, hence the pound falls further, and as the currency weakens, so we import more inflation, and round and round we go. Though the proposal to cap energy costs for businesses and households seems like a sensible one, because of the uncertainty about how high energy bills could rise, but, you know, that has to be paid for as well. And markets are now concerned about how the government will pay for this, given that we’re already at quite a high level of debt, post-covid.

Darius McDermott (DM):

Yeah, when we talk about the market, I think most people think about the stock market and you know, that’s perfectly reasonable. But there’s another market out there, it’s called the bond market and that’s government bonds, companies’ bonds, and wow, did the bond market hate the mini budget?!

So, we talked about Sterling. The other major factor is the ability of governments to borrow. And Jules has just talked about that borrowing to fund all these promises made in the mini budget, and that’s done via the gilts market. [A] Gilt is a UK government bond. And, I’m going to be approximating here, but the gilt market moved approximately one full percent on yield in one day. So, that means the yield has gone up. But, in bonds, when yields go up, prices go down. So, if you had a bond with a duration [to maturity] of say 10, you lost 10% of your capital in one day, by yields going up one full per cent.

So, this is really dramatic stuff – so dramatic that actually the Bank of England had to intervene in the gilt market yesterday to support it. The gilt market was basically broken yesterday morning. I’ve spoken to several bond fund managers and they [said] you couldn’t trade, because there was nothing trading. Prices [were] just falling on screen and they couldn’t sell anything, nor buy anything.

So, the Bank of England intervened, not something that [it] does very often. And the other point that Juliet makes is, you know, sort of the government’s doing one thing, which is throwing stimulus into the economy, at the same time when the Bank of England’s taking stimulus away, by raising interest rates, meaning our mortgage payments go up. And when rates go up, generally people spend less. So, it’s all very confusing, not just for listeners to our podcast, but it’s confusing for professionals in the bond market, and confusing for everybody.

The bond market really has not liked what’s gone on in the last week or so. They say a week’s a long time in politics, it’s not very long in the bond market; the last couple of weeks, it’s been horrendous.

So yeah, it’s [a] very, very challenging bond market. [The] Stock market also hasn’t liked it, but [the] stock market should be about companies as much as economies, and the bond markets, the gilt market is about the economy and the state of it, and it doesn’t like it.

(SS):

So, what now? Do we just wait for inflation to peak and hope for the best? What can investors do? Does the UK actually matter in the grand scheme of things? Or should we be looking more and focusing on the US and what’s happening there.

(DM):

I mean that’s exactly the point. It’s where you live, and you’re based. I was at conference yesterday, which was a big US firm and they have a big UK presence. And I think your view on inflation in the States, is quite different from your view on inflation in Europe. The major input in that, is energy; Europe is energy dependent, and the price of energy’s gone up multiple times this year, whereas the US actually produces energy and is not energy dependent.

So, I mean central banks, UK, Europe and US, are raising rates to try and get a hold of inflation. How much they have to raise rates to get there, is hugely up for debate. Some bond managers feel that rates will peak at six [per cent] in the UK, we’re only at two and a quarter today, [so] that’s another tripling. And I know lots of people are on fixed-rate mortgages and fair play if you are, but even those will eventually run out.

And we’ve just got used to cheap debt as a society, particularly individuals who were borrowing for 1% last year and now, you’re probably looking at four, or maybe in six months you might be looking at six.

So, it’s a hugely different environment for the consumer, for households. And where does it end? One doesn’t know.

But I’m always minded to think about why we invest, how long we are looking to invest for. And if you’ve still got a decent time horizon, I don’t think now’s the time to panic. I think, when we’ve talked about fixed income and bond investing on this podcast before, with [the] UK government, why would you buy a gilt [that] was yielding half a percent, when now you can buy the 10-year yield that’s yielding four and a half percent, or thereabouts? Actually, I’m getting paid. And now corporate bonds are yielding 6%. So, it definitely has bought fixed income back into our view of interest. Even though rates are going up and bonds go down, some of that is already priced into the market. The market’s pricing in 6% in the UK – interest rate. So yeah, it is definitely bond market; bonds are more attractive to us, and I think should start to come onto people’s radars, particularly if they want income.

(JSL):

Yeah, I think you’re right. The US and the UK are in very different positions at the moment. I think inflation in the US is sort of rolling over. My understanding is that the labour market is not so tight there. And, whereas in the UK here, as we’ve said, we’ve got this sort of, the Bank of England fighting to keep a lid on inflation. And you know, as well in the US, they’ve got a strong dollar, whereas as we’ve said, we’ve got weak sterling, which imports inflation and no signs, I think, of our tight labour market changing. So, you know, the danger is that wage inflation here becomes entrenched, and that means that the UK’s economic picture isn’t great.

But that being said, the FTSE 100 has actually been relatively resilient, because about 80% of the earnings generated by FTSE 100 companies come from overseas. So, they become more valuable as sterling declines.

And you’ll see the difference between the FTSE100 and the FTSE 250, which generates 40% of its earnings domestically, so that’s kind of been hurt a bit more.

So, you know, at the moment, the US economy looks much better, but the UK is really quite unloved. And I wonder if we’re going to start to see some M&A coming through in the UK, which could boost markets, because with the stock market being relatively unloved, and sterling being cheap, that’s a possibility.

(SS):

So, picking up on two things that you both mentioned there, one was sort of a view on government bonds at the moment. In the last quarter, the US high yield bond sector actually did best out of all bond funds and was in positive territory. What’s your view on perhaps high yield? And I’m quite surprised that they did well given concerns over recession. Does that basically mean that we don’t think the US will go into recession?

(JSL):

I think the jury’s out on that one. I think it’s likely to be a milder recession. And typically, with a recession, obviously defaults creep up, that’s what you have to worry about with high yield. But spreads have widened now, and you are now being paid better for holding these assets. The idea is, that hopefully if you invest with a good manager, they can avoid those which default, and you can receive a higher yield.

(DM):

Yeah, high yield is less correlated to the bond market. They are still bonds, [but] they tend to historically have more correlation with equities. So, they’re less sensitive to rates going up. And I think Jules is right – gosh, we’re agreeing for a change, [that’s] not like us – the US is likely going to go into recession, but it is likely to be less. And what does that actually mean for companies? So, high yield companies are companies with more debt and weaker balance sheets and weaker strength, so they have to pay a higher yield to borrow money from institutions. But the risk is that those companies go bust, and that’s called defaults, [the] default rate. So, high yield worries about defaults more than it does about rates, per se. And defaults have been at historic low levels because companies just haven’t been going bust. They haven’t had to go bust because of quantitative easing [central banks supporting the economy].

So, defaults are likely to go up (bad for high yield), but then high yield is still based on this spread [the difference between the yield on government bonds and the yield on other bonds] over government bonds, and if the base government bond has gone from nothing to four [per cent], and it has in the States – four, four and half [per cent] – high yield, everything [else] moves up [too] in the bond market, sort of collectively. I mean, good high yield managers? Absolutely. But high yield is again, an asset class that tends to do bad in recession, because companies go bust, and if you’ve lent to them, then you lose a decent chunk of your money. So, that’s where I think we are with high yield, at the moment.

(SS):

And, looking at other returns over the last quarter, Latin American equities and Indian equities have done well again, but I was quite surprised to see financials and both US and Japanese smaller companies in the top 10 sectors, in terms of performance. What can we read into those, perhaps starting with financials?

(JSL):

Well, financials typically do better in a rising interest rate environment. And interest rates are largely rising, globally. With economies around the world trying to keep a lid on inflation, almost 80% of major central banks are hiking at the moment. So, that is quite good for financials.

(DM):

I mean, there’s all sorts of different things at play. Latin America, I think, is probably a beneficiary of commodities.

India’s been the real standout market issue. Everything’s gone down, but India hasn’t, certainly in sterling terms anyway. And I think they took some serious reforms pre-Covid. Modi is still a very strong Prime Minister. He did the goods and services tax, and he got rid of all the sort of lower end bank notes, to try and stop corruption. So, they made a lot of positive changes. But the Indian stock market versus its own history, is now expensive.

We, on the funds that we advise on, have been actually taking some of our profits in India; they’ve done really, really well. Not much has done well this year, as we know, but India’s one of them. So, and Juliet covered financials. Latin America, I think is [a] commodity play and was cheap, and [as I] say, India has been a standout market, and fair play to them.

(SS):

But what about the US and Japanese smaller companies, [have you] got any thoughts on what’s happening there?

(DM):

Broadly to me, it’s counterintuitive, that small companies over the period have outperformed. Japan may be a bit of a reopening trade. Certainly domestic, you know, as Juliet said earlier, the smaller companies tend to be more domestic-oriented rather than larger companies, no matter where you’re based. Honda, Toyota, big, large companies in Japan, they sell a lot of stuff in Europe and America. But smaller companies tend to be more domestically focused. And Japan has had a long hard covid lockdown, and, as we will remember sort of more last year, you have that pent-up savings demand. So, that might be part of the reason, but it is generally counterintuitive that, in difficult markets that small companies outperform.

(SS):

And thinking about Japan, there’s some interesting things going on there as well at the moment. Could you elaborate on that a little bit for us, please?

(DM):

So, there’s another area where the bond market that, you know, the Bank of Japan are suppressing their bond yields by buying all their bonds. It’s a supply and demand game and it’s a balancing act. If they are unable to suppress the yields on their government bonds – having tried very hard to do so – if that breaks out of that range that they’ve currently got them controlled in, that would be a very bad signal for the global economy. It’s not what necessarily we expect, but this current month, September, a lot of the asset managers hold all their conferences, so we’ve all been out seeing different people, and that is something that worries everybody. And if Japan’s ability to suppress their bond yields breaks, that would be very bad for Japan and, and the global economy, and probably speed up the rate that we will go into recession.

(SS):

So, it’s been a pretty gloomy podcast so far. Is there anything good that’s happening that we can talk about?

(DM):

Well, everything’s cheaper! You know, [the] US at the start of the year was on 22 times PE [Price Earnings Ratio] forward earnings, it’s now on 17 times. It’s still not cheap, but it’s cheaper.

I think, talking to bond and equity managers in the last couple of days, they’re seeing more opportunities, because yields are higher. That’s more exciting for bond managers. The intra-day movement in bond markets have been so severe the last two weeks, there’s been money making opportunities. The other thing to say about global equities, is because the pound has been so weak, global equities have fallen less in sterling terms than they have in dollar terms. And we might see a big pickup in mergers and acquisitions, M&A, in the UK because our assets have got 30% cheaper this year because of the currency.

So, it’s not all doom and gloom and actually markets are already down. Stock markets and bond markets have had a terrible year. So, maybe we are looking at those rather than, you know, doom and gloom to come, because it’s already been a tough year. So, that would be the positive spin that one might be able to present.

(JSL):

Yeah, it’s hard, isn’t it? I mean things do look pretty gloomy right now. It’s pretty depressing when you look at the news generally, and when you are trying to find places to invest. I’m generally seen as the positive one on the team, and even I’m a little bit down in the dumps about things now.

But actually, as Darius says, that’s probably the time to be brave and invest, because actually if everybody’s nervous, then there’s probably a lot in the price already, I think, with a lot of investments.

So, you know, I always say it, it’s really boring, but I’ll repeat it again, drip feeding money in, when markets are going down, will pay dividends in the long run. And, as Darius says, corporate bonds are looking more interesting now, spreads have widened. And I saw a global corporate bond manager recently, you know, he was saying that you’re getting paid 5% now. And we’re talking sort of investment grade corporate bonds, so that’s something to look at.

(SS):

Yeah, I think Richard Woolnough, who runs the M&G Corporate Bond fund and the M&G Optimal Income fund, he said we’ve gone from TINA to TIAA, which is There Is No Alternative (to equities) to There Is An Alternative now because he was saying, there’s these opportunities in bonds and actually if you’ve got a multi-asset portfolio, bonds are now back and can start doing their job again, which they haven’t been able to do for a number of years.

(DM):

Yeah, well you weren’t getting paid to hold them. If corporate bonds, which have got company

risk – even if they’re stronger companies – were paying you two, two and a half [per cent] at the end of last year, and now the government bond is now paying six, it’s a decent yield, even if there is some volatility around the price. So, you know, I’m getting paid 6% to hold these assets now, whereas at [the] start [of] the year, we [were] getting two and a half. So, we tend to share Richard’s view that fixed income is becoming much more interesting now.

(SS):

Well, let’s hope the next three months are a bit more positive than the last three have been! Thank you very much for joining us again today. And if you’d like to listen to more of our podcasts, please go to Fundcalibre.com and don’t forget to subscribe via your usual channels.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.